Thoughts & Ideas

Monday, September 05, 2016

Are High Interest Rates a Primary Reason for Retarded Flow of Bank Credit?

The Hindu dated 29th August 2016 reports, "Banks unaware of SME issues,says Nirmala Sitharaman”. It reports that our Honourable Commerce Minister is of the opinion that (1) our banks haven’t been understanding enough of SMEs, and (2) High interest rates for long. The article goes on to elaborate that the Honourable Minister feels that interest rates in India are too high which in turn is effecting adequate flow of credit to MSMEs. 

Mrs. Sitharaman seems to be as confused about the issues as the banks that she is criticizing. Well I agree with her that banks in India have little understanding of credit risk which retards flow of credit not just to the SMEs but across all segments of the economy - retail, agriculture, large corporate – you name it. This is reflected not only in the myriad problems faced by potential borrowers, but also in other phenomenon, such as high NPA levels, propensity to invest large amounts in Government securities (more than the minimum required, even though returns are low - at least the harried bankers cannot be accused of improprieties in lending decision – the safety of capital is ephemeral) etc. But laying the blame on high interest rates does not give the correct or appropriate perspective, and such misplaced reasoning hides the real reasons for various imperfections plaguing our banking system, which in turn prevents optimum solutions to emerge.

For a growing economy like India, availability of adequate and timely credit is more important than cost. However, subsidizing credit costs leads to various unhealthy (and unintended) consequences. First, since the subsidized credit cannot be catered to everybody it starts getting rationed, inter alia, through muscle and political power – the first step in ever increasing spirals of corruption. Second, once access to scarce credit is not on merits but through use of power, the incentive to service it (that is, repay the loans) is so much lower!  Third, since muscle and political power plays a largish role in access to credit, it is the larger and bigger social constituencies who corner the bulk of the credit. This in turn leads to higher & growing levels of income and wealth inequality in the country.  Related to this is that, not only the more powerful are able to preempt scarce credit and as such further improve their economic (and social) hegemony, since there is lower pressures on them to repay the loans they get double the benefit. Initially from getting access to credit and having larger capital at their disposal and subsequently by not having to pay for it! As is said in Hindi “dono haath mein laddoo”! 

The adverse effects of artificially lower interest rates on credit goes on to corrode the viability of our financial system in other ways. To be able to lend money, any financial intermediary has to first have access to funds to lend. These funds come from the savings of the society. Now to be able to keep lending rates low, financial intermediaries have to keep interest rates on deposits low to ensure sufficient cushion for themselves to survive. The fact the nominal interest rates on bank deposits, on the average, do not even cover inflation rates is brutally brought out by statement of Dr. Raghuram Rajan in his speech titled Policy & Evidence at the 10th Statistics Day Conference 2016, Reserve Bank of India held on July 26, 2016, wherein he stated, “Many middle class savers value the high nominal interest rates on their fixed deposits, not realizing that their principal is eroding significantly every year”.   The result is that millions of poor people lack mechanisms for storing their savings which is not just secure but also provides a hedge on inflation!  As is well said – the road to hell is paved with good intentions!

This unhealthy cycle is best illustrated in our cooperative credit system which has failed to live up to its potential (inspite of various studies and interventions so as to revitalize it) essentially due to extensive political interference and corruption led by subsidization of credit. Even though the nominal rates of interest on cooperative credit may not be directly subsidized, the fact that the State Governments have year after year kept on underwriting the losses of the cooperative credit societies and are expected to continue to do so, provides enough perverse incentives to politicians of all hues to seek continuation of this vicious cycle. Is it any wonder that the cooperative credit system in India produces the most corrupt politicians?

This lack of understanding as to what constitutes credit risk and how to manage it, is reflected in the ever increasing procedures, prolonged delays in approval, all kinds of impractical terms of approval, demand for collateral security, specialized techno-economic feasibility studies, audited financials and of course Credit Approval Notes which resemble PhD thesis and not a tool for arriving at a rational credit decision! Bankers try desperately to hide themselves behind such smoke-screen since they do not know better, but it is of little avail. The entire burden of mush misfeasance eventually falls on us in terms of slower economic growth and an increasingly unequal society manifested in increasing crime and social dislocation.

The workings of the financial system are subtle and diffuse, but its effects are profound and direct on the real economy. There is need for more careful and deeper understanding of its functioning in the design and construction of a vibrant financial system which would lead to a better India. Just blaming high interest rates is simply playing passing the buck.

Tuesday, July 19, 2016

Appreciating Micro-Finance

The Hindu dated 20th July 2016 published a news article titledDue diligence by MFIs vital”, while reporting on the National Summit on Microfinance organised by Assocham in Hyderabad. While due diligence in any borrowing / lending situation is essential, the way MFIs go about doing this, which is much in variance to the practices followed by regular banks, is what makes them special. Not only are the practices developed and followed by MFIs different, they are cheaper and more effective. Let us see how this happens. 

In any borrowing / lending situation, if the lender (reasonably) expects the borrower to repay principal along with interest, the lender has to assess the ability and the intention of borrower to repay.  After the funds have been lent, the lender has to monitor the continued ability of the borrower to repay. Even with the best and most detailed appraisals / due diligence and other precautionary measures including insistence of collateral security, it is not necessary that the borrower would be in a position to repay the borrowed funds. And this is not because borrowers are inherently dishonest (in fact most borrowers are quite honest – at least more than the average banker).  The future is uncertain and circumstances change due to weather patterns, change in tastes, government policies etc. which often creates genuine difficulties in making repayments as per agreed terms.

Assessing the ability and the intention of borrower to repay and continued monitoring of loans is a costly and time consuming exercise (known as transaction costs). Moreover, where the loan size is small, the transaction costs as a proportion of loan size increases exponentially making small loans costly and unremunerative for regular banks.

Micro-finance seeks to solve this problem of high transaction costs by some innovative, by now well established techniques, which virtually does away from having the lender to do detailed (and costly) loan evaluations and monitoring. Some of these techniques include:

a)   Group lending: Small closed knit groups have a quality whereby the borrowers know each other well. So lending to groups who have self- selected themselves ensures that the group does both the appraisal and monitoring. Peer group pressure replaces due diligence by banks.
b)   Loan repayments aligned to the cash flows of the borrower rather than convenience of the lender, say through daily or weekly collections.
c)  Reducing costs to borrowers in terms of ease and reduced costs of transactions through standardized minimal paperwork, centralized collection points which is more convenient to borrowers, doing away with bribes or middlemen etc.
d)   Doing away with the distinction of loans for productive purposes vs consumer loans. One of the most interesting and useful characteristics of money is its fungibility (its raison d’etre). That is, command over money enables a person to use it for any purpose for which he desires. Therefore, after the money is lent it is difficult to trace its end use. Even if the loan draw-down is made directly for the purpose for which it has been approved, monitoring end used is difficult and costly. A borrower with a hungry child or a sick parent / wife cannot be faulted for using the funds at his disposal for his immediate pressing requirement than the purpose for which the loan was approved.
e)   Building incentives for regular repayment in the loan contract itself. Say by giving a small loan with promise that in case it is repaid regularly the borrower would become eligible for a (slightly) larger loan.
f)    Realising that making available safe, secure, reliable, and easy means of small savings are often much more important than making loans for large parts of the population.

Over time, MFI have developed a host of such techniques which have proved their worth in enabling larger flow of resources to the small and micro end of the financial markets. Traditional banks by temperament and structure have been unable to address this critical requirement. Reasons are many and complex, and this short monograph will not even attempt to address it!

It is sad that the news article did not reveal if the National Summit on Microfinance even discussed these very important and relevant aspects of this industry.

Sunday, February 07, 2016

Whither or Wither Indian Banking?

The news article, Govt., regulators must take blame for NPAs: SBI chief, in The Hindu (issue dated 13th January 2016) reported that Mrs. Arundhati Bhattacharya, the Chairperson of SBI, in course of delivering the ASSOCHAM Foundation Day Lecture was of the opinion that the blame for banking industry’s high (and rising?) NPA levels should not be limited to them but all stakeholders should share the blame. This seems to echo the old saying that, “To err is human but to blame it on the other guy is politics”. Mrs. Bhattacharya tries to pin down the other principal stakeholders with specific examples for the increasing levels of NPAs in the banking sector. Specifically, according to her the rising level of NPAs were due to (a) promoters bidding aggressively on the back of good times and some of them were diverting funds, (b) the regulators were letting banks make loans with tenors of as much as 30 years, and (c) the Govt. was permitting policy uncertainty to continue. 

Such a view point either reflects poor knowledge of the role and function of banks and other financial intermediaries in society, or amounts to a clear repudiation of responsibilities by the banking profession in India. Coming from the Chairperson of SBI, the chances of the first possibility is low and that is the reason I find the views of Mrs. Bhattacharya disturbing. Unless, of course, she is preparing herself for a career in politics.

The incidence of NPAs in the banking system is akin to a manufacturing organisation making defective products. Manufacturing organisations set up quality control systems which encompasses design of appropriate manufacturing processes, quality control of their raw material or sub-assembly suppliers, correct operation and control at each stage of the manufacturing process till production of the finished product. The quality is further tested as the product is used so that the quality can be further improved / costs brought down. For achieving consistently good quality products it is therefore essential for the quality control mechanism to be functioning well throughout the production process.

One of the key functions of banks is to produce loans of consistently good quality and the production process in this context consists of having an appropriate conceptual framework for lending, selecting suitable people with the required skills, giving them adequate and good training, understanding how or why credit risks arise and having clear laid down credit management policy, having a suit of loan products which are in line with the requirements of the potential borrowers and the risk capabilities of the bank, a not too cumbersome loan documentation process (this is extremely tricky since workable debt contracts cannot be complete contracts), monitoring the loans once it is made, and taking corrective action as and when required, entrapping the cash flows etc. All these taken together would ensure a high probability that the loans made are repaid at the time and on the terms agreed at the outset.  Failing which, banks have to have sound processes for recovering loans which go bad inspite of taking all possible measures earlier. Incidentally, RBI’s concerns on controlling NPAs seem also restricted on recovery rather than ensuring that probability of NPAs occurring is reduced. But this is another long story which I will save for another day. As such, one can safely conclude that the high and rising levels of NPAs in banks in India is a direct result of the failure of the banking industries quality control processes.

Keeping NPAs low for banks is critical for various reasons. First, NPAs deliver a double whammy to the bottom line of banks by reducing the quantum of interest earned (main source of income for banks) while simultaneously having them to make provisions (from profits and if that is insufficient from capital) for the principal amount of bad loans. Second, banks being highly leveraged entities have much lower room to maneuver fall in operating margins, something rising NPAs result in. Third, by affecting ability of banks to provide liquidity services to the real economy (since the quantum of lending possible by banks is inversely proportional to rising NPA levels) the income and employment opportunities in the economy start getting drastically curtailed with rising NPAs in the banking industry. Finally, banks hold the institutional memory of credit history of all the actors in the real economy in their records. This institutional memory is hard and very expensive to recreate once lost. When NPAs become so high that a bank has to be closed down, this memory is as good as lost forever. This in turn leads to a break in the payment cycle to and from the various players in the real economy, and hits the real economy really hard by drastically reducing both income and employment opportunities in the economy. This is the primary reason that no society (or its government) can afford even the smaller banks to close down, leave alone the big ones.  

Coming back to the specific issues mentioned by Mrs. Bhattacharya, it is the role of promoters and entrepreneurs to be optimistic about the future without which no society can operate, leave alone grow. And it is the role of banks to appraise loans so as to avoid adverse selection of potentially bad loans. Similarly, design of monitoring mechanisms in loan contracts should ensure that moral hazard problems arising from diversion of funds is avoided by raising early warning signals. I wish somebody had asked Mrs. Bhattacharya in that august gathering the reasons for banks not being in a position to fulfill these basic responsibilities. Isn’t appraising loans and monitoring them, including design and insistence of restrictive covenants, an essential part of credit risk management function of banks?

Mrs. Bhattacharya reportedly also mentioned that “Banks extended loans for long duration as much as 30 years while hoping funds would be recovered in 10 years”. I am not sure what she meant by saying this. A 30 year loan would have a 30 year repayment, it cannot be a 10 year loan nor a 40 year loan (unless restructured).  If it has a call option after 10 years, it becomes a 10 year loan if the call option is exercised but remains a 30 year loan if the option is not exercised.

This brings us to another key function of banks which is to address the maturity mismatch between deposits and loans, ie, its principal Liabilities and Assets. This function enables raising funds from, say, millions of small Saving Bank accounts for making large, longer term loans and investments with both the depositors and the borrowers being better-off, even after the bank as financial intermediary makes a decent profit in the process. This kind of maturity mismatch does create the problem of Asset-Liability management which can lead not just to Interest Rate risk (hits profitability of banks), but to severe liquidity problems (survival of the bank itself may be endangered). But it is part of the banking game which all bankers play all the time. Interest rate risk can be substantially covered by having floating rate interest rates on both deposits and loans. Since interest rates on deposits are sticker than that on loans, there always remains a certain quantum of residual interest rate risk on the bank’s books. However, if banks consider themselves as going concerns (and not gone concerns!), they can work out the risk of having a large Asset / Liability mismatch for a small portion of their total deposits without the overall risk being too large or unmanageable. This would enable financing long gestation projects while the bulk of the funding remains from short term sources. These are the basic skills of the banking profession and I hope Mrs. Bhattacharya does not mean that SBI lacks it!

Handling the credit risks arising from policy uncertainty by the Government is also a skill a banker brings, or is supposed to bring, to the table. This can be handled in various ways, say, by insisting on government guarantees (lazy banking), specifying low leverage levels, or innovative design of loan products (take out financing / refinancing / securitizing loans etc.), restricting the size of portfolio subject to such risks etc.

The disfunctionality of the Indian banking system is neither limited nor reflected solely in the high and rising level of NPAs, but is endemic in nearly every aspect of the industry. It is evidenced by large scale mushrooming of Ponzi schemes in which small depositors keep their hard earned savings with finance companies in the hope of getting a return which would not be negative in real terms because the banking system does not offer them a feasible alternative. Or, the difficulties faced by the smaller end of the market in getting loans which results in incidents like the call money racket recently in TS & Andhra, or the bad name brought on the micro-credit segment by a few unscrupulous operators. In practice it is a myth that private financiers are more expensive than our regular banking players if the transactions costs for delays, paper-work, bribery and worse are factored in. Even opening a simple deposit account at any bank requires tonnes of paper-work which can be quite intimidating (I had to fulfil KYC requirements to continue using by SB account which had been satisfactorily conducted for more than 30 years!).

Banks evolved by providing payment mechanisms to society. Even in this basic function the sheer inefficiency is sought to be remedied by having separate payment banks, inspite of the development negating the concept of economies of scope which is one of the key strengths of financial intermediaries like banks.

Ultimately, the problems being faced by the Indian banking industry can be traced to ineffective, backward looking top management. Unfortunately, the price is being paid by all Indians by way of difficulty in conducting their banking transactions, having few avenues of investment of their savings which give a decent positive real return at acceptable levels of transaction costs, or avoiding wading through a tsunami of paperwork in getting any kind of credit facility.