G20 can borrow a leaf from RBI's book

India must use its presidency of the G20 to showcase RBI's banking practices as these are more rigorous than those of many of its counterparts elsewhere

The storm that threatened to engulf and unsettle banking in the US and Europe has subsided. That doesn’t mean we can breathe easily. As unexpectedly as the storm struck in March, it may arise anytime.

The banking failures in the US and the near-failure of a major bank in Europe are bound to take their toll on those economies. The world at large cannot escape unscathed either. As with monetary policy, we have to reckon with the spillover effects of banking instability in the advanced economies on the rest of the world.

We can expect credit growth to slow down in the US and Europe.  Slower credit growth will translate into weaker gross domestic product (GDP) growth. A slowdown in the US and Europe impacts the demand for exports and hence growth in other economies. Capital flows will become more uncertain and dollar funding more expensive for developing and emerging economies. Even the IMF’s latest baseline projection of anaemic growth of 2.8 per cent for global growth, just 0.1 per cent below the January 2023 forecast prior to the turbulence in banking, seems optimistic.

The failure to manage risk in banking is again exacting a cost from the world economy. For the umpteenth time, bank management and bank boards have been found wanting. It is high time we faced up to basic truths.

First, bank management has an almost irresistible temptation to take undue risk. Given the high leverage at which banks operate, the potential payoffs to managers for risky gambles are huge. When banks fail, managers do not face meaningful penalties, such as imprisonment or heavy personal fines. Still less do they face the prospect of starvation — they would have earned enough in good times to last more than one generation.

Secondly, it is futile to rely entirely on bank boards to rein in the risk appetite of management. The history of bank failures is strewn with the debris of many a glittering board. Boards, whether in banking or in non-banking firms, have little incentive to perform. The “sage wisdom and guidance of the board”, to which annual reports refer cloyingly, is strictly for the birds.

The onus for guarding against bank instability is overwhelmingly on the bank regulator and supervisor. Regulations must provide the framework in which risk-taking is hemmed in. Supervision must ensure that compliance is happening. In both respects, regulators in the US and Europe have been found wanting.

The failure of Silicon Valley Bank (SVB) has been widely ascribed to the failure to manage interest rate and market risk. The bank collected short-term deposits and invested these in long-term government securities (which constituted 50 per cent of assets). It was undone when interest rates started rising and the bank’s holdings of government securities fell in value.

But those were not the only risks to which SVB was exposed. There was concentration of credit risk. SVB had excessive exposure to one business segment, namely, start-ups. There was also heightened liquidity risk. The overwhelming proportion of deposits was large-value corporate deposits or what are known in Indian regulatory parlance as “bulk deposits”. These are unstable compared to granular, retail deposits.

This may sound jingoistic, but it is fair to suggest that the Indian banking system is better equipped to pre-empt the sort of risks we are talking about. The build-up of market risk that happened at SVB is less likely in the Indian banking system. The average holding of government securities in the Indian banking system today is 29 per cent of liabilities. The majority of holdings are held to maturity and hence insulated from market risk. 

The Reserve Bank of India (RBI) monitors concentration risk closely. It has in place stringent norms for risk exposure to a borrower. Exposure to “sensitive” sectors, namely, real estate, commodities and the capital market, is restricted. The RBI is quick to draw attention to excessive exposure to any industrial sector or product.

As for liquidity risk, the RBI watches dependence on “bulk” deposits like a hawk. Where the dependence is high in absolute terms or out of line with that of peers, the RBI asks for the proportion to be brought down in a specified time-frame. 

The RBI’s monitoring of boards and management is more intense than elsewhere. Appointments to the posts of chairman  and managing director at banks require the RBI’s approval. The RBI typically approves terms of three years but may approve a shorter tenure. There are age limits for the managing director and chairman. 

There are norms for the composition of bank boards and for the audit and risk management committees. Most regulators limit themselves to fixing the ratio of variable pay to fixed pay of the chief executive officer (CEO). The RBI does this and, in addition, regulates the fixed pay of the CEO. It understands only too well the link between executive pay and systemic risk in banking.

Two reports that the RBI makes available to bank management are noteworthy: The Annual Financial Inspection report and the Risk Assessment Report. These highlight the entire gamut of risks, shortcomings in systems and processes, the functioning of the board, lapses in compliance, etc. Those who have sat on bank boards will vouch for the high quality of these reports.

Of late, the RBI has started scrutinising the business model of banks, as RBI Governor Shaktikanta Das acknowledged recently. Mr Das is quoted as saying, “We are now doing a much deeper dive into the business models of the banks, which may not be sometimes to the liking of the banks.”

The RBI need not be apologetic about its approach to regulation and supervision. The approach is intrusive, no doubt. It can be irritatingly prescriptive. It will be seen as micro-management. But it serves a purpose, namely, shoring up stability in banking.

There is a philosophy underlying the RBI’s approach. Banks impose systemic risk in varying degrees and hence are too important to be left to management, boards and the market. The lasting answer to bank fragility must be a substantive increase in capital. But that is a long way off. Until then, the RBI’s approach has much to commend itself.

The world cannot afford frequent bouts of instability in Western economies and their spillover effects on other economies. The US and Europe need to get their banking regulatory and supervisory act together. India must use its presidency of the G20 to highlight the banking practices at RBI, from which other banking systems might benefit.

ttrammohan28@gmail.com