Pradeep Raje: Make haste slowly

The GTB failure is a warning bell for other banks not to push their luck too far, too fast

One is sorely tempted to post an advisory upfront: forget the saga of the three new-generation private banks that have disappeared in the past five years, focus on the vulnerabilities of the ones that remain. For, therein lurks the danger of a far greater banking crisis that may even blow up into a full-fledged currency crisis.

You could be equally tempted to dismiss the proposition as an excessively alarmist view, all the more jarring because the other banks have built up huge franchises in recent years. But that is precisely the point one is driving at.

One of the most enduring mysteries in the past 30-odd years in global banking is the link between financial liberalisation and bank failures, and a bit further down the road to currency crises. After all, one of the central pillars of financial liberalisation is the end of financial repression, which usually takes the form of deregulation of interest rates, freeing banks of mandatory lending requirements, the works. Simple logic would suggest that banks should emerge stronger in this situation.

But the burden of proof is that bank fragility increases manifold post-liberalisation. In a seminal survey of the history of bank crises between 1970 and the mid-1990s, Graciela Kaminsky and Carmen Rheinhart* reported in 1996 that 56 per cent of the 25 banking crises in the sample were followed by a balance-of-payments (BoP) crisis within three years. On the other side, 24 per cent of the 71 BoP crises were followed by banking crises within a year of the currency crisis. Headline cases of banking crises leading to a BoP crisis include Argentina (1981), Brazil (1987), Chile (1982), Colombia (1983), Finland (1991 and 1992), Mexico (1994), Norway (1992), Peru (1985), Spain (1992), Thailand (1983), Turkey (1994) and Venezuela (1994). In most of these cases, a BoP crisis followed within two years of a banking crisis.

More importantly, in 18 of the 25 cases of banking crises in the sample, the financial sector had been liberalised in the preceding five years. The data set is so compelling that economists have begun to wonder whether there is a chain of causality that links financial liberalisation with bank failures and finally, to broader BoP crises.

While it is nobody's argument that Indian banks are still in a "crisis" zone, the short point in pulling out all this dense stuff is that there are specific reasons why crises spill over from one place to another.

Kaminsky and Rheinhart postulated that these linkages were too serious to be brushed away as mere coincidence "" of course, couched in much more technical language "" and suggested that perhaps there are common causes for the twin crises. Over the years, many refinements have been made to this line of thinking but the basic story remains the same. Liberalisation tends to send out misleading signals to the banking system.

In the reflected warmth of a string of liberalisation measures, companies start to plan big, which is understandable because one of the unique selling propositions of liberalisation is to let market forces decide the equilibrium levels between demand and supply. Now, with companies gung-ho on future expansion plans, banks are naturally drawn to the robust profitability projections.

Simultaneously, retail customers tend to be much more optimistic about future earnings levels, prompting a surge in retail lending. All in all, liberalisation leads to a credit boom in the banking sector, both on the corporate and retail side. The domestic consumption boom is partly met by increased imports since domestic capacities take some time to go onstream. That leads to a widening current account deficit.

The second part of the argument is that to fund this credit boom, banks are forced to search for higher capital. Post-liberalisation, accessing international capital markets seems to be a natural choice, as much for the finer rates available to neo-liberalising countries as for the thrill of being the first to tap the international markets. What's more, the poster boys of international investment banking are there to welcome the poster boys on the neo-liberalising world with open arms: supply meets demand, as always.

The next step in this argument is a little open to differences of opinion, but let's say for whatever reason "" a domestic or an external shock "" the sanguine expectations do not materialise. The banks are left holding a vast basket of bad loans. Failing profitability of banks forces foreign capital to the nearest exit. Note also that it is precisely in such times that the stock markets display their displeasure and concern over failed expectations. Foreign capital in the equity markets, usually in the form of portfolio investments, seeks an immediate exit.

The two strands come together in an explosive mix and before the authorities know it, the swooshing sound of outgoing capital is followed by the dull thud of an economy falling in a full-fledged BoP crisis. The argument is that even if the authorities have a vague clue as to how to fix the problem, their hands are tied because of the banks' huge bad loan problem. Textbook defences, such as hiking interest rates to tackle the problem first from the currency side, are no good because the banks will accumulate more bad loans in the process.

But why should this story play out time after time like a bad Hollywood movie? To that, no one has a clear answer, although Gerard Caprio of the World Bank** suggested there was the case of a "missing model" in which bank regulatory and supervisory structures are either not compatible, or are grossly out of step with the rest of the liberalisation process. One has had occasion to add to this literature, but at this point in time, our concern is with the remaining private banks, which seem to be growing too fast for comfort.

Then there is another strand in the academic literature that says that the newly-"franchised" (set up) banks are all the more aggressive in undercutting the established competition because they want to build up market share. Look around in the home loan or credit card market. Banks are actually thrusting pre-signed cheques at you at every traffic signal: "Take it, we will talk later". In effect, in selling below market rates, these banks do not mind taking a small loss per unit of additional capital deployed, provided they get the volumes in the market place.

It is an extremely perverse logic, but the dynamics of this "super-competition" is driven by the fact that volumes once created will help bring in cheaper capital at a later date, as investors fall over each other to buy the bank's stupendous success story. Thus, over the medium term, the average cost of capital will decrease and operations will become sustainably profitable. The essential proviso is that these banks survive the initial period of shaky fundamentals. That is why some economists have even suggested putting curbs on the expansionary inclinations of the newly-set-up banks.

The erstwhile Global Trust Bank (GTB) failed the proviso. It went out aggressively to court loans to capital market intermediaries and other sensitive sectors to build credit volumes. It had almost built a niche franchise in this area. But an external shock in the form of an equity market collapse in 2001 kayoed it. By March 2002, the bank had wiped out its entire capital. The glitch in its story was that it could not raise in time the subsidiary dose of cheap capital that it was banking upon.

Our concern with some of the surviving private sector banks is all the more because of their international linkages, both in terms of the higher limits for portfolio investment allowed and the base equity capital raised abroad.

The chances of a banking crisis blowing up into a BoP crisis are much greater. Perhaps there is reason to hasten slowly. No bank makes a lasting impression by working overtime (and at traffic junctions) to build volumes if the end result is going to be a spectacular failure. But then no bank thinks it is going to fail. That's the reason why we need to put regulatory advisories against banks trying to do too much in too short a time.

* The twin crises: The causes of banking and balance of payments problems by Graciela L Kaminsky and Carmen M Rheinhart, International Finance Discussion Paper No. 544, March 1996, Board of governors of the Federal Reserve System.

** Bank regulation: The case of the missing model by Gerard Caprio Jr., Policy Research Working Paper No 1574, 1996, World Bank.