The RBI might just succeed in killing the Banking System

Written way back in Oct-2011, some of my very raw thoughts on why what the RBI was doing could offer no solution to the situation then, and could possibly lead to NPAs and lower interest rates, both of which did happen. Right or wrong, there could always be a debate. Looking back, I see this was a very aggressive write up almost an angry tone, and I am just reproducing it "as is".

The RBI has been taking crucial steps to revive the Indian Banking System and thereby, the nation's future. It is rightly said that the nation's strength lies in the strength of its banking system. Indian banking system turned into a very strong bandwagon under Mr YV Reddy, the mastermind banker. However, off late, the strength in system is taking a beating with the new steps taken by the current RBI governor. In this article, I have tried to write about the effects of the destructive steps that the central bank has taken in the last few months.

Fighting inflation - The Outdated Way
The traditional way to fight inflation is to raise the interest rates which will hit the people's pocket and thereby reduce spending, hence demand, and then prices come down. However, the RBI has forgotten the fact we are in a highly strong trajectory of growth. They have considered only economic laws but not the principles underlying fundamental life. The economic laws are subject to certain conditions. One must understand that any item of need, sold for whatever rate, will be sold. For example, we all buy water paying Rs 15 per litre though it is available free of cost. Tomorrow, if the bottle costs Rs 25, we just can not avoid drinking water. It is very easy for the retailers to pass on the price increases to the consumers as the consumers are ready to buy at any given price. Nobody thinks about food inflation while eating food, not even Mr Subbarao. In other words, you can not decrease your food intake because food rates are up by 12% while you expected it at 5-6%.

The future of inflation fighting measures
To get more practical, lets take an example of a middle class family where the family income is, say, Rs 25000 a month. The family is able to save Rs 5000 after all spending over food, clothing, shelter, school fees, etc. Now, when you raise rates, the family will not buy 4kg rice instead of 5kg. They will buy the same quantity by paying a higher price. Thus, the savings squeeze to, say, Rs 3000. You raise rates again and the savings will reduce to Rs 1000. Thus, there is no way you can battle this. Asking to stop eating sugar because it causes diabetes rather than making attempts to reduce sugar prices is utter non sense. Were onions not sold at Rs 100 a kg? Were there no purchasers? Did people stop buying or stop eating onion? Thus, any increase in prices will only reduce the saving ability of the public and thus the savings in the nation. 

The balances start appearing in current accounts (of businesses) and disappearing from the savings accounts. The banks will be happy till this stage. But then, the pinch comes soon. Soon, the savings turn negative and people start withdrawing the funds that they have saved. Or rather, they will start defaulting on EMI payments. The NPAs rise. And then, we reach a debt clutter which will be difficult to understand. And very soon, we will becomes the USA or the UK and our banks will start shutting doors or ask the Government for capital infusion or bailouts or loan waivers. The Government can borrow from IMF and increase its debts and fall in the national debt trap. Alternatively, it can increase tax rates on corporate and take out all those amounts lying in the current accounts of the banks in the form of taxes and give the bank the same amount as fresh capital infusion. What a Trick..!! The bank's external liability turns into internal liability to the shareholder (Government) and the balance sheet looks Wow again. The banks give interest to public. The public give to corporate. The corporate give to the Government. The Government gives it to the banks. A viscous circle where money wanders till it is laundered.

Therefore, the RBI must rather try to actually reduce the prices rather than reducing the demand. The RBI must understand the underlying fact that we do not eat 2kg rice instead of 1kg just because it is available cheaply. The sugar rates have fallen back to old levels and most retailers are even offering sugar free with purchases of certain items but does any data indicate that sugar consumption has increased. The sugar stocks have turned sick. Of course, the scene is different with automobile sales. But then, to keep these on a track, the bank must ask the Government to raise duties & taxes on car sales rather than increasing interest rates in general and affect everything including the housing sector making a fundamental need in-affordable. The RBI must understand that the current economy is so vibrant like a shining mirror that if you try to hit it with a brick, it will hit back with a rock, unintentionally. This is exactly what is happening. The more the prices are rise, the more careless people get with finances. The public will stop planning their finances and start spending recklessly as the saving amounts (like 500, 1000) do not interest them. Thus, the leaders leading the nation have to seriously think about the underlying facts & the long term effects rather than blindly looking for short term solutions by following the traditional economic laws, and that too, without completely understanding the laws.

The Big Bank Theory
Indian banks are on a very strong platform. The big banks reporting 20-30% growth rates consistently over the years is not less than a miracle. As the progress has been happening over a long term, the banking industry is in a kind of consolidation phase now. Trying to mess with them at this point of time can be very damaging. The recent deregulation of interest rates can be a big blow to banks, and in turn the economy, in the long run. The RBI should not have forgotten that the banks are already stressed for the sudden changes in saving account rules over the last one year.

The first blow came when the RBI announced that the banks will have to pay interest on savings account as per daily balances (like it is calculated on loans) and not on the minimum balance maintained from 10th to last day of the month. The banks interest outflow on savings account has increased by 60-70% on account of this rule.

The second blow came when the interest rate was increased from 3.5% to 4% pa on savings account. The interest outflow to savings account increases by another ~15% on account of this rule.

The third blow has come with deregulation of interest rates offering a competitive advantage for banks with low CASA ratios to pull markets towards them.

In all these decisions, the big banks have been big time losers. The big banks survive on impressive margins offered by CASA amounts lying with them. They benefit most from these funds and these funds are their major source of earnings. The scenario will take a bad hit in the long run. The RBI or the Government might think that the public is happy. But then, they have to understand that the public is not bothered about SB interest rates. The public is more concerned about the food prices, petrol prices and inflation that is snatching their pockets. A very few people think about earning interest in the savings accounts. The public rather considers FD or RD route in case they have an interest element on their minds. I guess, the PMO or the FMO or the RBI might not have received even 1 request from the public asking them to rise SB interest rates or deregulate them when we consider the lacs of requests that have gone to them seeking their help in battling price rise. Such unnecessary steps might not be welcome. Nobody celebrated these decisions though they mean more income to the public.

Small banks have already started increasing their SB interest rates. Big banks will be forced to follow suit.

The Small Elephants
Another big question is, will the small banks be able to handle the large fund flows on to their balance sheets? Managing such fund flows is not an easy task. The small banks are not well equipped in marketing their loan products or in recovering the funds they lend. There are definite hurdles on this front as well.

If the big banks stick to honesty and say that they can not offer more than 4% interest rate, the SB account holders might start moving to smaller banks & take their FDs & RDs along with them. The balance sheets of the big banks will start deteriorating. The deposit to loan ratio will take a hit and soon, the balance sheet will turn ugly. A situation will come when there will be needs for limitless capital infusions (like in the US, UK & advanced nations today) and yet, the amounts would stand insufficient to pay for their expenses or the deposit maturity amounts. The fall will be as simple & quick as the fall of Lehmann. It just happens and you will never know.

If the big banks do not want to lose market share and increase the rates at par with smaller banks, their profit margins will take hit. The banks that are showing a 30% YOY growth will fall to 10-20% odd healthy levels but the smaller numbers are bound to create a negative sentiment in the economy. Investors might turn bearish and start selling these bank stocks. Any such aggressive selling of a bank's stock represents lower confidence in the economy and the markets might take a bad hit and thereby kill the India Long Term Story.

Coming Up.. The Killing
All this can lead to a situation where banks will look for alternate sources of income to show the 20-30% growth that they have been achieving YOY. One such stream would be to enter investment banking. Of course, the RBI only will give permission to Indian banks to start the investment banking arm as soon as the stress results are out. And once the banks start getting trading income, the balance sheets will turn haywire. Every ratio will go out of gear and you can never understand what is happening. Trading income is sweet in the beginning but trading losses are not just sour, they are poison.

Banks might also land up to window dressing their accounts. It might start with, just this quarter kind of approach to save a face and its effect might carry on all over years. And one fine day, we have the Satyam kind of bubble burst.

There are a lot of disadvantages of all these steps that the RBI is taking and everything will show up in the long run. The Governors must understand that Indian Banking System is one of the most honest and strongest system in the world. Any steps that hurt them might force them to, unintentionally, enter into dishonest world and the public might lose their faith in the banks as well. We already have lost faith in many things that are supposed to be our lifeline. Please note that Banking business runs purely on faith & trust. That is why, we bankers firmly believe, 'Faith reaches where Reasons don't'. I do not know how the big bankers have forgotten this basic rule which they were taught when they entered this field.

The target must be to reduce inflation by reducing prices by facilitating better credit facilities and help growth of the nation. Moderating growth is definitely required till it moderates. It must not be done at the cost of curtailing growth. Moreover, you can not curtail growth of us youth who are nowhere interested in stopping ourselves for whatever reason. Sell us anything at any rate, we will buy it if we need it. When the equation clearly says you can not kill demand, try something else. Sorry but you might have to read Economics lessons again before misusing your powers to ruin a nation. I remember the 'Back to School' with Bata ad.

Another mistake that the RBI might be forced to do in the future is to allow 100% FDI into banks. Of course, the day will come when national treasury will dry and we will need international funds. And another one might be throwing open the banking industry for anyone & everyone to do the business and thus, turn them into fish markets. Soon, you will run out of trust and thus, the depositors will not give you their monies and neither will the debtors.

I do not believe SB rate deregulation will do any good (than the evils it can do) because, firstly, one must also understand that deregulation of interest rates, in the long run, means 0.5% or even 0.25% rates will have to be accepted by the public once the banking system starts facing challenges. The cream will get over very soon and all that will be left is the bread. Secondly, as long as SB rates are regulated, banks are serious about earnings to meet their interest commitments. Thirdly & most importantly, having SB rates at 4% means that FD/RD rates will definitely be higher than that. Tomorrow, your FD might earn 1% or half a percent interest and you have to take it or break it. That's the trap.