‘Buy Now, Pay Later’: What is it, and how does it affect customer protection?
By Deepti George, IFMR Finance Foundation
This research paper titled “Modernisation of India’s Banking Sector” is published as part of IFMR Finance Foundation’s “Notes on the Indian Financial System” research series.
India’s banking sector is characterised by a few large national banks and many smaller banks of a regional nature, all of which have traditionally been forced to adopt similar strategies in expanding their banking business. Such strategies have been characterised by an almost exclusive Originate-To-Hold-till-Maturity (HTM) approach to managing asset books in an environment where a significant portion of credit continues to be targeted to specific ‘priority’ sectors at artificially low prices based on policy mandates. These high cost and high risk approaches have resulted in several anomalies that currently plague the Indian banking system. The high accumulation of non-performing assets on banks’ books and the continued multi-year government-led capital infusion are only symptomatic of these anomalies. This paper seeks to lay out a set of ideas that look at root causes of bank performance, which will then pave way for the modernisation of the sector.
At the heart of these recommendations is an attempt to go back to first principles of banking and to reflect on what banks’ managements and boards (notwithstanding their ownership patterns), and the banking supervisor need to focus on in order to set the course for a globally competitive banking sector for India, and the paper is organised into two broad sections that reflect these two categories of recommendations. A third section deals with recommendations to improve risk management outcomes for credit institutions by enabling the adoption of derivatives and insurance.
Below is a summary list of recommendations.
- Banks must undertake better risk-based pricing of their loan assets and for this, banks need to rely on processes and frameworks that reveal the true costs incurred in originating loans for various borrower profiles and asset classes. These frameworks include Matched Fund Transfer Pricing (MFTP) to understand cost of funds, Activity Based Costing (ABC) to understand transaction costs, and Risk-Adjusted Performance Measurement (RAPM) for measuring the cost of equity.
- In its risk-based supervisory process, the RBI must move away from detailed instructions in its Monitorable Action Plan (MAP) and shift towards an approach of specifying targeted risk scores for each bank based on its unique risk position. As a prudent target to place on banks, RBI can focus on ensuring that Systemically Important Financial Institutions (SIFIs) consistently meet low risk scores, while non-SIFIs have more leeway to take on risker endeavours and therefore are to meet higher capital norms commensurate with their riskiness.
- RBI must provide differential provisioning (both standard and impaired assets) and asset classification norms that reflect the underlying riskiness of each asset class.
- RBI must require banks to demonstrate IFRS parallel run on their books, and also require the 21 new bank licensees to become compliant with IFRS from start of business to prevent the establishment of legacy systems.
- Banks will need to be permitted to move away from an exclusive originate-and-hold-till-maturity strategy and gradually start to document all their loans using debenture / bond documentation so that the liquidity of their balance sheet improves. Credit facilities documented as bonds or Pass-Through Certificates (PTC), whether originated directly or purchased in the secondary markets should be permitted to be held to maturity (HTM) based on declared intent. To this end, there is no longer a need for an artificial distinction between the banking book and the trading book that prevents banks from holding bonds in the former. RBI or FIMMDA must develop and publish Standardised Debenture Trust Deed (DTD) templates that can be used by banks for bonds and loans to improve investor confidence in lower rated bonds and the tradability of loans.
- There is a need to reimagine the role of universal banks as one that is no longer engaged as risk originators but rather as being risk aggregators, with freedoms to rebalance their portfolios based on risk-profiles and diversification outcomes that each bank decides for itself. Tools such as the Generalised Herfindahl-Hirschman Index (HHI) are useful for banks in quantifying the extent of diversification in portfolios containing a mix of assets that are correlated to various degrees. It is worthwhile to consider the use HHI as a measure of concentration risk, as has been used by the U.S. Department of Justice in its Horizontal Merger Guidelines.
- RBI must require greater levels of disclosures from all banks with regard to concentration levels to each segment/sector, largest counterparties, as well as results of stress tests, both at an overall balance sheet level as well as at a segmental level at least annually so that these banks compete with each other on the strengths of their balance sheets alone, in a level playing field where no entity gets favoured over others due to lesser disclosure requirements.
- Banks must equip themselves with instruments such as credit derivatives for better risk management of their portfolios. The permission from the RBI to use CDSs for loans held on banks’ books would make CDSs much more useful as a risk management tool, and this is especially so for regional banks who can purchase CDSs from large national banks who are better placed to warehouse those risks that regional banks are exposed to.
- Banks must be permitted to hedge commodity price risks on their agri lending portfolios and offer them to their customers on an OTC basis. In order to permit this, the Government can notify agri-commodity futures and options under the “Any other business” category of the Banking Regulations Act.
- In order to guard against large scale defaults resulting from catastrophic events, banks must work closely with insurance companies to purchase bank-wide portfolio level insurance against events such as large scale rainfall failure on a regional or national basis, instead of having an expectation that relief would be provided from national or state budgets.
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