Fixing India’s Banks: Making Banking Boring Again
The best banks are boring banks, whose strength is in the maturity of their processes for managing capital, writes Nachiket Mor.
This is the second in a series of articles that focus on better banking for India.
India is in the midst of one of the worst economic crises that it has ever seen. Financial services and, given their central importance in India, banks in particular, will need to be an important enabler on the path to recovery and they are, at least in theory, well-positioned to do so.
India has less than 1 bank per million population, while France has more than 5 per million and the United States has 15 banks/million people. Strong entry barriers severely limit competition between banks, generating an artificial supply constraint. This guarantees an unlimited scope of business to those with bank licenses. Additionally, driven by this lack of competition, most banks—particularly government-owned ones and the larger private sector banks—have been able to set their savings and current account rates to levels well below those of the risk-free treasury bill rate.
Consequently, unlike most banks worldwide, Indian banks enjoy virtually guaranteed profits from the ‘depositor penalty’ that they collectively and unfairly impose on their depositors. In the U.S., for instance, the ‘depositor penalty’ has been close to 0.10% on an average in the past six years, as compared to 4% in India over the 10 years since deposit rates have been deregulated.
Sadly, despite these enormous structural advantages, banks in India have struggled to generate a reasonable return on equity even in their best years.
The system as a whole has experienced a severe crisis in every decade. Banks also have, as a group, left vast swathes of the population unserved, and the sector as a whole has remained small in size even relative to the modest-sized Indian GDP, and shown little, if any, product innovation or evidence of consumer centricity.
Additionally, as their consistently poor performance on the non-performing assets front indicates, banks have priced and allocated credit poorly, acting perhaps as the most significant drag on the growth of the Indian economy rather than the enabler they ought to be. Every low-quality asset that has received credit has failed to generate growth or employment for a country that is desperately in need of both, while sectors and businesses such as SMEs with growth and employment potential have been starved of credit.
Managing Capital Right
There are, of course, many reasons for this state of affairs, but the root of the problem is not, as is commonly believed, public sector ownership of a large number of banks. It is that banks in India, both government and privately owned, almost uniformly lack a strong foundation from which to build their super-structures and growth plans. Even mild tremors tend to destabilise them, leave alone the big shocks that pandemics like the present one have generated. So, what are we getting wrong? And what needs to change?
However, most banks in India see capital management merely as an annual compliance exercise run by a specialised department in order to satisfy the regulator or to print in their Annual Reports. They fail to recognise that these are merely after-the-fact accounting exercises, and that capital is in fact being truly ‘managed’ on a day-to-day basis by the manner in which the millions of transactions are being approved and priced in the heart of their operations.
While there are many embedded processes that banks have, there are three which are central to the capital management process and which members of the boards of banks and their supervisors and regulators, need to understand and keep a laser-sharp focus on. These are, Activity Based Costing or ABC; Matched Fund Transfer Pricing or MFTP; and Risk-Adjusted Performance Measurement or RAPM; and they apply, not in aggregate, but to every single transaction that is originated within the bank.
ABC provides a precise calculation of how much the transaction cost of the bank is in terms of overheads. MFTP does this for the exact price of money, which is maturity-, duration-, and quantum-linked, at the instant the money is disbursed or collected. RAPM brings both of these together and combines them with internal model-based estimates of associated expected and unexpected losses arising from credit risk, market risk, and operations risk, and the contribution of the transaction to the aggregate situation of the bank, using indicators such as the Herfindahl–Hirschman Index which assesses concentration risk. Aggregated across transactions, and across business lines, this then builds up to the aggregate position of the bank.
Two, these measures are to be combined with modern accounting and risk management practices such as Ind AS, risk-based capital adequacy assessment, and stress-testing against defined scenarios, which are imposed on the banks by the regulator and disclosed externally. Doing so creates a consistent set of incentives for banks to focus on their core.
The Skills That Bank Boards Lack
However, despite the centrality of these measures for capital management, there are few, if any bank board chairs, audit committee chairs, managing directors, or bank supervisors, who understand or engage with these issues even superficially, and can provide even a broad idea of what, for example, the Herfindahl–Hirschman Index means, leave alone explain how it is computed. Given this lack of engagement, particularly at the level of the board chair of most banks, it is not surprising that banks do not generate an adequate return on their capital.
This has not only led to the development of low-quality bank balance sheets, but has also had the attendant consequence that broad-based bond markets have failed to develop. That has it harder for companies to access these markets, and for banks to rebalance their portfolios post-origination, even if they wanted to. Additionally, since this has the net effect of the capital and risk position of the bank being consistently misstated, in order to effect any counter-cyclical movements in the banking system, instead of relying on aggregate capital level signals, the regulator is forced to take recourse to endless tinkering with detailed rules such as those for NPA-recognition, further exacerbating these distortions.
Three, the skills required to enable ‘boring banking’ are well understood and relatively easy to train for. Perhaps as a first step, bank board members, their chief executives, and bank-supervisory cadres need to be asked to acquire a formal certification in them before they are permitted to take on these roles. Government-owned banks are well-positioned to perform well, but in order to do so they, strangely enough, need to behave more like hidebound public sector institutions, and insist on rigid adherence to these core processes. Much more than the owners, it is the role of well-qualified independent directors and regulator representatives who sit on the boards of these banks, and that of the bank-supervisory cadres, to ensure that they do.
A strong core also allows the periphery to become riskier. As the system gets closer to the frontiers of SME finance, micro-lending, new unbanked geographies, and agricultural finance, well-managed banks can build strong and stable partnerships with multiple types of risk originators, and use their larger sizes to act as risk-aggregators, diversifying away the probabilities of unexpected losses, through careful structuring and management of their own, much larger, balance sheets.
This can happen without the frequent ‘sudden stops’ and ‘blow-outs’ that have become a regular feature of the Indian banking landscape and which have caused so much downstream damage. This can also allow banks to start lowering the ‘penalty’ that they impose on depositors, a penalty that has been unfairly penalising them and putting enormous downward pressure on the extent of financialisation of savings in India.
Nachiket Mor is a former banker and has served on the Board of Directors of the Reserve Bank of India and its Board for Financial Supervision for many years. Deepti George is Head of Policy at Dvara Research. These views are entirely personal.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.