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.