Thoughts & Ideas

Tuesday, September 24, 2019

On PSU Bank Merger - Missing the Woods for the Trees

Mr. Krishnamurthy’s spirited views on how the proposed merger of PSU banks be handled (The Hindu, 24th September 2019 - Makingthe grand Indian PSB mergers work) seems akin to a typical response in banks where loan appraisal notes are prepared after the decision to sanction a loan has been made so as to ensure smooth and hassle free disbursement without leaving any trace of the indiscretions on those who have to implement the decision!

It also raises some interesting questions.

First, does the merger move demonstrate the lackadaisical approach of policy planners? There is a one word answer to that. NO, in capital letters without any spelling mistakes. Irrespective of persuasion or ideology it is always in the interest of the ruling political class to keep control of the key financial intermediaries firmly in their hands. In India this has ensured, on one hand control over sanction of freebies in the form of cheap & directed credit and loan waivers to key players (read that as local politicians and strong-men) in the mass market which in turn enables them to get the votes in required numbers to win elections. On the other hand, it has helped steady and assured funding to key businessmen and industrialists who in turn finance and grease the political machinery. Merging the PSU banks by reducing the numbers would enable easier control on both sides of this game. It is as simple as that! This is also the main reason why some of the key recommendations over the decades have been blissfully ignored. Such as disbanding of Department of Banking (Narasimham I), more care in selecting top executives (Nayak – short-listing was opaque and typical interviews were virtually a shame), or the continued operations of BBB in selecting top executives from the same jaded cohort and no progress in recruitment of competent and professional for Bank Boards.

Second, was the key concern about announcing the merger lack of clear articulation of the rationale behind bringing disparate and weak banks together or the desperate need to announce some mighty sounding changes so as to dampen the effects of other disturbing information about the economy? Is it just a coincidence that the merger was announced about 1 hour after the latest GDP numbers were announced?

Third, as far as efficiency gains or improvements are concerned, why does all discussion get stuck only at the high NPA levels? Net profits in banks is arrived at by first deducting operating costs and then provisions from net interest margin. Staff costs of PSU banks as a percentage of Operating Costs is 3 to 4 times that of their private sector counterparts. Now since staff in PSU banks are not on the average paid 3 to 4 times that of private sector banks (not even by a very long shot), it should be obvious that a major reason for the lower profitability is also on account of high staff costs on account of low staff productivity. The underlying reasons could be low morale, outdated and redundant operating procedures, low skill levels, over manning etc. Somehow this aspect, that proximate cause of low profitability in PSU banks is also due to low staff productivity, hardly finds mention in any discussion.

Fourth, the narrative does not explain the high NPA levels at par with PSU banks in many high-profile private sector banks (both existing and those who have become history) or some well-known and established foreign banks. Could there be some other underlying reasons such as an outdated conceptual framework or misplaced regulatory priorities under which banking is practiced in India which contribute to the regular occurrence of high NPA levels? A framework which is not challenged by the academic community but carefully nurtured by the regulator? For example, the artificial dichotomy between working capital finance from term debt (only going concerns can hope to service debt and for an entity to continue as a going concern, it requires both working capital as well as term finance), or the heavy reliance on security as the basis for most lending (depending on foreclosure of security as the prime means of recovery of debt would impose such high transaction costs that no financial intermediary can even hope to be viable), or failure to differentiate between equity and debt risk (where the asset portfolio contains both equity as well as debt risk with no clear demarcation between the two and the pricing is based wholly on debt risk) ensures that the portfolio is perpetually sub-optimally priced and lending operations would be ab initio non-viable and there would be a steady incidence of NPAs which no amount of window dressing (including indefinite postponement of implementation of the Indian Accounting Standards (IndAS) norms for banks) can hide. No amount of ministrations or efficiency gains can help convert this congenital defect.

Fifth, a suggestion which keeps recurring is the need to induct professionals, especially in risk management and technology areas, at market related remuneration levels. What seems to be forgotten is that monetary returns are far from being key drivers of any professional worth his salt. Good professionals also need a culture and working environment to live up to their potential and in the absence of which they either become white elephants or simply pack up and leave.

Sixth, without clarity on market niches which exist and may be fruitfully exploited, and the kind of products and skills required to exploit them, there can be no direction on the kind of training that is required or should be imparted. Without such clarify, there would continue to be extreme competition in narrow product market segments leaving vast sections of the society and economy outside the pale of formal financial intermediation – with its accompanying discontents. One example which should provide the proof – if a proof is required – is the extremely low levels of utilisation of humongous numbers of PMJDY accounts. And this is not because the potential for savings is absent in the Indian economy. Is it a wonder that Indian financial markets continue to be highly fragmented?

Seventh, related to the above is that if PSU banks are to be really efficient and effective they need to build the ability to strategize and develop skills in identifying and exploiting market niches.

Seventh, why should and to what extent could governments actively plan steps to offset a possible slow expansion in bank credit? Is that an acceptance of the unsaid fact that existing PSU top management are incompetent? Or that the patronal relationship carefully built up over the last five decades between bank management and their political masters has ensured that present day management are incapable or precluded from taking independent decision taking? Moreover, if the government has to involve itself in distangling ownership in JVs of  PSU banks, what are bank managements expected to do?

No amount of visionary leadership or rhetoric can replace a basic understanding of how financial markets operate, which is in no way helped by the fact that they have a mind of their own and operate in fairly counter-intuitive ways. And without that understanding any fiddling around in the policies and practices on operation of financial markets is nothing short of quackery. Research over the last half a century has helped clarifying very many aspects, but our policy makers and academics refuse to take cognizance. The irony is that a key aspect of this understanding was developed by an American economist working at the Indian Statistical Institute at Delhi!

Wednesday, July 03, 2019

Term Lending Institutions or Universal Banks?

There has been and continues to be a failure for a long term market for funds to develop in India. In this context, Dr. Rangarajan’s suggestion (The key agenda must be to accelerate growth, The Hindu, 29th May 2019) to revive the setting up of separate long-term financial institutions, partly funded by government, on the face of it, seems a plausible solution.

However, considering that financial intermediaries are highly leveraged entities who function on thin operating margins and are able to attain viability through economies of scope, whereby they offer numerous varied services, pure term lending institutions would be incomplete organisations and may find it very difficult to continue as viable going concerns without continuous budgetary support.

Furthermore, the limited interactions they would have with their clients as pure term lending organisations would preclude accumulation of vital information on their clients’ intention and  ability to service debt. Again, term lending institutions with a portfolio of debt exposure would find it difficult to build remunerative viable asset portfolio since on one hand they would be exposed to the down-side risk on their exposures virtually without limit, their upside benefits from pure debt exposures would be limited.

Addressing all such inconsistencies in their organisation design would convert the term-lending institution into a universal bank!

The need of the hour is to salvage the project appraisal and management skills of the DFIs which have been accumulated at much cost and effort over the decades and is unfortunately left to decay. This can only be done if these skills are recognized and given due importance.

Tuesday, December 18, 2018

Are Interest Rate Subventions a Cure to Improving Financial Health of SME & Small Agriculturists?

Prof. Pulapre Balakrishnan’s article, Independence and accountability published in The Hindu, dated 9th November 2018 is well written and a balanced exposition. However, his suggestion (“If, in the spirit of contriteness as it were, the government wants to reach out to them, the right course would be to provide interest rate subvention”) for providing interest rate subvention for improving the financial health of medium and small enterprises seems to be dictated more by emotions than by either logic or empirical evidence on such interventions.

Interest rate subsidies, which such subvention would entail, creates various distortions and negative consequences for the economy and society. These include,

a)      It is available only to those who have taken bank loans, ie a small minority of the populace.
b)      Such policy generates excess demand for bank credit, which gets rationed essentially through exercise of political and economic power. That is, those with political and economic muscle corner a greater proportion of bank loans.
c)      This in turn leads to growing levels of income and wealth inequality. First, because the rich and powerful now have larger capital at their disposal. Second, they get it at cheaper rates than the market clearing rate. Third, their incentive to repay is lower.
d)     The excess demand for credit cleared through extra-constitutional means, also leads to generation of humungous amounts of corruption – affecting  politicians, bureaucrats, and banks.
e)      The losses on account of bad loans in turn make the banks weak / sick.
f)       This in turn forces banks to give lower returns to their depositors. (Incidentally, the Governor of RBI has gone on record in his speech dated 26th July 2016 stating, “Many middle class savers value the high nominal interest rates on their fixed deposits, not realizing that their principal is eroding significantly every year”!). A direct consequent of lower interest rates on deposits is that it reduces the savings rate of the economy, making the country rely more on foreign capital.
g)      Since the benefits are concentrated and the resultant pain extremely diffused over the entire society there is little concentrated efforts to counter it. These aspects of negative consequences of cheap credit is hardly visible in the media or policy documents.   

Furthermore, interest rate subvention would have to be substantial if it is to make a difference to the financial viability of any project, especially considering that total interest costs may not be a very large proportion of overall costs for any but the most profitable projects.

As such, with large amount of the interest rate subvention all the negativities and distortions associated with using interest rate subsidy in promoting trade / industry would very well come into play. 

As an underdeveloped country, higher levels of capital in all forms (physical, financial, human, technological etc.) are required. Making it cheap, but difficult to obtain is not helping anyone, least the intended beneficiaries. It just salves middle class conscience and converts us into a society of alms-receivers. Availability of credit is much more important than cost. Pushing cheap credit does not solve problems of connectivity (roads / telephone lines), irrigation, power, social equality, lack of information, lack of basic skills which make people productive, good health etc. Not having ability to usefully employ credit, is like giving an illiterate man a book on religion or philosophy with the hope that it would do enlighten him! Credit given to persons without ability to utilize it helps in driving borrowers into a debt trap.

A better way to promote accumulation of financial would be by focusing more on the deposit side of the banking business. Especially using technology and redesign of process to make it  easier to open and operate simple depository accounts. Presently, the processes we have implies that for a daily worker to operate his account he / she has to forego a full day’s earnings. Is it any wonder that there are so many dormant PMJDY accounts or that the level of operations in the non-dormant accounts is low?

Governance in PSUs

Prof. T T Ram Mohan’s is a well-known and respected academic, who regularly publishes his views on various banking and financial markets related subjects in established newspapers and journals. In his article, The RBI concedes a vital principle, carried by The Hindu, dated 22nd November 2018 makes a number of valid observations and deductions. However, I would like to differ with him on the following issues: 

a)      The need for the Board to exercise its powers so as to overrule management decisions would not arise if the Board has being giving meaningful strategic direction and the management is up to its responsibilities. Therefore, for a well-functioning organisation the need for Board to exercise its powers so as to overrule management decisions should rarely arise. This is where the criticality of composition of the Board comes into play. Considering the composition of the RBI Board, it is anybody’s guess as to how independent it is in taking considered, non-partisan decisions, and giving broad strategic direction. The composition and functioning of Boards of PSUs, especially PSU Banks, is a readily available glaring example.

b)      Prof. Ram Mohan states that, “The RBI management may or may not accept the inputs of the Board”. Would this not amount to insubordination? If the management of RBI (or any other corporate body howsoever organised) differs from the opinion of the Board, the options available to it are (i) re-represent with cogent arguments (ii) accept Board’s decision and implement, failing which (iii) step down from the management. The luxury of not accepting inputs of the Board is just not available to the management under any circumstances.

c)      If RBI’s revaluation reserves have arisen due to changes in rupee value of its gold and foreign currency holdings, will it not violate the matching concept accounting principle by netting it off against government securities? And if such netting is done, would it not amount effectively to “stealing” from Paul to pay Peter? Well one of the qualities which make money valuable is its “fungibility”!

d)     Prof. Ram Mohan also suggests and justifies need for relaxation in PCA norms. Which is in other words nothing but support for regulatory forbearance - one of the principal contributing factors to present mess which is Indian banking industry. The concern for adequate, timely, and reasonably priced credit flowing to various economic agents is not just valid but extremely pressing and critical. However, regulatory forbearance (by any name / form including loan write-offs, directed and cheap credit, Mudra Loans, 59 minutes loans etc.) does not address the issue and as has been repeatedly seen contributes in making the problem even more complex and intractable, ultimately adversely affecting all and sundry.

In this context, I would like to mention that the lending procedures / standards which are followed in Indian banking primarily evolved to address financing of trade. Credit risk in terms of Moral Hazard was covered by having security charge over the commodity being financed (preferably under banker's lock and key) and risk of Adverse Selection was addressed by stipulating margins and periodic valuation. This was further supported by stock statements / inspections and worked fine as long the lending was restricted to financing trade in commodities, valuation of which was fairly well predictable. For commodities with high volatility in valuation, suitable higher margins were stipulated. However, once financing of manufacturing is considered there is no way the borrowing entity can continue as a going concern without both long and short term debt. As such, the dichotomy of working capital finance vs term / project finance is not just anachronistic but also illogical. There are several other conceptual inconsistencies in the existing lending framework used by the Indian banking industry.

For example, coming to the financing of services (which now constitute more than 50% of the Indian economy) with virtually no tangible primary security, the existing processes fail all together leaving the financing of this sector to the ministrations of the equivalent of quackery.

The conceptual framework under which lending is done in India is therefore in my considered opinion no more relevant to cater to Indian conditions - agriculture, manufacturing, trade, or services. Therefore the difficulties in accessing bank credit, prolonged delays, and the high levels of NPAs arising periodically should not be surprising. 

In the absence of a suitable, coherent, workable, conceptual framework for lending, bankers have fallen back primarily on provision of collateral security. This in turn brings other complications. First, collateral security does give comfort but hides the nature of risk being taken on by banks on their lending book - in terms of debt risk versus equity risk. Now since both debt and equity risk is indistinguishably mixed up in the overall portfolio of Indian banks, while the pricing is wholly debt related, it is but natural that NPAs arise since the overall portfolio is sub-optimally priced. Second, provision of collateral blinds banks to the basic fact that their primary security is a going concern generating surpluses, which can be pre-empted for debt servicing. No bank can survive by resorting to foreclosure of security especially since they are highly leveraged entities, work on wafer thin operating margins in the lending business, and therefore have very little margin of safety in making mistakes. Let alone relying wholly on rectification of past mistakes.

The lack of coherent conceptual framework for lending is also amply displayed by the decision making process in banks, with extremely long appraisal notes, multiple iterations and queries which prolong the time for decisions to be made, stipulation of all kinds of irrelevant and unworkable loan covenants etc. All these aberrations are essentially insurance policies being taken by officials involved in taking lending decisions. Poor guys are just trying to protect their backsides with the ever present vigilance sword hanging over them.

The present situation of Indian banking is the direct result of mis-governance practised by different governments over the past 50 years plus. Irrespective of persuasion or ideology, the political class has strongly entrenched perverse incentives to control the financial markets – it helps in getting votes by controlling rural elites with promises of cheap credit and lone waivers and at the same time helps in garnering funds for fighting elections from the large capitalist class. Over and above all this, the icing on the cake is the ability to twist the arms of PSUs for financing pet projects through resort to CSR funds.  The strategy is especially endearing since the benefits are highly concentrated, while the consequences are highly diffused over the entire populace and prolonged over time.

To achieve this state of affairs, the first step was emasculation of management – which has been largely achieved for nearly all PSU organisations. Maybe RBI is one of the remaining bastions to be overcome!

Sunday, December 09, 2018


I am quite sure that Maithili Tyagi, a Kayastha girl from Kanpur, would be an extremely unique person. For that matter, any man, woman or child belonging to the Kayastha community, hailing from any part of India (the Kayastha community is quite widespread over Bengal, Bihar & Jharkhand, UP, Rajasthan, Madhya Pradesh, and parts of South India such as Hyderabad & Aurangabad) with the surname of Tyagi would be a particularly rare exception. I have not met anyone or heard of any Kayastha with such a surname. Though I am sure, so many seasoned, senior IPS officers many of whom had had successful stints with RAW and IB and were thick skinned diplomats would have been easily hoodwinked into believing that Maithili Tyagi, was a Kayastha girl from Kanpur.

I am also surprised as why Maithili Tyagi, a Kayastha girl from Kanpur and daughter of a conservative Sanskrit teacher, could not and should not have been familiar and comfortable with the Urdu language (page 83 – The urge to reply to Ashok Naraya in an Urdu couplet was strong but I had to refrain from doing so). The Kayastha community is known for its long association and erudition in Urdu and Persian, with local lore in UP & Bihar often referring to them as adha-Mussalman (semi-Muslims). Prominent Kayasthas such as Munshi Premchand wrote in Urdu and Firaq Gorakhpuri was a very famous Urdu shaiyar. Babu Rajendra Prasad, mentions in his autobiography that he learned Hindi after the age of 24-25 and had started his law practice. Prior to this, the languages in which he had had his formal education and in which he was comfortable were English and Persian. That is, apart from Bengali, having picked up that language on shifting to Calcutta for his education from his middle-school onwards. Hyderabad is famous for its Kayastha connection with prominent members of their nobility being from this community. Incidentally, Wikipedia informs that there is a fairly large Kayastha Muslim community in India (and Pakistan)!

If Maithili Tyagi, as a good investigative Kayatha journalist, had done some background check, she would have come to be aware that as per some modern (and much respected) academic work on social change in India, the Kayastha community owes its formation to those Indians who associated themselves with Muslim rulers in helping them run their administration, which could not be done without local help. While caste Hindus, would lose their caste by associating themselves with the Muslims, this left only those locals for this purpose who were outside the caste system – the Outcastes (referred to variously as Depressed classes, Scheduled Castes, or Dalits) and who had no caste to lose! Therefore, while Kayasthas remained Hindus by religion, they are not part of any of the four varnas – they are neither Brahmins, Kshatriya, Vaishya, nor Sudra. The community is essentially formed of those dalits who moved up the  social ladder by associating themselves with the Muslim rulers and in the process picked up various Muslim cultural traditions such as love for non-vegetarian food and partiality to Persian, Arabic, and Urdu language. By the way, a friend informs me (and I have no reason to disbelieve him) that  Tyagis are a sect of Brahmins who have given up (tyaag diyaa) presiding over pooja and yagya.     

By the way, yours truly (another Kayastha) had his aksharabhyas (a child’s initiation to formal education) on Basant Panchami in front of image of Goddess Saraswati by writing alif, be, the with a piece of chalk on a wooden slade and not ka, kha, ga. For the aksharabhyas of one of my cousins, the Moulavi Saheb, was an intrinsic part of the ceremony!  

For a book with an arm long list of endorsements (at least 16 in the edition of the book with me) and acclaimed by among others, Caravan, The Wire, and Scroll who published chapters of the book, it has too many mistakes - typographical, grammatical, syntactical, and conceptual. For example, Rajan Priyadarshi, moves from being an OBC (page 38 – Priyadarshi, he informed us, also belonged to the OBC class) to being a Dalit (page 43 – I met Rajan Priyadarshi, the person you had asked me to speak to as a Dalit; and page 44 – I am a Dalit). Similarly, Girish Singhal’s surname suggests that he is from the bania caste, ie, which would make him from the OBC community and not a Dalit. I little more serious, careful proof reading might have helped.  

Like any respectably Bollywood potboiler, the book inserts an item number in the form of Usha Rada (with all due respect to this lady). There is virtually a whole chapter (Chapter 5) devoted to her, though her only connection to the subject matter of the book seems to be that she was an IPS officer of the Gujarat cadre and as such a professional colleague of most of the other dramatis personae around whom the book revolves. There is absolutely no rhyme or reason as to why she should find mention in the narrative.

One aspect of the author’s personality which is surely to be lauded is her sense of self-importance verging on the psychotic. Statements such as, “That I was the journalist who had sent the Home Minister of Gujarat behind bars” surely seems to suggest something like that.  

Justice B N Srikrishna mentions in the Forward to the book that, the nature of truth has baffled philosophers all over the world for ages. He goes on to mention, “As to whether the material presented in this book represents facts, or mere perspective events, is for the reader to judge.”  After reading the book, cover to cover, twice over, I have a dirty hunch that he might be hinting to the hapless readers, who would be investing their time and money in wading through the tome in the hope of finding some gems, that it could also be a piece of hallucinatory outpourings or its more sophisticated version, magic realism. I have no hesitation in confessing that I am neither a philosopher, nor omniscient, nor an award winning investigative journalist of national and international fame. I am just a semi-literate, schizophrenic, unemployed kabbadi player

If, the basic rule of journalism is evidence, the wealth of ‘evidence’ presented in the book should surely have resulted in a string of convictions by now. 

Overall, the book lacks both focus and credibility – it just seems to be a product of some slick marketing.

* Notes:
         My views are based on the Second Edition of the book.
         Direct quotations from the book are in italics.

Sunday, August 12, 2018

Payment Banks

Payment bank’s seem to be much in news lately for a lot of wrong reasons. Some are questioning their continued viability, especially considering many of those who had shown interest in obtaining payment bank licenses have backed out. Others are questioning the very rationale of their existence / formation in view of seeming never ending violations of license conditions by the existing players. 
To appreciate this very topical and interesting issue, which might soon affect all our lives, one needs to appreciate a little more on how financial intermediaries, such as banks, operate and maintain their viability and profitability.
Bank's around the world are highly leveraged entities working on wafer thin margins and are able to generate profits by resorting to "economies of scope" and at the same time avoiding bad-debt losses. That is, they use the same set of available assets (investment in branches, information systems, people etc) to offer a wide variety of related services, on each of which they make small amounts of money. These services include deposits, loans & advances, money transfer services, payment services, investment advisory along with third party sales of investment products such as mutual funds, insurance etc. Bad debts, inflict a double whammy on banks. First, bank’s lose out on interest income on bad debts thereby depressing their operating profits  and second they have to make provisions out of their operating profits (and if that is insufficient from their Net Worth) on the quantum of bad debts. Incidentally, banks start making operating losses by the time their Gross NPA levels increase a level of 4% to 5%! This makes bad debts anathema for banks.
Payment bank's by definition / as per their licence conditions are precluded or restricted from offering a whole lot of these services, thereby, prima facie, making their operations sub-optimal by default! So would the brave-hearts (and their financial backers) who have ventured out in setting up payment banks eventually lose the shirts of their backs?
Inspite of this congenital draw-back, it was necessary to introduce this innovation in Indian financial markets, since they bring skills and technology which will help (is essential) to bring down transaction costs. Traditional banks not only lack this technology but are by experience / temperament hesitant in adopting it.
The question here is how would bringing down transaction costs, help. Consider a simple Jan Dhan Yojana Account. The government has pushed establishing these accounts and lap-dog banks have fallen all over themselves in fulfilling their quotas of opening such accounts. But then why are there so few operations in these accounts? Why have such a large number of JDY accounts virtually nil balance? The simple answer is because it is very expensive to operate these accounts!
A poor worker would have to lose a day's earning to go to the branch to either deposit / or withdraw funds, or for that matter do any transaction. The time, effort, and money spent in going to do the transaction and the opportunity cost of income foregone in going to the bank are all part of the customer's transactions costs. Similarly, these small value accounts add more to transaction costs of the banks than to their revenue and as rational entities they have no incentive to promote them. Don’t believe me? Try and open a JDY account in any branch, anywhere in India.
Now technology is available which would substantial bring down such transaction costs. Many of us are already benefiting from it. The trick is to take it to the masses. The way the market for shampoos / cell phones exploded in India when 5 rupees sachets and life time free incoming calls was introduced, the same way the banking market is very likely to explode with reduction in banking transaction costs. And this explosion will take the real economy along with it on a sustainable growth path where there would also be no need to cook up GDP figures.
Once the technology base of banks is strengthened and is assimilated, the same set of skills can further transform all the other area of banking operations bringing down overall operating costs of banks even further.
And such innovations, especially those bring about disruptive changes, are rarely brought about by existing players. Hence, Payment Banks, Small Finance Banks et al!
Over time, payment banks have only two options – either being bought out by traditional commercial banks or building up a customer base large enough to enable them buy out one of the existing banks. I expect that soon, very soon, they will have plenty of such options available. I don’t expect them to lose money or investors who have put their money in their equity to lose their shirts!
Yes, there are and will continue to be hiccups.  But wouldn’t life be extremely flat with nothing whatsoever to grumble at!

Monday, June 25, 2018

NPAs – Isn’t Prevention better than Cure!

The large and increasing levels of Non Performing Assets of the Indian banking industry has been hogging headlines for quite some time now, and there seems to be no end to the saga. To manage and contain this problem academicians, policy makers, RBI, and the Government have come up with various solutions with the insolvency code being the latest kid in the block. 

The proximate reasons for phenomenal increase in reported non-performing assets (NPAs) over the last three years, is not change in economic conditions or wilful defaults. It is simply because we had a strong regulator who insisted that banks follow the laid down, internationally accepted norms for recognizing NPAs – the so called Asset Quality Review. Otherwise, it would have been business as usual till one fine day the banking system would have simply collapsed and taken the real economy (and all of us too) along with it!

Any solution to a problem needs to first look at the reasons as to why the problem has arisen. Let us do the same for our “NPA” problem!

A manufacturing organisation makes physical products – say cars, or detergent, or steel utensils etc. To ensure consistent production of goods of high or at least acceptable quality they set up quality control systems which encompass 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. For achieving consistently good quality products it is therefore essential for the quality control mechanism to be functioning well throughout the production process.

Similarly, one of the key functions of banks is to continuously produce good quality loans & advances. By good quality, it means loans which are remunerative and have low probability of default. From this perspective, the incidence of high and growing levels of NPAs in the Indian banking system is akin to a manufacturing organisation making a larger than acceptable level of defective products.

The production process used by banks to ensure that consistently good quality loans are made consists of making a series of appropriate judgments or decisions for which banks need to have, inter alia, an appropriate conceptual framework for lending, selecting suitable people with the required skills, giving them adequate and suitable training, understanding how or why credit risks arise and having clear laid down credit risk  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 are far from 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 & advances made are repaid on 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.

Now for banks to be able to take sound decisions it is essential to create a governance framework which encourages and nurtures independence and professionalism. Something which is just not engendered by having RBI, GOI, vigilance departments, criminal investigations, and courts micro-managing how banks perform their work and breathing down the necks of bankers 24 by 7. One result of such micro-management is the extremely voluminous loan appraisal notes prepared by banks. This detracts focus on the nature, quality and key risks of the credit while protecting all the people involved in the decision making process from any adverse outcome. The consequence is extreme delays in decision making and no clear cut indicators on accountability. In practice, ultimately the most helpless lowest level official, who has no support of the union or political support of any kind who ends up facing the music. This in turns leads to decisions being based on all kinds of extraneous reasoning which have little to do with the borrower and the credit risk. Appraisal notes running into 100 – 150 pages is the norm. I really wonder as to what kind of reasoned decision taking can take place under such circumstances. 

I would like to give another small (and totally unrelated to present discussion on NPA management) example of micro-management by RBI. For anyone doing any kind of business, the base level understanding is that they should know their customer. Even a doctor evaluates his patients on parameters others than strictly medical, say on socio-economic parameters, before prescribing any line of treatment. Now banks have to follow a strict and detailed KYC norms prescribed by RBI (which is also extremely difficult to comprehend). Are our banks and bankers so incompetent that they are unable to properly and correctly evaluate their customer?

Having nearly 70% of our banking system in the public sector has had another extremely adverse effect – the virtually complete absence of creativity and innovation. The closed, one size fits all framework for recruitment, promotions, pay-scales, to the extremely outdated and dysfunctional conceptual system under which most lending and monitoring is done, and the identical Core Banking System has left little room for experimentation and innovation, or growth. After all only open systems can hope to achieve negative entropy! Public sector does not automatically mean lack of professionalism and accountability, provided governance systems enable and nurture it. In this regard the continued interference of DOB, MOF with its natural consequence of politicization of decision making at all levels is a key factor and needs to be addressed forthwith. Any change for the better would have to start from here.

On the conceptual framework of lending in India, a couple of issues are extremely critical. First, the dichotomy on working capital versus term lending is not only artificial but also misleading. For the lender there should be only one focus, the debt servicing ability (both quantum as well as volatility) of the borrower and mechanisms for entrapping cash flows. No borrower can service its debt (which is the same as no lender can expect recovery) by recourse of foreclosing just either the working capital assets or the long term assets – or even both. For debt to be serviced the sine quo non, which is invariably missed out, is a functional borrower which can be expected to continue indefinitely as a going concern and create economic surpluses. Second, the single minded focus on security in lending misses on the nature of risk – whether the risk being assumed is in the nature of a debt risk or an equity risk – resulting in mispricing of the risk. An experience through which all of us have lived for more than 30 years are our DFIs. They were taking exposures on a portfolio of assets where their risk was essentially equity / quasi-equity in nature while their returns were wholly debt related. It is natural that the returns from such a portfolio would be sub-optimal. The main culprit here was equity risk premium, not sloppy appraisal or monitoring or the biggest bug-bear of all of us – corruption.       

The idea of having a “bad bank” is very much workable, if and only if, the reasons for proclivity of Indian banks to continuously create NPAs is first sorted out. The capital requirements can be fairly easily be met even for transferring entire reported NPA level of Rs.10 lakh crores. First, the bad bank need not take over the entire NPAs at book value. They can very well take it at a discount of say 10% of the book value with agreement to share any surpluses in recovery over a certain minimum. That would reduce the total capital requirement to Rs.1 lakh crore. Second, banks typically function at a Capital Adequacy Level of about 12%. As such the equity required to fund holding Rs.1 lakh crores of assets would only be around Rs.12,000 crores, with the balance funded through debt. This equity be funded on 50:50 ratio with GOI picking up Rs.6000 crores and the banking industry taking over the balance Rs.6000 crores. The balance capital requirement could be met through debt from the banking industry itself specially if such debt were guaranteed by GOI and qualify as SLR investment.

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 manoeuvre fall in operating margins, something rising NPAs result in. As such, it is important that actual NPA levels be monitored regularly and closely, otherwise they start making losses. Third, by affecting ability of banks to provide loans as well as liquidity services to the real economy (since the quantum of lending / funds available to grease the economic system with banks is exponentially inversely proportional to rising NPA levels) the income and employment opportunities in the real economy start getting curtailed (rather drastically) with rising NPAs in the banking industry. Finally, banks maintain the institutional memory of credit history of all the actors in the real economy in their records. It is very hard and expensive to recreate this information once lost. When NPAs become so high that a bank becomes bankrupt and 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, which in turn hits the real economy hard by drastically reducing both income and employment opportunities in the economy. These are the primary reasons that no society (or its government) can afford even the smaller banks to close down, leave alone the big ones and making managing NPA critical for our collective well-being.

Monday, June 18, 2018

On the Functioning of Financial Markets

The article, “The Jan DhanYojana, four years later” in The Hindu dated 29th May 2018  though topical, and containing a few hard facts and figures, does not do justice to this very important subject and is way off in some of its conclusions. I will try and justify my contentions in this monograph. Please have a little patience.

Financial Inclusion is not just about opening bank accounts, using these accounts, and providing access to formal credit. To appreciate the importance of the concept of Financial Inclusion one needs to step back and see why and how strong, stable, and inclusive financial systems (banks and other financial intermediaries, finance companies, cooperative credit societies, capital market institutions etc. along with a strong regulatory framework) are essential for steady, accelerated, and equitable economic growth.  There is extensive literature on the subject starting from the 1960s, especially seminal ideas propounded by Gurley, Shaw, McKinnon et al. 

Naturally, for an inclusive financial system, all or most citizens need to be involved and be part of it. For example, people need to be able to ride the Bullet Train if they are to benefit from it. Just watching it whizzing past is not going to be of much help to either the people who built the Bullet Train, those who operate it, or the general public!

Developed and well-functioning financial systems, inter alia, (a) enable users to reduce the cost of exchanging real resources ie, through elimination of rigidities and reduction in transaction costs through both economies of scale and scope and use of technology by the financial intermediary; (b) leading to more efficient resource allocation, (c) provide the backbone of the payment mechanism, (d) helping to distribute and reduce risk for users (through tenor transformation, portfolio diversification, better monitoring through specialized skills etc), (e) enable easier accumulation of short & long term surpluses, (f) balance savings with need of funds over lifetime changes etc.  

Now starting with saving mechanisms, for any user of financial savings product (such as a JDY account) it should be safe, convenient, reliable, and cost effective. If a person has to spend half a day (that may mean losing a full day's earnings) to go to the bank to deposit or withdraw money he or she would obviously not use the facility. Add to that the paperwork in opening and operating the account. Or the transaction costs for small value receipts / payments using app-based software.  From the bank's point of view, transaction costs for servicing small accounts tend to be rather high and are naturally neglected - it just does not make commercial sense. Furthermore, if there aren’t steady and regular interactions between the intermediary and its customers, no trust based relationship can be built up leading to its eventual atrophy. 

The authors mention that 48% of bank holders have not done a single transaction during the past one year. This statistic by in itself hides the fact that there are have been reports of bankers putting in paltry sums of Rs.1 to Rs.10 in JDY accounts to show some transactions and lower number of zero balance accounts!1

As far as penetration of JDY accounts are concerned, the statistic that 80% of adults having bank accounts level mentioned in the article may need some scrutiny since the thrust of JDY is that all families should have functional bank accounts and the focus is not on individuals.

It also does not bring out the urgent need and pent up demand for savings mechanisms for small savers. In a study conducted by Stuart Rutherford2,  he discusses the service provided by Jyothi, a middle-aged semi-educated woman who makes her living as a peripatetic deposit collector in Vijayawada, whose clients are slum dwellers, mostly women. Jyothi has, over the years, built a good reputation as a safe pair of hands which could be trusted to take care of the savings of her clients. Jyothi’s accepted deposits of Rs.5/- every day so as to collect Rs.1100/- over 220 days. After which she returned Rs.1000/- to the depositor and retained Rs.100/- for her services. This translates to an annual negative interest rate of 30% per annum for rendering deposit services! Which I suppose is more than sufficient to make all our academics, policy makers, bureaucrats, politicians to start shouting Bharat Mata Ki Jai / Holy Marx / Jai Bhim or whatever and jump all over the place. But the fact remains that savers are willingly paying that kind of money since they value that service which the formal financial systems has failed to provide. Rutherford goes on to mention that slum dwellers in a neighbouring slum where there is no Jyothi at work actually envied Jyothi’s clients. Service providers for savings take different forms in our slums, villages, hamlets such as chit funds (formal & informal), Self Help Groups, and the numerous multi-level marketing companies which keep springing up from time to time all over the country.

All this springs from failure of our organized formal financial systems to provide such a service. The sad part is that this was not always so. Commercial bank’s did offer variations of something called Pygmy Deposits where deposit collectors made daily / weekly visits to collect the small savings and they provided this service without incurring a loss! For example, see the experience of Syndicate Bank discussed in Financial Innovations and Credit Market Evolution by V V Bhatt (EPW, Vol XXII, No 22, May 30, 1987). These were the days when banking operations were fully manual and as such the benefit of much lower marginal operating costs through use of digital technology was not available.

The thrust on promoting savings also does not take into account another critical aberration in our financial systems. Namely, due to widespread financial repression financial savings in formal institutions give a negative return in real terms! In this context, it is worth quoting the erstwhile Governor of RBI3 has gone on record in his speech wherein he mentioned that, “Many middle class savers value the high nominal interest rates on their fixed deposits, not realizing that their principal is eroding significantly every year”! Does that indicate as to why our society is subject to repeated onslaughts of Ponzi schemes all of which eventually and inevitably collapse. But during the course of their short existence promise an avenue for building up liquid financial saving which does not give negative returns in real terms.   And I am not even hinting on the effect of TDS on bank deposits which is extracted with clinical efficiency thanks to the superlative strength of Core Banking Systems.

Now let us see what happens in the absence of formal mechanisms for collecting small savings. They would have to be saved in kind since saving in cash would entail it losing value over time due to inflation if it was not lost, stolen, or borrowed away. If the saver managed to evade all these possibilities there is always the chance of it being spent on gambling or liquor. Saving in kind also has the added disadvantage of lacking fungibility and liquidity (the characteristics which gives fiat money its intrinsic value).

There also seems that there is another major and deep-seated myth among our academics and policy makers  -  that the poor do not and cannot have savings, or at least substantial savings. They need to appreciate that since earnings are highly variable and uncertain for the poor and they have absolutely no social security of any kind, savings are critical for survival. The small bits of savings is what enables the poor to survive from one misfortune to another. These savings take various interesting forms (again due to the failure of formal financial markets), such as, having reciprocal borrowing arrangements with friends and relatives, maintaining credit reserves with whom they provide services and products (by not immediately drawing down payments which are due), social practices such as neota, maintaining excess reserves of food grains and other items of inventory, keeping a few heads of goats, pigs, chicken etc which could either be sold or consumed as per dictates of circumstances etc.

This myth is also directly responsible for lack of attempts to design better savings mechanisms and for the stress on provision of credit as the proverbial magic wand for solving issues of “financial inclusion”.

Savers using the services of formal financial institutions like banks are cursed once again in another way. Since our bank’s are not making sufficient profits on the lending side of their business, they are naturally unwilling and unable to provide higher rates of returns on savings, especially in real terms! This suggests that the inefficiencies of the banking system and the borrowings from the formal financial sector are being subsidized by the deposit keeping community at large.

Now if one were to argue for promoting savings since it makes social sense,  one could also seek that the government should subsidize some portion of the operating costs – maybe through a reverse auction kind of mechanism. Banks could compete for achieving lowest cost for providing particular desired services, with the subsidy levels being based on this level. Since this subsidy would benefit society at large there would be much less scope for corruption. Otherwise banks will (and are becoming) become sick. Policies and practices which make banks sick will ultimately be of no good to either its customers or the economy. Continued good health of banks is essential for the real economy to remain robust - the reason they are so heavily regulated. Sick banks which have to be closed down also result in loss of institutional memory of the credit history of society, something which is impossible to recreate. For social and economic systems it is equivalent to heart failure in humans.

Technology may help in reducing transactions costs. Unfortunately, the system which has evolved over the last 30-40 years has resulted in traditional (PSU) banks lacking the requisite technical skills. Even worse, the one size fits all policy with industry wide equality in pay-scales, service conditions, internal processes, even the Core Banking System that they use, has stifled creativity and innovation. Something which is essential for growth of a vibrant financial system. An argument often given is that bank nationalization has enabled large increases in financial savings in the economy with its resultant positive effect on capital accumulation and economic growth. However, no one bothers to think about the cost of such savings mobilization – could the same levels of savings have been mobilized in more efficient ways, ie at lower costs?

The new generation pvt sector banks and the newest chips of the block - payment banks / small finance banks - either have too little incentives to pursue these market niches or are circumscribed by definition from benefiting from economies of scope, respectively!

Now coming to the stress laid on provision on easy access to credit, one needs to first appreciate that the ability or temperament to productively use credit is not very widely prevalent in any society. As such only a limited number of persons or families can benefit from access to credit. Furthermore, additional credit, cheap or costly, is no substitute for functional roads, primary health and education facilities, organized markets, or an administrative machinery which can prevent exploitative relationships. Even worse, there are well documented severe negative consequences in following a credit focused financial inclusion development strategy which include:

a)   Increasing levels of inequality in income and wealth since directed credit is cornered by the wealthy and politically powerful who thereby increase the capital at their disposal and become even more wealthy and powerful.  Larger loans means larger benefits, smaller loans means smaller benefits, and no loans means no benefits as far as the borrowers are concerned. And bulk of the people lie in the third category.

b)  Incentive to repay by borrowers who have preempted credit (typically through muscle or political power) is lower which not only further increases their economic and political status but simultaneously weakens the financial intermediaries who have lent the funds and have to book the consequent losses.

c)    Development of large and widespread corruption since the benefits are concentrated while the pain is widely spread, there is little focus or effort at tackling the resultant problems. Is it a wonder as to why our cooperative credit system produces some of our most corrupt politicians?

Another issue which hardly ever gets raised is the cost of capital. Interest rates reflect the cost of capital and it is well known that in India there is a very wide difference in the interest rates charged by most formal financial institutions / banks versus those charged by the fairly well organized informal institutions. The question that next arises is whether the informal sector is charging excessive rates or is the formal sector mis-pricing cost of capital.

Well interest rates in the informal markets are, prima facie, higher than formal markets. But would they still be considered higher cost after accounting for delays, the numerous trips, and the bribes with their associated real, direct and opportunity costs involved in accessing formal credit? The higher interest rates in informal markets also reflect the fact that (a) they are taking exposure to much higher risk levels, (b) provide kinds of services (other than credit) that formal intermediaries cannot even dream of, (c) have much less capital at their disposal as such require to charge higher rates to generate equivalent absolute amounts of return, (d) entire capital is in form of personal equity as such do not benefit from leverage (banks with Capital Adequacy Ratio of say 10% effectively have a leverage of  10:1) with its consequent benefits, and (e) during the slack season their capital is idle and does not generate any returns or meager returns.

Total cost of credit consists of basically two components, a fixed cost of accessing the credit which varies little with quantum of credit and a variable component, the actual interest rate. As such, for small value loans the average cost can be quite high since the fixed component has to be recovered from a smaller principal amount. This is another reason as to why informal lenders score over formal lenders, especially for small value loans and continue to be relevant. In this regard, Jerry R Ladman4 argues that “The partitioning of the market between BAB (a formal lender) and moneylenders shows the two lenders are providing different services. The moneylender provides credit quickly, on short-term basis, and in relatively small amount.”

Incidentally, the All India Rural Credit Survey (1951) (considered the gold plate for study of rural credit world-wide) does not support the prevalence of widespread use of exorbitant levels of interest rates commonly alleged to prevail in India! Data in this Survey indicated that village moneylenders grossed only an average of 11 percent per annum on their lending5!

Formal studies6 also suggest that the higher interest rates charged by the informal sector can be largely attributed to risks and administrative costs and not to monopoly power

Considering these factors, the conclusion arrived by most mainstream policy makers and the impression generally carried by most of us that informal money lenders are blood sucking thieves and rogues of the highest order seems not really substantiated by facts and logic. The reader may also care to remember that interest rates charged by many formal sector entities such as credit card companies and FinTecs involved in lending are not exactly cheap and more akin to rates charged by the informal sector.

Before concluding I would like to share a few quotes attributed to the ever-provocative Dale Adams, (Emeritus Professor of the Ohio State Rural Finance Program):

a)      "It is curious that the discomforts caused by a few people going into debt and not being able to repay tend to dominate general views held about financial intermediaries. The use of extreme cases to make general points is refined to an advanced art form in discussions about financial markets. Stories about poor farmers who lose their land to evil moneylenders are retold until people think that most loans go to default ….". (from Effects of Finance on Rural Development in Undermining Rural Development with Cheap Credit)

b)      … lenders provide loans, not gifts, and this creates obligations. When misfortunes strike, those obligations cannot always be met, putting the borrower into even greater jeopardy (from The Economics of Microfinance, by Beatriz Armendáriz de Aghion and Jonathan Morduch).

c)       … to the unwashed it (empowerment) conveys the impression that smearing a dab of additional debt on a poor woman will transform her into Super Woman. Those who insist on using this bloated term grossly overstate the contribution that indebting crusades play in easing poverty. More debt does not cure malaria or HIV/AIDS. It does not provide clean drinking water or prevent flooding. It does not improve law-and-order or eliminate weeds in a borrower’s crops. It does not make crops grow in barren soil or provide secure title to land that squatters occupy. It does not provide schools or teachers for the poor . . . (from The Economics of Microfinance, by Beatriz Armendáriz de Aghion and Jonathan Morduch).

There is much room for change / improvement in policy framework to enable our banks deliver on their capabilities. But such change should be based on an understanding of the nuances of functioning of financial markets and their main players such as banks. Propounding old, half-baked, hackneyed theories is not the way out – it is getting us into deeper mess.

1.   Government claims Jan Dhan Yojana was a big success. Here’s a reality check by Mayank Jain, The Scroll, 6th September 2017;  & Jan Dhan Yojana: One Rupee Balance and the Dormancy-Duplication Problem by Anuj Srivas, The Wire, 14/09/2017.
2.     The Poor & their Money, Stuart Rutherford, Oxford India Paperbacks
3.    Policy & Evidence.  Inaugural Address by Dr. Raghuram Rajan, Governor, Reserve Bank of India at the 10th Statistics Day Conference 2016, Reserve Bank of India on July 26, 2016, Mumbai 
4.    Ladman, Jerry R. Loan-Transaction Costs, Credit Rationing, and Market Structure: The Case of Bolivia, in Undermining Rural Development with Cheap Credit.
5.   All-India Rural Credit Survey, Vol. 1, The Survey Report, pt. 2, Bombay, Reserve Bank of India, 1957, pp. 490-91. - quoted by David H Penny in Rural Financial Markets in Developing Countries, page 66.
6.   Bottomley, Anthony. Interest Rate Determination in Underdeveloped Rural Areas, American Journal of Agricultural Economics 1975;
7.  Long, Millard F. Interest Rates and the Structure of Agricultural Credit Markets, Oxford Economic Papers 1968.