India’s fundamentals are strong

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India’s fundamentals are strong

Monday, 20 March 2023 | Bikash Narayan Mishra

India’s fundamentals are strong

Oscars for an Indian film and the best performance of Indian banks in a decade buttress the confidence in the Indian story

About a month back the Hindenburg story led to a series of reports expressing concerns and apprehensions about Indian Banks’ exposure to a particular business house. The strong framework and resilience and of course the recent gains of the Indian Banking sector came under the radar. In no time the regulator made a statement saying that the size and robustness of the Indian banking system are too large and strong to be affected by a one-up incident. The banking sector in India is stable, and the various key parameters of banks such as capital adequacy, asset quality, liquidity, Provision coverage and profitability are healthy, the RBI added.

The entire nation heaved a sigh of relief, our banks are safe! But hardly the dust had settled something goes seriously wrong 8000 km away in Silicon Valley. The 40 years old Silicon Valley Bank (SVB), the 16th largest in the US, collapses. And subsequently, one more the Signature Bank (SB) too. As if this was not enough, we have another crisis. Credit Suisse, a global investment bank and financial services firm based in Zurich Switzerland is in news. Their shares closed lower by over 30 per cent on 15th March.

How do we read these developments? Let us start with SVB.

The fact remains that both SVB and SB failed at an enormous speed. Their failure in US banking history is two of the three biggest, the third being collapse of Washington Mutual in 2008. How could this happen? Although there are 08 types of core risks in banks viz Credit, Interest Market, Liquidity, Operational, Compliance/Governance and Reputational. SVB's failure had much to do with the Interest and Liquidity risk.

Interest Risk: A bank faces interest risk when the rates increase rapidly within a short period. This is what has happened in the US since March 2022. The Federal Reserve has been aggressively raising the rates. It has already done that by 4.5 per cent and it is likely the rate, which is now at 4.75 per cent, may reach 6 per cent soon to curb high inflation in the country. As a natural corollary, the yield on debt goes up commensurately. As the yield on security goes up the prices come down. SVB had a massive share of its assets,55 per cent, invested in fixed-income securities.

Of course, interest rate risk leading to a drop in the market value of bonds is not a cause of concern as long as the owner can afford to hold on to it until maturity, hold till maturity (HTM). At that point, it can well collect the original face value without realizing any loss. The unrealized loss stays hidden in the bank's balance sheet and disappears over time. But if the owner has to sell the security before its maturity at a time when the market value is less the unrealized loss becomes an actual loss.

The SVB was forced to be in the latter situation. As there was mounting pressure from its customers to withdraw their deposits to meet their cash shortfalls SVB had to sell a substantial amount of its bond portfolio at a heavy loss. This brings us to a liquidity risk which is an after-effect of interest rate risk.

Liquidity Risk is the risk that a bank will not be able to meet its obligations when they become due without incurring losses. Customers of SVB were withdrawing their deposits beyond what it could pay using its cash reserves. So, to help meet its obligations the bank decided to sell $21 billion of its securities at a loss of @1.8 billion. The drain on equity capital led the lender to raise over $2 billion in new capital. The call to raise equity capital sent shock waves and led to a loss of confidence in the bank. This triggered more withdrawal.

A bank run like this can cause even a healthy bank to go bankrupt. This has happened in India also on a couple of occasions. In the digital age, it is even more possible because people can well withdraw money from their homes also. The Signature bank too faced a similar problem, as the SVB collapse prompted many of its customers to withdraw their deposits out of a similar concern over liquidity risk. The deposits of SVB and SB were uninsured to the extent of appx 90 per cent adds another dangerous dimension to the whole issue.

Even as the business model of SVB was different from that of Indian Banks in as much as the former’s resources came more from the corporate sector whereas in India it is the retail/household who contribute to the deposits of the banking system to the extent of 63 per cent. These deposits are sticker with a duration from 6 months to five years and people do not move to G- sec quickly. On the assets, side loans are approx. 65 per cent of assets and investments 25 per cent. Besides, G-Secs from 18 per cent of total assets for private sector banks (PVBs)and 22 per cent for Public Sector Banks (PSBs). The investment pattern is also different. In India, out of every 100 rupees invested by banks, 65 rupees go to loans and 25 rupees towards bonds and other debt instruments. SVB had invested heavily in bonds/long-term securities to the extent of 55 per cent.

Credit Suisse: The shares of Credit Suisse hit an all-time low on 15th March leaving financial markets all over the world feeling distinctly uneasy. However, following the throwing of a lifeline by Swiss National Bank a $54.5 billion life line to credit Suisse the shares have bounced back.

The move from the Swiss Central Bank comes just days after the US regulators had to take control of SVB and SB. HSBC took over the UK Arm of SVB for a nominal value. So, these are signs of turbulence in the global financial system. Cracks have indeed appeared in the financial pipes and will they burst as they did fifteen years ago?

The famous economist Nouriel Roubini, nicknamed” Dr Doom” for his usually pessimistic and sometimes correct predictions argues Credit Suisse could be another Lehman Brothers; too big to fail, too big to save. Larry Fink, the founder of the world’s biggest asset manager, BlackRock, says we may be in for a “slow-rolling crisis which could see hundreds of small banks go bust in the US, like the savings and loan crisis of the 1980s. But one thing is clear international regulators have learned from the last crisis that speed is of the essence, which is just as well. The US federal and Bank of England have indeed acted swiftly to find a solution.

These outbreaks of instability make it clear that when you reverse nearly 15 years of close to zero interest rate, as has happened in US and UK too suddenly things can break and we had an SVB and SB collapse. But it will not be a reality that the central bank ambulance will always arrive and will arrive in time whether in the West or the East.

SVB collapse is a textbook case of Asset-Liability mismatch- where short-term money is put to long-term use. This is reminiscent of what happened to the Indian mutual fund industry soon after the IL&FS crisis when various debt schemes invested short-term money into illiquid papers. The Global Trust Bank which failed and was merged with one of the PSBs in 2004 enthusiastically played in the capital market much beyond the statutory levels set by the regulators. It was involved in the stock market scam of 2001. Against the backdrop of Oscar awards after a long gap and at a time when the banks in India are gaining traction & about to end up with the best performance in a decade this fiscal and also when our governor has been awarded the “Governor of the Year” award for 2023 by the international publication Central Banking what is the Mantra. It is time for the continuation of quick action by the regulator and time for liberalization mixed with more regulations.

(The Author is a former Banker and Senior Advisor with Indian Banks Association. Views expressed are personal)

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