Banking on banks

As the banking regulator, it is the responsibility of the Reserve Bank of India to monitor and regulate the risk taken by banks. Banking is a risky business as the recent developments involving the Global Trust Bank GTB indicate so clearly. The equity held by banks is very low, compared to the portfolio they build. If equity is 5 per cent of total assets 8212; the loans and bonds held by the bank 8212; then a few loans going bad can make a bank go bankrupt. And, this may not happen because of incompetence or corruption. It may be the ill-effect of the business cycle.

Yet, the way banking has been treated in India, is to create an aura that banks have low risk. People have been led to believe that money in banks is safe. The main reason for this belief has been the large share of public sector banks in India which, even when managed badly, have not been allowed to go under. The response of the banking regulator to poor performance of banks has been very mild. The RBI has not flexed its muscles as the regulator and imposed penalties or shut down banks. Even when banks have violated existing regulations, such as capital adequacy requirements, the regulator has not pulled the plug under them. Worse, when things have gone bad, banks have been bailed out, been merged with other banks or been given loans by the government. The capital injection of Rs 9,000 crore into IDBI in Budget 8217;04 is just another example of the phenomenon. This pattern of behaviour by the government and RBI has created wrong incentives in the system. If the regulator continues to act soft and does not take punitive action, managements get the wrong message. They will come to believe that incompetence is never going to be punished. This could prevent improvement in the management of banks.

Similarly, depositors should clearly understand that only balances of up to Rs 1 lakh are covered by deposit insurance. If depositors place more than Rs 1 lakh in a bank, they are taking the credit risk of the bank. By bailing banks out every time there is a crisis, the RBI is creating the impression that no bank will ever be allowed to go bankrupt. Unless banking regulation is strict, unless weak banks are forced to shut down, the health of the banking sector in the long term cannot be ensured. While the GTB crisis may have been overcome through its amalgamation with Oriental Bank of Commerce, the problem of weak regulation and the wrong signals it sends to depositors, does not get addressed. The GTB crisis should serve as a much-needed reality check.