Home / Opinion / Columns /  Opinion | Time for govt, RBI to rethink bank architecture

If a tweet was all that was allowed to understand the Reserve Bank of India’s (RBI’s) announcement on Friday, it would read like this: RBI says ‘lend’ to banks. Banks say: you are safer, we keep our money with you and big companies that are already liquid. RBI reduces the interest on money banks keep in the central bank (reverse repo down by 25 basis points), RBI gives 50,000 crore to banks through targeted long-term repo operations or TLTRO 2.0, and another 50,000 crore to Small Industries Development Bank of India (Sidbi) and National Bank for Agriculture and Rural Development (Nabard) to lend to microfinance institutions (MFIs) and non-banking financial companies (NBFCs).

Banks globally have a problem. They are not transmitting the money that central banks are providing to businesses that need the money. Imagine that the world has been put into a business coma as we wait for the pandemic to recede. But during this time, the oxygen and basic nutrition needs to be given to keep the patient alive—money to pay rents, interest and salaries is needed by firms to just stay alive. Firms and tiny entrepreneurs need to borrow to stay afloat. Banks typically lend to the larger part of the market and NBFCs and MFIs to the rest—they provide the last mile that banks do not.

The US Federal Reserve has taken to buying corporate bonds directly rather than through banks. RBI has not gone that far, but is using its firepower to nudge banks to lend to those who are credit-worthy and who desperately need the money. It has done two things to facilitate this. One, it has further reduced the reverse repo rate.

This is the rate at which banks lend to the central bank—they keep their surplus money with the RBI and get some interest on it. Banks borrow from RBI at the repo rate, which is 4.4% right now.

A few weeks ago, the central bank had reduced the reverse repo by a larger percentage than the repo to decrease the incentive to banks to keep money with RBI, but found that as on 15 April, banks still had almost 7 trillion with the RBI under this window. Today, RBI has cut the reverse repo by another 25 basis points to 3.75% to increase the difference between the borrowing rate and the lending rate, hoping that this makes banks lend to firms, rather than keeping their money safe with RBI even though it earns a fraction of what banks can get outside. The difference between the rate of borrowing and lending is now 65 basis points.

Banks are displaying deep risk aversion—the desire to keep their capital safe rather than risk investing in investment-worthy bonds. The first round of money put into the system through TLTRO 1.0, brought 1 trillion.

TLTRO is long-term (one-to-three years) funding to banks at the repo rate or a short-term rate. Banks took the cheap loan and lent to high-rated public sector units (PSUs) and AA-plus firms—essentially entities who had enough liquidity. The money did not find its way to smaller and medium firms, NBFCs and MFIs—entities that actually reach the last mile.

RBI today has put another 50,000 crore as part of TLTRO 2.0. Banks can only get this money if they lend to NBFCs and MFIs. For A and A-minus (these are still investment-worthy) bonds issued by firms in these sectors, banks stand to get a return of between 10-14%. Banks are borrowing at 4.4% and have the option to lend at a multiplier. That is the incentive given by the RBI to get money down the pipeline. Lose 65 basis points if you seek safety of money with the RBI or stand to gain almost 6-10 percentage points in interest if you lend. It remains to be seen if banks take this nudge and begin lending to lower than the highest safety bonds.

Two, another 50,000 crore is being provided as refinance to three institutions (Sidbi, Nabard and National Housing Bank) that reach the small-scale firms, rural sector, housing finance firms, NBFCs and MFIs. Again, this should help money reach the last mile.With transmission, or the liquidity given by the central bank not going down the line, maybe this is a good time for the government and the RBI to rethink its bank architecture. Clearly, there is too much competition at the top end of the market—everybody wants the safe paper and deals.

There is very little action at the middle and lower end of the market. The development of a robust corporate bond market will help. So will the setting up of an early alarm system as proposed by the Financial Resolution and Deposit Insurance (FRDI) Billto prevent a financial firm failure, take the whole system down. The global coronavirus pandemic is an opportunity to smash through the existing incumbents and equations to rebuild banking and lending infrastructure. Both the finance ministry and the central bank should use the crisis to bring about deep changes in the way Indian banking has worked. Actually, not worked.

Monika Halan is Consulting Editor at Mint and writes on household finance, policy and regulation.

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