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banks seem to be the prime targets of the government's
reforming zeal. Having encouraged foreign acquisition,
consolidation and universalization in the banking system,
the Finance Ministry's current thrust seems to be to
find a host of new areas of activity for these institutions.
According to unconfirmed reports, the Reserve Bank of
India (RBI) has approved a proposal from the government
to amend the Banking Regulation Act to permit banks
to trade in commodities and commodity derivatives. This
offer to banks, of one more new avenue of speculative
investment by removal of a prohibition on commodity
trading that has been in existence for long, merely
furthers the fundamental changes that have been under
way in India's banking sector.
These changes impinge upon the nature of the institutions,
operations and instruments that constitute the sector.
Institutional changes include: a rapid increase in the
number of new private sector banks; a process of consolidation
of banks that thus far has principally affected the
private banking sector but is now being consciously
promoted in the public sector as well; privatization
of equity in public sector banks; mergers of banks and
other financial institutions, particularly development
banking institutions; and the creation of universal
banks that are in the nature of financial supermarkets,
offering customers a range of products from across the
financial sector such as debt products, investment opportunities
in equity, debt and commodity markets and insurance
products of different kinds.
Implicit in these institutional changes are changes
in the operations of the increasingly ''universalized''
banks. The most crucial change has been an increasing
reluctance of banks to play their traditional role as
agents who carry risks in return for a margin defined
broadly by the spread between deposit and lending rates.
Traditionally, banks accepted small deposits that highly
liquid investments protected against capital and income
risk. They in turn made large investments in highly
illiquid assets characterized by a significant degree
of capital and income risk. This made banks crucial
intermediaries for facilitating the conversion of savings
into investment.
Given this crucial role of intermediation conventionally
reserved for the banking system, the regulatory framework
which had the central bank at is apex, sought to protect
the banking system from possible fragility and failure.
That protective framework across the globe involved
regulating interest rates, providing for deposit insurance
and limiting the areas of activity and the investments
undertaken by the banking system. The understanding
was that banks should not divert household savings place
in their care to risky investments promising high returns.
In developing countries, the interventionist framework
also had developmental objectives and involved measures
to direct credit to what were ''priority'' sectors in
the government's view.
In recent years, liberalization and ''denationalization''
have changed all that and forced a change in banking
practices in two ways. First, private players are unsatisfied
with returns that are available within a regulated framework,
so that the government and the central bank have had
to dilute or dismantle regulatory measures as is happening
in the case of priority lending as well as restrictions
on banking activities in India. Second, even public
sector banks find that as private domestic and foreign
banks, particularly the latter, lure away the most lucrative
banking clients because of the special services and
terms they are able to offer, they have to seek new
sources of finance, new activities and new avenues for
investments, so that they can shore up their interest
incomes as well as revenues from various fee-based activities.
In sum, the processes of liberalization noted above
fundamentally alter the terrain of operation of the
banks. Their immediate impact is a visible shift in
the focus of bank activities away from facilitating
commodity production and investment to lubricating trade
and promoting personal consumption. Interest rates in
these areas are much higher than that which could be
charged to investments in commodity production. According
to a study (Consumer Outlook 2004), conducted by market
research firm KSA Technopak, Indian consumers are increasingly
financing purchases of their dream products with credit
that is now on offer, even without collateral. "Personal
credit offtake has increased from about Rs 50,000 crore
in 2000 to Rs 1,60,000 crore in 2003, giving an unprecedented
boom to high-ticket item purchases such as housing and
automobiles," the study reportedly found.
But there are changes also in the areas of operation
of the banks, with banking entities not only creating
or linking up with insurance companies, say, but also
entering into other ''sensitive'' markets like the stock
and real estate markets. It should be expected that
this growing exposure to non-collateralized personal
debt and entry into sensitive sectors would increase
bank vulnerability to default or failure. The effects
on bank fragility became clear after the stock scam
of the late 1990s. The RBI's Monetary and Credit Policy
Statement for the year 2001-2002 had noted that: ''The
recent experience in equity markets, and its aftermath,
have thrown up new challenges for the regulatory system
as well as for the conduct of monetary policy. It has
become evident that certain banks in the cooperative
sector did not adhere to their prudential norms nor
to the well-defined regulatory guidelines for asset-liability
management nor even to the requirement of meeting their
inter-bank payment obligations. Even though such behaviour
was confined to a few relatively small banks by national
standards, in two or three locations, it caused losses
to some correspondent banks in addition to severe problems
for depositors.''
Interestingly, this increase in financial fragility
has been accompanied by the emergence of new instruments
in the banking sector. Derivatives of different kinds
are now traded in the Indian financial system, including
crucially, credit derivatives. Most derivatives, financial
instruments whose value is based on or derived from
the value of something else, are linked to interest
rates or currencies. Credit derivatives are based on
the value of loans, bonds or other lending instruments.
A working group of the Reserve Bank of India had recommended
in 2003 that scheduled commercial banks may initially
be permitted to use credit derivatives only for managing
their credit risks. But banks were not permitted to
take long or short credit derivative positions with
a trading intent. Credit derivatives were seen as helping
banks manage the risk arising from adverse movements
in the quality of their loans, advances, and investments
by transferring that risk to a protection seller. Using
credit derivatives banks can: (1) transfer credit risk
and, hence, free up capital, which can be used in other
opportunities; (2) diversify credit risk; (3) maintain
client relationships, and (4) construct and manage a
credit risk portfolio as per their risk preference.
Banks in India have quickly responded to this opportunity.
For example, soon after the introduction of interest
rate futures in India, Citigroup concluded three securitization
deals worth Rs 570 crore ($126.6 million), where yields
on government securities or the call money rate, were
used as the benchmark for pricing floating rate payments
for investors. The underlying receivables arise from
a large number of fixed rate loan contracts made for
financing commercial vehicles and construction equipment.
The risk here is being shared with mutual funds, who
are reportedly the major investors.
Even the conservative State Bank of India (SBI) has
taken a plunge into the credit derivatives market to
cope with the risk arising from its growing loan portfolio.
The bank had recorded a growth of almost Rs 36,000 crore
or 25 per cent in its loan portfolio on a year-on-year
basis till September 2004, staring from a total loan
assets position of Rs 1,35,000 crore in the corresponding
period of the previous year. Of this credit growth recorded
by the bank, more than 40 per cent had been contributed
by retail assets. Credit derivatives offered an opportunity
to hedge against the risks being accumulated in this
manner.
It should be clear that credit derivatives are an industry
response to the increasing fragility which comes with
the changed nature of banking practices. Derivatives
of this kind permit the socialization of the risks associated
with the liberlaization-induced transformation of banking.
These trends are in keeping with changes in the international
banking industry as well. As The Economist, London,
put it: ''The world's leading banks decided some years
ago that lending is a mugs' game. They began to get
rid of their loans, repackaging them and selling them
off as securities, or getting others to re-insure their
risk.''
From the point of view of the banks this effort has
been extremely fruitful. Thus, when there was a major
melt down in corporate America, as a result of financial
fraud and accounting malpractice, leading to the closure
of giants like Enron and WorldCom, leading banks that
had lent large sums to them appeared unaffected. According
to one estimate, loans totalling $34 billion were wiped
out through these bankruptcies. But far less amounts
showed up as losses in the bank's accounts and, in the
second quarter of 2003, Citigroup reported a 12 per
cent increase in profits and J.P. Morgan Chase a 78
per cent increase.
It should be clear that these losses have to show up
somewhere in the accounts of the financial system, but
as the Bank of International Settlements (BIS) argued,
it is not easy to trace them. ''The markets lack transparency
about the ultimate distribution of credit risks,'' it
declared. One reason could be that these losses were
being borne by insurance companies, which would be treating
them like any other casualty loss so that they are not
identifiable. The BIS sees this conundrum as being the
result of the substantial growth of the practice of
credit-risk transfer—the shifting of risk from banks
on to the buyers of securities and loans, and on to
the sellers of credit insurance.
In sum, the traditional image of the great banks with
armoured vaults has little to do with the banks of today.
The latter appear to make loans and then pass them on
as quickly as possible, pocketing the margin. That allows
them to take bigger risks in trading securities, derivatives,
and foreign exchange. But these risks do not go away.
At the end of 2002, though non-bank entities accounted
for just 10 percent of the syndicated loan market in
the US, they held 22.6 per cent of the bad or doubtful
loans. The same is now happening in India, increasing
the fragility of a host of non-bank financial institutions,
such as pension funds, mutual funds and life-insurance
companies. Unfortunately, rather than recognise this
danger, the Finance Ministry is keen on ensuring changes
of the kind described above through a State-directed
process of financial engineering. The full implications
of the resulting changes would be revealed only in the
days to come. But the experience elsewhere provides
cause for concern.
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