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Suman Bery: Shooting the messenger

The downgrade of SBI's financial strength by Moody's contains important messages

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The downgrade of State Bank of India’s (’s) by ’s Investor Services has come as a shock to India’s financial markets. The international rating agency expresses an opinion on the “standalone” financial strength of financial institutions and assigns a rating to specific debt obligations of the institutions concerned. In the case of SBI, the “standalone” rating (also termed the financial strength rating) has been downgraded to D+ from C-, equivalent to a so-called for the institution of Baa3. As a result of this downgrade, admittedly so far by just one of the rating agencies, SBI, despite the support of the full faith and credit of the Indian government, is now judged a weaker creditor than private sector banks such as , and .

SBI’s Tier-I capital ratio, at 7.6 per cent, is currently below the eight per cent that the Indian government has committed to maintaining for public sector banks, and well below the private sector banks listed above*. While SBI is expected to proceed with a rights issue to raise its Tier-I capital ratio, Moody’s further observes that notwithstanding their expectations that SBI’s capital ratios will soon be restored, “SBI’s efforts to secure this capital for the better part of the year demonstrates the bank’s limited ability to manage its capital ... given that a bank’s ability to freely access the capital markets is an important rating criterion globally” so a downgrade in the financial strength rating is justified. Looking ahead, Moody’s believes that SBI will find itself capital constrained again in a relatively short period of time.

It goes without saying that rating agencies did not cover themselves with glory during the recent global financial crisis. They were deeply complicit in providing the highest credit ratings to synthetic instruments put together by clever investment bankers, and their business models are shot through with a conflict of interest.

At the same time, we should be careful not to shoot the messenger and try to understand carefully what signals this rating downgrade conveys in the present global environment — not only in the case of SBI but also for the overall structure of the Indian banking system. In exploring these wider ramifications, I would like to acknowledge the work of Professor of Stern School at the New York University.

Professor Acharya has been engaged in two parallel programmes of work over the past year: one examines the evolution of regulatory reform in the advanced countries in response to the financial crisis and the other looks into market and regulatory responses to the crisis in the Indian banking system. These two streams of thinking have come together in a draft paper prepared for the International Growth Centre, which will be published soon.

The paper titled “The Dodd-Frank Act and Basel III: Intentions, Unintended Consequences, Transition Risks, and Lessons for India” examines the mechanisms by which the global financial crisis spread in the advanced countries, the appropriateness of the regulatory response as represented by the revision of the Basel III rules for regulatory capital and leverage for banks, and by the Dodd-Frank Act in the United States. While the paper has been designed primarily to be of interest to financial sector regulators, there are some important messages for a wider audience.

Shooting the messengerA key message from both the work on the US and Europe and the work on India is that there are significant, empirically substantiated links between government-created deposit guarantees and what finance professionals call “moral hazard”: the propensity of institutions that enjoy government indemnity to take risky bets in the expectation of a bailout. In the United States an elaborate regulatory machinery was set up in the 1930s to prevent commercial banks from gambling with insured deposits.

The most visible symbol of this was the separation of commercial banking from investment banking. This was represented by the break-up of banking conglomerates like the House of Morgan into JP Morgan and Morgan Stanley under the . The erosion of these boundaries in the mid-1990s is a widely cited explanation for the build-up of leverage that took place thereafter. The UK proposal to “ring-fence” the guaranteed activities of commercial banks and the so-called Volcker rule in the United States are examples of initiatives designed once again to separate the protected and the speculative aspects of banking.

What is the relevance of any of this for India? Professor Acharya draws two implications, and I agree with both. The first is that the natural tendency of a government-supported institution will be to take on risky behaviour, and strong supervision is needed to counteract these tendencies. The Indian response has been twofold: capital controls and strong asset controls (primarily in the form of statutory liquidity ratio) which restrict the risk-taking activity of the banks. These strictures apply to all banks, but Professor Acharya argues on the basis of his research that the private banks have so far been disadvantaged by the statutory guarantee of PSU bank liabilities.

It is, however, his second point that is more important in the Indian context, which is that sooner or later the contingent liabilities represented by guaranteed deposits do get called, and the country’s fiscal position needs to be strong enough to absorb these liabilities.

Moody’s action right draws attention to two inconvenient truths about India’s current banking system. The first is that the largest public sector bank lacks the capital required to support the credit growth that the economy requires. Second, the government is poorly placed to provide the additional capital needed, or indeed to make good on the implicit guarantee offered to all depositors. As always in India, the problem is serious but not urgent, but we should thank, rather than berate, Moody’s for putting these issues on the policy agenda.

The author is country director, India Central Programme, International Growth Centre

He also served as an independent elected director (shareholders’ representative) on the central board of SBI between 2002 and 2008

Views are personal

* Tier-I capital represents the highest quality equity and reserves available to a bank to absorb losses on its asset portfolio, resulting from changes in market valuations, credit losses or operational causes such as fraud or technology failures

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