The RBI Discussion Paper on large exposures is timely and pragmatic as it comes at a stage when there are three pressing concerns about the financial system.
The first is the efficient use of capital where bank funds should be made to work better, especially since we are into Basel III where the norms are more stringent. The second is the systemic risk that has entered the system, which is manifested in the creation of NPAs and restructured assets. This problem is acute as large exposures to specific companies and corporate groups has posed a growing threat for banks, with those in the public sector being affected relatively more acutely. The third is the absence of alternatives for borrowers who perforce access banks and supplement the same with external borrowings, which has its own set of issues.
The difference between the existing and proposed guidelines is quite straightforward. A bank can, from January 2019, lend not more than 25% of its tier-1 capital to a company or a group, unlike the current situation where a company can access a maximum of 25% and a group 55% of total capital of the bank. The concept of capital, too, has changed and been narrowed down to tier-1 instead, which makes sense given that Basel III is all about higher and stringent capital conditions with focus on tier-1 capital. Last, the concept of “group” has been widened from a genetic relationship to also one of economic interdependence.
The question that can be posed is whether such restrictions come in the way of lending for a bank? The answer is that it does, but given that they are dealing with public money for which RBI and the government are finally responsible, there have to be prudent standards for lending.
Banks, on their own, have not fared too well on this score, and while RBI has pointed out that group exposure levels have not come close to the limits in most cases, it is always better to be prudent. Thus, any such guidelines have to be treated as being necessary to ensure the solvency of the system and lower the incidence of crisis-like situations, which is what sound regulation is all about.
In fact, an extension here would be that RBI should periodically reveal the vulnerable sensitive sectors that have been moving towards the NPA thresholds so that banks are warned about increasing their exposures in these areas. This will be a logical corollary of the proposed move so that there is a continuous flow of information from the central bank to the commercial banks. Currently, the identified sectors are mining, textiles, steel, infrastructure and aviation. By providing such signals, RBI could make banks more discreet with their lending. Maybe at an advanced stage, RBI could also have such limits set for sectors and hence move beyond the “group” concept. This is so as often problems are more sectors-specific, which should be eschewed.
The goal of such a move is to develop alternative sources of funding from the market. Companies that seek a larger quantum of funds will not be able to access the same from the banking system, and would progressively move over to the corporate bond market. Today, the market is restricted to mainly private placements with banks and financial institutions being the major borrowers. This equation is bound to change as companies will enter this market in a big way.
Markets are more efficient as they reduce the cost of intermediation. But relying more on this system will also mean that there have to be safeguards built and this is where credit rating agencies (CRAs) will have a major role to play. The information asymmetry that exists in any financial deal has to be efficiently bridged by them. Currently, the idea of having a bank intermediate is to use its superior knowledge to evaluate projects and channel deposit money to credit. With direct interaction between the investor and the borrower, the CRAs will play a critical part in the development of this market. An unbiased credit opinion from a third-party does add valuable information for the potential investor.
The move by RBI is hence very pragmatic as India is at a stage where large doses of investment will be required for funding growth. The banking system is clearly not in a state to provide support, and as a large number of projects would be in the infra space, the maturity tenures would create asset-liability mismatches. Rather than have some banks taking on this onus—which can jeopardise the system in times of a crisis—it is prudent to spread out the risk across markets. The same holds for short-term finance, where the commercial paper market can be accessed by companies which are also cheaper. RBI has spoken of having medium-term notes of 3-5 years which will add variety to the market by widening the options available.
This entire approach will also bring about better management practices from corporates once they are to be judged by the market, especially when there are limits to the comfort received when borrowing from banks. Given that there is generally a tendency for higher-rated bonds to elicit investor interest, we could hope moving towards a more prudent and robust financial system over a period of time. This model works fine in several developed countries, and if the cliched dots are connected, we could be there by 2020.
The first is the efficient use of capital where bank funds should be made to work better, especially since we are into Basel III where the norms are more stringent. The second is the systemic risk that has entered the system, which is manifested in the creation of NPAs and restructured assets. This problem is acute as large exposures to specific companies and corporate groups has posed a growing threat for banks, with those in the public sector being affected relatively more acutely. The third is the absence of alternatives for borrowers who perforce access banks and supplement the same with external borrowings, which has its own set of issues.
The difference between the existing and proposed guidelines is quite straightforward. A bank can, from January 2019, lend not more than 25% of its tier-1 capital to a company or a group, unlike the current situation where a company can access a maximum of 25% and a group 55% of total capital of the bank. The concept of capital, too, has changed and been narrowed down to tier-1 instead, which makes sense given that Basel III is all about higher and stringent capital conditions with focus on tier-1 capital. Last, the concept of “group” has been widened from a genetic relationship to also one of economic interdependence.
The question that can be posed is whether such restrictions come in the way of lending for a bank? The answer is that it does, but given that they are dealing with public money for which RBI and the government are finally responsible, there have to be prudent standards for lending.
Banks, on their own, have not fared too well on this score, and while RBI has pointed out that group exposure levels have not come close to the limits in most cases, it is always better to be prudent. Thus, any such guidelines have to be treated as being necessary to ensure the solvency of the system and lower the incidence of crisis-like situations, which is what sound regulation is all about.
In fact, an extension here would be that RBI should periodically reveal the vulnerable sensitive sectors that have been moving towards the NPA thresholds so that banks are warned about increasing their exposures in these areas. This will be a logical corollary of the proposed move so that there is a continuous flow of information from the central bank to the commercial banks. Currently, the identified sectors are mining, textiles, steel, infrastructure and aviation. By providing such signals, RBI could make banks more discreet with their lending. Maybe at an advanced stage, RBI could also have such limits set for sectors and hence move beyond the “group” concept. This is so as often problems are more sectors-specific, which should be eschewed.
The goal of such a move is to develop alternative sources of funding from the market. Companies that seek a larger quantum of funds will not be able to access the same from the banking system, and would progressively move over to the corporate bond market. Today, the market is restricted to mainly private placements with banks and financial institutions being the major borrowers. This equation is bound to change as companies will enter this market in a big way.
Markets are more efficient as they reduce the cost of intermediation. But relying more on this system will also mean that there have to be safeguards built and this is where credit rating agencies (CRAs) will have a major role to play. The information asymmetry that exists in any financial deal has to be efficiently bridged by them. Currently, the idea of having a bank intermediate is to use its superior knowledge to evaluate projects and channel deposit money to credit. With direct interaction between the investor and the borrower, the CRAs will play a critical part in the development of this market. An unbiased credit opinion from a third-party does add valuable information for the potential investor.
The move by RBI is hence very pragmatic as India is at a stage where large doses of investment will be required for funding growth. The banking system is clearly not in a state to provide support, and as a large number of projects would be in the infra space, the maturity tenures would create asset-liability mismatches. Rather than have some banks taking on this onus—which can jeopardise the system in times of a crisis—it is prudent to spread out the risk across markets. The same holds for short-term finance, where the commercial paper market can be accessed by companies which are also cheaper. RBI has spoken of having medium-term notes of 3-5 years which will add variety to the market by widening the options available.
This entire approach will also bring about better management practices from corporates once they are to be judged by the market, especially when there are limits to the comfort received when borrowing from banks. Given that there is generally a tendency for higher-rated bonds to elicit investor interest, we could hope moving towards a more prudent and robust financial system over a period of time. This model works fine in several developed countries, and if the cliched dots are connected, we could be there by 2020.
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