Banks, brokers and the RBI

The central bank needs to act decisively in order to shield banks from the volatility of whimsical markets.

AS the dust settles around the post-Budget stock market collapse, attention is being directed at the role played by the banking system in the events that led up to the mini-crisis. The explicit role of a few cooperative banks and some smaller private sector banks is now well documented. There were some, like the Madhavpura Mercantile Cooperative Bank and the Global Trust Bank, that where willing to accommodate brokers with funds to invest in shares to an extent where their exposure to particular brokers and to the stock market was far beyond what would be considered prudent. There were others, like Bank of India, that were willing to discount instruments, however safe, representing more than unusually large sums of money, issued by organisations whose ability to back such instruments were obviously doubtful. Yet others have been characterised by a degree of exposure to investments in the affected banks, which could imply large losses that could affect their viability.

These acts of omission and commission (concentrated no doubt in a few cooperative banks in a few centres) which helped finance a speculative run that collapsed in the wake of a bear attack have not merely triggered investigations of varying intensity against individual officials in the system but threatened the existence of at least one bank, forced losses on others and left a large number of small savers with no access to their own money. These developments have raised questions about the adequacy and efficacy of the regulatory framework designed and implemented by the Reserve Bank of India (RBI). The RBI has been quick to respond. Unfortunately, however, that response combines an effort to trivialise the fallout of the crisis for the banking system, to declare that the acts of omission and commission were more the exception than the rule and that minor tinkering with the regulatory mechanism would be adequate to deal with the problem.

This emerges from the following paragraph in the RBI's Monetary and Credit Policy Statement for the year 2001-2002 (portions of which have been highlighted here in order to focus on the thrust of the central bank's reading of the problem): "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. In the interest of financial stability, it is important to take measures to strengthen the regulatory framework for the cooperative sector by removing 'dual' control, by laying down clear-cut guidelines for their management structure and by enforcing further prudential standards in respect of access to uncollateralised funds and their lending against volatile assets."

Clearly, the RBI sees the problem as being largely restricted to the cooperative banking sector. In order to cover itself against the criticism that it ignores the fact that the problem goes deeper and is systemic, the RBI has hastened to add: "In the light of recent experience, some corrective steps to prevent commercial banks from taking undue risks in their portfolio management are also outlined."

A CLOSE look at the evidence suggests, however, that the RBI's response is indeed inadequate. The exposure of banks to the stock market occurs in three forms. First, it takes the form of direct investment in shares, in which case the impact of stock price fluctuations directly impinge on the value of the banks' assets.

Second, it takes the form of advances against shares, to both individuals and stock brokers. Any fall in stock market indices reduces, in the first instance, the value of the collateral. It could also undermine the ability of the borrower to clear his dues. In order to cover the risk involved in such activity, banks stipulate a margin, between the value of the collateral and the amounts advanced, set largely according to their discretion.

Third, it takes the form of 'non-fund based' facilities, particularly guarantees to brokers, which renders the bank liable in case the broking entity does not fulfil its obligation.

As at present, the RBI guidelines regarding bank exposure to the stock market apply only to direct investment in shares. Even these have been substantially relaxed in recent times. According to guidelines issued in October 1996, when banks were being encouraged to invest in stocks as part of the process of financial liberalisation, banks were permitted to invest up to 5 per cent of their incremental deposits in the stock markets. Initially, investments in debentures/bonds and preference shares were included within this 5 per cent ceiling. However, as stock market performance was increasingly accepted as an indicator of the success of reform, and the government was under pressure in 1997 to revive the flagging markets, it sought to encourage banks to invest more in the markets by taking debentures/bonds and preference shares out of the calculation of the limit in April 1997. This made the ceiling only relevant for investment in equities. Driven by these signals, a group of 21 public sector banks increased their investments in equities from Rs.1,488 crores in 1997 to Rs.2,293 crores in 1998.

In September last year, these guidelines were relaxed even further based on the recommendations of a committee comprising senior executives of the RBI and the Securities and Exchange Board of India (SEBI). The committee held that instead of setting a ceiling on bank investments in equity relative to incremental deposits, banks' exposure to the capital market by way of investments in shares, convertible debentures and units of mutual funds should be linked with their total outstanding advances and may be limited to 5 per cent of such advances. This was subsequently accepted by the RBI and is the guideline that prevails now.

The RBI is sanguine about the risk of bank exposure to capital markets because this is well below this much-relaxed ceiling. A technical committee set up by the RBI to review guidelines for bank financing of equities, observed that investment in shares of the 101 scheduled commercial banks constituted 1.97 per cent of all outstanding domestic advances as on March 31, 2000. This, it noted was well below the 5 per cent limit prescribed in the RBI's circular dated November 10, 2000.

As argued above, for banks investments in equity constitute only one form of exposure to the stock markets. Advances against shares and guarantees to brokers provide other forms. But even on this count the RBI's technical committee is quite positive. This is because: "The total exposure of all the banks by way of advances against shares and debentures including guarantees, aggregated Rs.5,600 crores, comprising fund based facilities of Rs.3,385 crores and non fund based facilities, that is, guarantees, of Rs.2,215 crores, as on January 31, 2001 and constituted 1.32 per cent of the outstanding domestic credit of the banks as on March 31, 2000."

HOWEVER, there is much that these figures conceal. To start with, the aggregate level of exposure across the banking system hides the fact that the 'overall' exposure on the part of some of the private sector banks, whose 'dynamism' has been much celebrated, has been far in excess of 5 per cent. As figures collated by the RBI's technical committee reveal, at the end of 2000 the exposure to the stock market by way of advances against shares and guarantees to brokers stood at 0.5 per cent of total advances in the case of public sector banks, 1.8 per cent in the case of old private sector banks, 4.8 per cent in the case of foreign banks and a huge 15.3 per cent in the case of eight new private sector banks. Thus, the so-called 'dynamic' private banks which are seen as setting the pace for the rest of the banking sector, and are attracting depositors by offering them better terms and better services, are the most vulnerable to stock market volatility.

Secondly, this exposure of the banking system and of those that lead the pack in lending against shares, is dominantly to a few broking entities. The evidence on the relationship between Global Trust Bank and Ketan Mehta only begins to reveal what the RBI's monetary policy statement describes as "the unethical 'nexus' emerging between some inter-connected stock broking entities and promoters/managers of some private sector or cooperative banks."

Thirdly, the liquidity that bank lending to stock market entities ensures increases the vulnerability of the few brokers who exploit this means of finance. Advances against equity and guarantees help them acquire shares that then serve as the collateral for a further round of borrowing to finance more investments in the market. These multiple rounds of borrowing and investment allow these broking entities to increase their exposure to levels way beyond what their net worth warrants.

Finally, by undertaking direct investments in shares while providing liquidity to the market, the banks themselves are further endangered.

BANKS are built on trust. As intermediaries they accept deposits from risk-averse savers, who are offered avenues to make relatively small investments in highly liquid financial assets characterised by low income risk, to fund large investments that are relatively illiquid and characterised by a high degree of capital and income risk. They are able to play this role because of the belief that sheer scale allows them to cover costs, hedge against risk and honour their commitments.

These institutions need to be shielded from market volatility. It is possibly for this reason that the RBI technical committee on bank lending against equity, while holding that the basic framework of regulation need not change, recommends that the 5 per cent ceiling on bank exposure to stock markets must not apply just to direct investments in equity but to all forms of exposure including lending against shares and guarantees to brokeRs.

But this small step in response to the recent crisis may prove extremely inadequate. Five per cent of advances, while small relative to total bank exposure, is indeed large relative to the net worth and the profits of the banks. Major losses as a result of such exposure can therefore have devastating consequences for the viability of individual banks. Given its blind commitment to financial liberalisation, India's central bank appears reluctant to learn its lessons.