The RBI’s continuance of the cash withdrawal limits, along with the thrust on digital banking, is aimed at averting the possibility of a bank run

“Do you fear a run on the banks?” This was the question posed by some MPs in the Parliamentary Standing Committee on Finance to Urjit Patel, Governor, Reserve Bank of India (RBI). Before he could respond, former Prime Minister Manmohan Singh intervened by saying, “No, you don’t have to answer this question.” Had the Governor answered the question, he would probably have listed out scenarios that could result in a bank run. Since the 2008 global financial crises, central bankers are actively engaged in the issue of financial stability and pre-emption of bank runs. The RBI too has been bringing out half-yearly Financial Stability Reports (FSR) since 2010, in which one section is devoted exclusively to the commercial banking sector. The reports contain sophisticated stress tests that gauge the risk to the banking system based on liquidity-cum-insolvency contagion scenarios. These reports are reviewed by a subcommittee of the Financial Stability Development Council that functions under the Finance Ministry.

Any professional banker would never deny the possibility of a bank run. Banking is a risky business. A bank lends out money received from its depositors. The presumption is that all depositors will not demand all their money back at the same time. There is liquidity risk if the bank is unable to repay on demand the money it has accepted from the depositors. There is credit risk if the bank is unable to recover its loans.

The central bank, as a regulator, ensures that a bank is prepared to meet liquidity and credit risks. The capital to risk (weighted) assets ratio (CRAR) is a safeguard that the capital base of a bank is not eroded. The statutory liquidity ratio (SLR) is a safeguard that a bank is able to return deposits of customers on demand.

Credit and liquidity risks

In order to further mitigate these risks, the RBI is adopting international standards prescribed by the Basel Committee on Bank Supervision and the Financial Stability Board. It has directed banks to give up forbearance in the classification and reporting of non-performing assets (NPA) from April 1, 2015.

In simple terms, this means that as banks stop playing ‘pretend’, the loans that were earlier classified as ‘standard’ assets will now be downgraded, leading to an increase in the loan defaults. Excess provisioning will lead to a decline in profits; in some cases even chipping away bank capital. This declining trend is discernible in the bank performance during 2015-16. The ratio of gross NPAs to gross advances increased sharply from 5.26% to 10.69% for nationalised banks and marginally from 2.10% to 2.83% for private banks from March 2015 to March 2016. According to the December 2016 FSR, as of September 30, 2016, the return on assets for public sector banks was -0.1%, and 1.5% for private sector banks. Similarly, the return on equity for public sector banks was -1.5%, and 13.4% for private sector banks.

Credit risk covers possibilities of defaults by individual borrowers and borrower groups. For example, if because of borrower default, one bank fails, it is likely to trigger a domino effect across banks — since banks have financial linkages with each other besides exposure to the same big borrower groups. However, a bank with adequate CRAR would be able to withstand this credit shock.

The December 2016 FSR reveals interesting results of stress tests conducted using 10 different scenarios based on the information of group borrowers. The tests show that CRAR would fall below 9% for two banks if there is default of the top 1 borrower group; five banks if the top two borrower groups default; 12 banks if the top five borrower groups default and as many as 22 banks if the 10 top borrower groups default.

A typical liquidity risk scenario covers unexpected deposit withdrawals (10% withdrawal in 10 days or a 15% withdrawal in 5 days) in banks on account of loss of depositor confidence. The December 2016 FSR analyses the liquidity risk to the banking system on the assumption of increased withdrawals of the uninsured 10% deposits (presently these are 69% of total deposits) and unutilised portions of 75% sanctioned working capital limits. The tests show that only 49 out of the 60 banks in the sample will remain resilient (by using their SLR and High Quality Liquid Assets) in such a scenario. In case of incremental shocks in an extreme crises, banks will be able to withstand withdrawals of 15% of deposits using their remaining SLR investments. In other words, 11 out of the 60 banks will fail the liquidity test! The report does not disclose the names of these 11 banks.

Banks on the precipice

Incidentally, Viral Acharya, the new RBI Deputy Governor, in a study titled ‘State intervention in banking: the relative health of Indian public sector and private sector banks’, concludes that the Indian banking system needs radical reform and recommends repealing the SBI Act, SBI (Subsidiary Banks) Act, and Nationalisation Acts 1970, 1980. One of the scenarios studied assumes the absence of regulatory forbearance on restructured assets (as directed by the RBI with effect from April 1, 2015). The results show that in such a scenario the tier I capital of all public sector banks slips below the mandatory 6.5% level and four public sector banks become insolvent.

As anyone familiar with quantitative tests would know that the stress tests are based on certain assumptions and not foolproof in their replication of reality. However, these tests do indicate that the banking system is apparently not even prepared for the withdrawal of 10% of depositors funds. Perhaps, a more appropriate question for the RBI Governor would have been, “How are you planning to prevent a bank run?”

It is therefore not surprising that the RBI is continuing with its cash withdrawal limit of ₹24,000 and managing perceptions by allowing minor concessions to current account holders (while ATMs continue to run dry). This, along with the thrust on digital banking, is ensuring that a large portion of the uninsured deposits remains within the banking system, thus precluding the possibility of a bank run.

Meera Nangia is an Associate Professor in commerce at the University of Delhi. Her doctorate was on the Indian banking system.