Banks harbingers of financial instability

The government in a recent carefully worded statement announced that it would amalgamate Dena Bank, Vijaya Bank and Bank of Baroda, which would make the combined entity the third largest bank in India.

The debate as to whether this is amalgamation or merger and which of the three banks would benefit the most from it will go on for sometime. Some experts feel that this will be followed by more such amalgamations and lead to consolidation in the banking industry.

There was also news that rating agencies ICRA and CARE had downgraded the rating of debt securities issued by Infrastructure Leasing & Financial Services (IL&FS) papers sharply to D (Default). This has opened a Pandora’s box, leading to redemptions of non-convertible debentures (NCD) of housing finance company DHFL by DSP Mutual Fund, triggered by speculation of likely downgrade of DHFL’s NCDs, too. Had our ‘Lehman moment’ come soon after the 10th anniversary of the collapse of Lehman Brothers on September 15?

Banking or economics 101: banks are intermediaries that “accept deposits for the purpose of lending”. And, in the process of taking money from savers and giving it to borrowers who are in need of them, banks create money many times over and add to the money supply in the economy.

The regulator knows that the amount of credit or money supply the banks can create depends on the money multiplier. The money multiplier is the reciprocal of the reserve ratio. If the reserve ratio — which in India is cash reserve ratio (CRR) and statutory liquidity ratio (SLR) — is 20%, or 1/5th, the money multiplier is five. It means that banks can create money five times the original money supply.

If the central bank feels that there is excess money supply, it will increase the reserve ratio to 25%, and the money multiplier will decrease to four — banks can now create money by four times only. Like any other central bank in the world, the Reserve Bank of India (RBI) also controls the money supply by varying the reserve ratio.

While this is a traditional textbook description of what banks do, what it fails to explain is that banks could also make economies unstable. The textbook definition failed to predict or explain the global financial turmoil of 2008.

Banks can create financial instability in an economy when they lend money. That financial instability is inherent in the way banks lend money to retail and corporate customers has been wonderfully explained by former chairman of Britain’s Financial Services Authority Adair Turner in his book “Between Debt and the Devil: Money, Credit and Fixing Global Finance”.

Turner says that when banks lend money to households and firms not for productive investments but to primarily finance purchases of real estate that already exists, they drive up asset prices, prompting banks to create still more debt for the same and create a bubble.

The classic example is Bengaluru itself, where real estate prices went up exponentially after the banks and housing finance companies (HFC) started giving loans to build or buy homes and even for vacant sites. When banks lend, they not only create money but also create “demand” for real estate or consumer durables where there was none before.

What is worse is the RBI making home loans part of ‘priority sector’ lending and coaxing banks to lend more to this segment, leading to spiralling of real estate prices. Fortunately, a subprime mortgage-like crisis of 2008 may not happen in India as long as banks here do not bundle home loans to create exotic mortgage-backed products and sell them at higher price to prospective buyers.

There are also other factors, like stringent norms on bad loans (non-performing assets, or NPA), which was around Rs 10 lakh crore or 11% of total loans as on March 31. The tough NPA norms have resulted in 11 banks being brought under a Prompt Corrective Action framework. The PCA restricts their ability to lend. While this is the case with public sector banks, RBI also has issues of divergence of NPA reporting with many private banks, too.

Is there a cure?

Unfortunately, as long as banks exist and as long as they have the infinite capacity to create money, financial instability is “hardwired” into the financial ecosystem. Financial instability is something that all of us have to live with. The only thing that analysts tell us after every financial crisis is that “this time it’s different”.

Turner argues that the ability of banks to lend against deposits should be curtailed for the sake of future financial stability, a prescription that may sound too radical and harsh. However, Turner demolishes the notion that regulators and academics have of ‘Financial Innovation’ — that they should be welcomed and encouraged because these products result in “price discovery” and efficient “risk allocation”.

(The writer is with Manipal Academy of Banking, Bengaluru)