How Safe are our Banks: October 25th 2008: DNA

The only way to ensure secure banking is to have strong prudential practices in place
The US government’s decision to take stake in the private institutions following the financial crisis has been interpreted as a move towards nationalisation. This, it has been said, is a clear vindication of the view that capitalism in the current form delivers greed under the veil of efficiency. India, fortunately has not been affected because we were conservative, and probably wiser, on hindsight. Is this feeling of security really justified or is it misplaced?
The recent scare that was caused by possible problems with ICICI Bank got the FM and the RBI to jointly vouch for the strength of the bank. This should make us stop and think. Are we really secure in a flattened world? And, in case things really went wrong what could be the consequences?
To the question as to how safe are our banks, there’s no clear answer. Nobody ever expected that the high growth in mortgages in the USA which were dressed up as securitised assets was actually an explosive waiting to be detonated. The fall of Bear Stearns and other investment banks was a result of something which went wrong which no one expected would go wrong, which is the case with all financial crises.
The RBI was prompt to get the banks to reveal their exposures to Lehman, but Lehman is just the tip of the proverbial iceberg. The fact that banks do take on large exposures in non-fund based activities is worrisome. When a bank lends money directly for a project, the risk is known. When it provides support to a derivative instrument or lends to another institution which has exposures to such instruments, then it loses that many degrees of freedom. In a quest to earn more non-fund-based ‘other income’ banks actually built up contingent liabilities which run into multiples of their own balance sheets, which is a concern.
However, there are other ticklish issues which have surfaced in the name of competition wherein banks have been chasing the customer to credit cards and mortgages. This was the route taken by several private banks to garner a greater share of the retail pie, as wholesale credit was not growing fast. Banks pitched for retail loans which looked good because they were small tickets and all could not default at the same time — but this did happen in the US which germinated the present financial crisis in the form of the sub-prime crisis.
Credit cards can be explosive as even today they are being provided indiscriminately to customers over the phone or outside the airport without any due diligence. These cards have spread quite swiftly increasing consumer spending and one is not sure about the defaults.
The message is that there are booms and busts for every phase of economic activity. It has been seen in manufacturing, in construction and there is no reason for it not to happen in the banking sector. That the RBI has been conservative has helped, but the regulator must monitor banks closely.
From the point of view of the deposit holder, the natural question raised is as to what would happen in case a bank went down under? If the bank was small, then the RBI could take care of it easily with a merger that took care of the depositors’ interest. But what could be done if a bank with a balance sheet size of Rs400,000 cr goes down? Deposit holders today are insured for Rs 100,000 and quite clearly, this needs to be enhanced. But here again the problem is that if say Rs250,000 cr of deposits have to be paid by the insurance company, where will the money come from? Secondly, a large bank cannot be merged with another one given the size involved — a failed large private bank might make another go down under the burden of the losses.
Given that there is no easy solution, the question of government participation in banks becomes relevant again. Public sector banks provide more confidence to deposit holders. Less than a decade ago Dena Bank, Allahabad Bank, United Bank and UCO Bank were in deep trouble — but no one withdrew their money because they are owned by the government.
However, a rumour regarding the stability of ICICI Bank started a run on the ATMs. It may make sense for the regulator to have a nominee on the boards of private banks (this may lead to several groans) so that someone responsible knows what is happening.
Commercial banking is a mundane business and as one is dealing with public money, the deployment of such funds must be judicious. Capitalism espouses creative destruction of institutions, but when the subject is banking it cannot be permitted. The only solution is to have strong prudential practices in place, and hope that things do not get out of control.