By Deepti George, Dvara Research
The troubles of the banking sector, and public sector banks (PSBs) in particular, are well known. Reform proposals have focused largely on ownership and have issued strident calls for privatization. Even if there was political support for this idea, there are a few important challenges.
The total current account and savings account (CASA) base of PSBs in India was Rs30.2 trillion (including State Bank of India, or SBI) and Rs 18.9 trillion (excluding SBI) in 2017. By and large, this reflects the confidence of customers in the implicit government support to these entities. One has to only recall the brouhaha on the Financial Resolution and Deposit Insurance (FRDI) Bill’s bail-in issue to realize that banking customers in India expect their deposits to not face any uncertainty, even when the bank is failing. In such an environment, and where alternatives in the form of other well-managed banks with significant branch networks are not yet fully in place, privatization could cause a flight of savings from banking to physical assets—a trend that has been in any case stubbornly persistent despite all the gains in financial inclusion.
We propose a pragmatic alternative to privatization of PSBs. The core strength of PSBs is the deposit franchise. Their branch network in far-flung areas, combined with the trust reposed in the government, means that they are the preferred choice of the mass-market customer, rural customers, and, often, retired individuals.
Given the low deposit rates offered by banks in India relative to the risk-free rate, these deposits represent tremendous value in terms of a profitability cushion. The erosion of value really happens on the lending side. This occurs due to a few reasons: firstly, mandated lending through various schemes, in addition to priority sector lending targets; secondly, the poor risk management competencies of banks, particularly vis-à-vis managing the concentration risks of specific sectors and business groups; and third, lack of specialized underwriting skills, given that customers tend to range from large firms and farmers to small businesses and mortgages. The math here is straightforward—the risk-adjusted return from the lending activity of the bank erodes all the value created by the deposit-taking activity.
Narrow banking proposals that suggest PSBs only invest in government securities (akin to the payments bank design) run the risk of starving the real sector of much needed bank credit. What we propose is to find a balance between completely discretionary lending and zero lending by PSBs. We call this the “risk aggregator” model. Here, the deposit-taking activity would continue as present. On the lending side, rather than PSBs directly originating credits through branches or consortia and hoping for the best, they would assemble a portfolio of credits that are originated by specialist institutions (non-bank finance companies and small finance banks) with credit appraisal and underwriting capabilities in chosen sectors and geographies.
Assembling this portfolio of loans can be done through a variety of ways, such as direct purchases of their loans, and by investing in securitized assets representing underlying loans originated by these specialist institutions. This also implies a clearer role for these specialist institutions and their contributions to extending credit in an efficient manner. With such an assembled portfolio of loans, the “risk aggregator” is to then focus on managing aggregate risk on the balance sheet. One could argue that if PSBs are not competent to make loans in the first place, would they be competent buyers of risk in a secondary market? That is where internal credit assessment processes and external ratings have a big role to play in ensuring that there is sufficient information about the loan pools being bought by PSBs.
This is not entirely a new idea; glimpses of this model can be seen in the priority sector lending certificates market and the micro-loan securitization market where specialists trade assets with non-specialists in a markets framework.
A full transition into the creation of banking aggregators would ensure a more efficient approach to capital, while, importantly, preserving the deposit franchise of PSBs. This is because under the risk aggregator model, the PSB asset book would be highly rated owing to the high levels of diversification and granularity in underlying loans.
Portfolio-level guidelines would need to be specified, including concentration limits in relation to their capital, not just to sectoral or regional concentration, but also to large and connected exposures to single borrowers or closely related groups of borrowers. The risk aggregator model would be subjected to high-quality risk reporting requirements that would be made possible by the availability of accurate and complete data along business lines, legal entity type, asset type, industry, region and other groupings that permit identifying and reporting risk exposures, concentrations and emerging risks.
The Reserve Bank of India has innovated on the banking design in recent years with the introduction of the differentiated banking regime. PSB as a risk aggregator fits into this thinking, especially in the context of transforming existing institutions to safer regimes, particularly in light of new requirements, such as the implementation of new reporting norms, around the corner.
This article first appeared in Livemint here.