Fatal flaw in private banking systems..

Prof TT Rammohan has an article on the topic.

As Indian media and experts blame all ills on India’s public sector banks , the western world has an opposite take on the matter. There is a joke someone was telling me on this. First you take a loan from a public sector bank to go to a foreign university. Then you come back as an expert questioning the entire essence of the same public sector banks.

The author reviews Mr Adiar Turner’s recent book which points to issues in private banking system:

Banks, we know, can create money and credit that is a multiple of the deposits they take. Economists have long pondered how to place prudential limits on the creation of credit. Without such limits, economies would face runaway inflation. There are two mechanisms that they have thought up in order to limit excess creation of credit by banks. One is to require banks to have a minimum of proportion of their liabilities as liquid reserves with the central bank (“fractional reserve” banking). The other is to ensure that the interest rate is kept at a level at which inflation is low and stable. Economists reckoned that these two mecha­nisms would keep credit creation within bounds.

They have been proved wrong. Why? Because they overlooked an important fact about bank credit in advanced eco­nomies. Contrary to what the textbooks tell us, bank credit does not go mainly to finance new capital investment. It goes towards financing existing assets, mostly real estate. In the advanced economies, 60% of all lending in 2007 was towards real estate, up from 30% in 1928. A significant portion of the remaining 40% went towards commercial real estate.

Turner gives three good reasons why banks predominantly finance real estate. First, they see lending against real estate as relatively safe. Second, housing accounts for most of personal wealth in advanced economies. Third, as economies become information intensive, industries need less of capital investment. As a result, the price of capital equipment has tended to fall. Investment thus comes to be dominated by a category of goods—physical construction—whose prices tend not to fall.

The supply of housing, especially the high-end variety which attracts the bulk of investment in real estate, is inelastic. As more and more credit chases a limited supply of real estate, prices shoot up. One day, the bubble bursts.

The two instruments intended to restrain credit are of little avail. Reserve requirements are modest and can still permit large expansion in credit. Inflation does not rise a great deal because asset prices have risen. Conventional monetary policy, which relies on the use of interest rates, does not respond to asset bubbles. Thus, the very nature of lending in advanced economies predisposes them towards crises.

Turner rejects the notion that some of the solutions that have emerged since the crisis—stipulating higher capital requirements for banks, finding ways to fix the too-big-to-fail problem, etc—will not solve the problem. He is right. The higher capital requirements under the much-touted Basel 3 accord will still leave banks with a leverage ratio of 33:1. Even if the resistance from banks were overcome and we were able to stipulate a leverage ratio of 10:1, banks would still be able to create excess credit and would still be vulnerable to failure.

The only answer, Turner suggests, is for central banks to impose restrictions on creation of credit by private banks. For instance, in imposing risk weights on bank loans, central banks should take into account the social value of credit extended by banks. If we do restrict credit creation by banks, however, we are faced with a macroeconomic issue: how do we expand nominal demand? Turner proposes a solution that will cause central bankers to fall off their chairs: the monetisation of government deficits. Mainstream economists will, no doubt, regard Turner as something of an economic Naxalite.

He adds Turner should have looked at Indian Public sector banks:

For us in India, Turner’s thesis about private banks has interesting implications for banking policy. It is a pity that Turner has not looked closely at the public sector-dominated model in Indian banking. This system is almost unique in not having had a single crisis for over two decades. (For all the hysteria over public sector bank (PSB) losses at the moment, what we have is a stressed situation, not a crisis involving the failure of multiple banks.)

It is worth giving some thought to how this outcome has come about. Three features tend to turn private banks into weapons of mass destruction: the capacity to create credit, high leverage, and incentives for risk-taking. Of these, the last one is relatively muted under public ownership. In PSBs, bankers’ rewards are not tied to the profits they make. So PSBs tend to be relatively averse to risk and their decisions not as motivated by considerations of profit.

This may seem bad at the micro-level. PSBs tend to underperform private banks precisely for these reasons and have been faulted on this account. However, the macro outcome turns out to be a favourable one. We have a system that is stable because not everybody is chasing risky gambles with high pay-offs for managers.

Turner would like central banks to ensure the outcomes he thinks are desirable, such as preventing excess creation of credit or directing credit to socially useful purposes. Might it be that public ownership in banking—with some fine-tuning to achieve better governance—could achieve the same outcomes, as the Indian experience has shown?

Not entirely true. PSBs surprisingly have taken risks in their lending portfolio by lending to airlines of all businesses. Earlier PSB assets were stressed on account of loan melas, rural loans etc. This time it is mostly loans trapped in infra sector.

But yes overall, one would think PSBs to be less risky and adventurous. This takes me back to the question I had asked earlier, why do bad loans happen only at public sector banks?

Banking has become a problematic industry after the crisis. There are no easy answers over ownership and governance. There is little doubt that mess of Indian PSBs is not even a fraction of mess of private banking systems of US and UK. But then in India we are pretty much blind to what is happening around the world and busy copying them for whatever their worth may be..

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