How To Bring Banks In India Back To The Credit Market

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Which comes first: The chicken or the egg? This age-old riddle has sparked many arguments and the scientists are still in quest of the right answer, applying the principles of evolutionary biology.

The Indian banking community too, at the moment, is busy trying to solve a similar puzzle: What comes first — the credit or the credit-worthy borrower? With their backs to the wall, bankers do not find too many borrowers around who have the ability to pay back loans but the chorus for credit from every segment of the economy is getting louder by the day.

What are the bankers doing with their money – the public deposits in their kitty? They are parking that in the Reserve Bank of India’s (RBI’s) reverse repo window and earning a measly 3.75 per cent interest. The income is low but safe. Last week, the industry offered to keep between Rs7.2 trillion and Rs7.57 trillion a day on this platform.

To absorb the money, the RBI needs to offer government bonds as collateral, which it has in plenty at the moment. It can open another window to drain out or sterilise excess liquidity from the system.

That is a standing deposit facility or SDF where banks can park money. This instrument was recommended by the Monetary Policy Framework committee, headed by Urjit Patel, in 2014. Four years later, the 2018 Union Budget included a provision for the introduction of the SDF. To accept money through this route, the RBI does not need to put any collateral on the table. Most importantly, the SDF can offer lower interest rate than reverse repo, say, 3.5 per cent or even 3.25 per cent to the banks.

The RBI does not necessarily need to run out of securities (to offer as collateral) to start the SDF facility. It can do it even now, with the approval of its board. The 2018 Finance Bill says the RBI can accept money as deposits, repayable with interest, from banks or any other person under the Standing Deposit Facility Scheme, as approved by the Central Board, from time to time, for liquidity management.

The RBI gives money to banks through its repo window and a marginal standing facility or MSF. To get money from the repo window, banks need to offer bonds as collateral and, if they don’t have the collateral, they can get money through the MSF route, paying a higher interest rate. The positioning of SDF vis-à-vis MSF is identical to that of reverse repo vis-à-vis repo.

Of course, there are many other tools at the RBI’s disposal to release and absorb liquidity. For instance, it can buy and sell bonds in the so-called open market operations, raise or pare the banks’ cash reserve ratio or the portion of deposits the banks need to keep with the RBI on which they do not earn any interest.

Yet another instrument to sterilise liquidity is the market stabilisation scheme or MSS. Here, the RBI sells government bonds – outside the annual market borrowing of the government which bridges its fiscal deficit. Introduced in April 2004, MSS was used by the central bank initially to drain rupee liquidity arising from its dollar buying (for every dollar RBI buys from the market, equivalent amount of rupee flows into the system).

This can be revived but the cost for MSS is borne by the government unlike reverse repo and SDF for which the RBI incurs the cost. So MSS is clearly ruled out at this point. The RBI can cap the banks’ access to the reverse repo window and drive the liquidity traffic to SDF.

What purpose does this serve? Well, it cuts the cost of sterilisation. But more importantly, if the banks are risk averse and happy keeping money with the regulator instead of giving loans, the lower interest rate will be a disincentive. It may force banks to lend.

That’s the theory doing the rounds now. It may not help. We need to do more to break the risk aversion of banks.

Banks are not convinced how many borrowers – big, medium, small and micro– are genuinely distressed because of the impact of Covid-19 and how many are waiting to gatecrash and get the bank loan for other purposes. After the collapse of Infrastructure Leasing & Financial Services Ltd in 2018, along with others, Diwan Housing Finance Corp. Ltd too was in the queue for bank loan. It went bust later.

Simply put, banks are scared. Even if they give loans, many of the medium, small and micro units have eaten up their capital during the lockdown. Where will they get the equity? Should banks make the same mistake that they had committed in the past – substituting promoters’ equity with debt?

Then there’s the sword of Damocles hanging over the bankers’ head — all accounts exceeding Rs50 crore, if classified as bad loans, must be examined by the banks through a forensic audit from the angle of possible fraud.

The risk aversion in the Indian banking system is deep-rooted and the bankers do not want to make the mistakes they had committed to prop up the economy after the collapse of the US investment bank Lehman Brothers Holding Inc.leading to the global financial crisis. The RBI too should not become too liberal in offering forbearance to the banks, which it had done in the aftermath of the 2009 crisis.

However, since the present crisis is far more serious than what we had seen a decade back, it needs to be tackled differently.

The Preamble of the RBI Act sets its mission this way: “To regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” Exceptional times calls for exceptional actions. Why can’t the RBI take credit risk directly and buy corporate bonds?

The government, on its part, can offer a credit default guarantee up to a certain percentage of all new loans given to the critical sectors. It can also offer interest rate subvention to certain categories of borrowers.

Only concerted efforts by the central bank and the government can bring the banks back to the credit market. Along with the banks, the government and the RBI too must shed their risk aversion.

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