Beware of the lazy banker

Indian Express, 20 September 2004

If interest rates go up, you may think you will suffer if you have a loan and benefit if you have bank deposits. However, the interest rate effect could play out quite differently. This may be because what is now at stake is the health of your bank. You need to worry far more as a depositor than as a borrower.

Banks hold large portfolios of government bonds. And, interest rates and bond prices follow an inverse relation: A drop in interest rates means a rise in bond prices. A rise in interest rates is synonymous with lower bond prices. Banks who own government bonds have thus suffered a loss owing to the recent rise in interest rates.

Globally, banking regulators have been quite tuned to this problem. In general, they have required that banks measure the mismatch between interest rate risk of their assets and liabilities, and safeguard.

RBI has put a primary focus on credit risk. Pressure has been created by making banks disclose the amount of NPAs they hold. Banks have been forced to hold equity capital proportional to their credit risk. These steps required banks to monitor credit risk.

The clampdown on risky loans encourged banks with weak credit delivery and monitoring mechanisms to become ‘‘lazy bankers’’. They chose to invest in dated government bonds which gave high returns. This was risky as the bank’s income and balancesheet would be affected in the event of a change in interest rates.

However, in the case of interest rate risk, no proper attempt was made by the RBI to address the problem. This was despite the fact that by 2002 it was clear that many banks had very large interest rate risk exposure. Roughly two-thirds of banks in India in a sample of major banks stood to lose over 25 per cent of their equity capital in the event of an increase in interest rates by 3 per cent.

Some initiatives were taken, such as the requirement of an ‘‘investment fluctuation reserve’’ (IFR), and submission of an repricing statement to the RBI but they were rooted in conceptual confusion and did not solve the problem.

IFR consisted of money to be kept aside in case the bank gets into trouble when interest rates move. The mistake in RBI’s IFR was that the size of this reserve was not correlated with the interest rate risk exposure of the bank. Banks were required to hold 5% of the total value of their holding of government bonds. Whether a bank held long dated bonds or short dated bonds; whether it balanced these assets correctly using corresponding liabilities, it had to hold the same amount of IFR. This created conditions under which banks did not have the incentive to correctly measure and monitor interest rate risk. Banks with low risk got penalised because they had to hold IFR just like incompetent high risk banks.

The period from 2001 to 2004 is littered with lost opportunities where RBI could have dealt with this problem more effectively. Repeatedly, RBI advised banks to be careful. But this message was inadequate in the absence of proper regulation. A regulator needs to establish sound rules.

After failing to do the job of a regulator in the 2001-2004 period, RBI has now swung into action by trying to sweep bad news under the carpet. RBI’s recent rule changes on how to value investments at prevailing prices will now allow banks to ignore futher losses that are suffered on bond portfolios. A bond price will drop from Rs 115 to Rs 105, and the bank will suffer a genuine loss of Rs 10, but RBI regulations are friendly and will allow the bank to pretend that this loss never happened.

So not only did RBI start out with mistakes in interest rate risk regulation, even after it became clear that banks were taking major risks, it allowed banks to do interest rate speculation on a large scale. These same banks are now being supported by RBI in an effort to hide further bad news. These banks could well become insolvent on account of interest rate movements, but the regulator will turn a blind eye to it. With the support of the regulator, the bank will be able to conceal news of insolvency from depositors and shareholders.

Such banks would effectively be ponzi schemes, paying off depositors who leave using money from new depositors who are walking in the door. This ostrich like attitude of hoping that the problem would go away on its own is an extremely risky strategy. Even now it is not too late and the RBI should set its house in order.

Ila Patnaik