Column: Getting Volckers Rule to India

Written by Madan Sabnavis | Updated: Dec 18 2013, 10:46am hrs
The implementation of the Volcker Rule, which basically ensures, or rather tries to ensure, that the taxpayers money is not used for speculative trading, is important for two reasons. The first is from the point of view of prudence, where the sanctity of the ethos behind intermediation needs to be preserved. The purpose of intermediation is to channel funds from savers to borrowers, and banks have superior knowledge and analytical tools to bridge information asymmetry to evaluate borrowers. As a corollary, using this money for taking calls in the market is not desirable. The way it has been so far is that when profits are made, the traders and executives reward themselves with bonuses while losses are socialised with the deposit-holders bearing the brunt.

The second is more ideological in naturewhy should we stop at just trading and not look at core lendingbecause the genesis of Volcker was the financial crisis where the concept of sub-prime lending sparked the rot. Therefore, it was lending which started the weakening of the walls.

The present Volcker rule is obviously a good move as it tries to put a halt to proprietary trading by banks which means that they cannot invest in private equity funds, stocks, hedge funds and commodity pools, etc. However, there are exceptions which are allowed that tend to dilute the rule as they are open to interpretation. First, one can trade in government bonds. The assumption is that we can never have a crisis here. But in the American context, the fears of a US default are not unreal any more. This can create chaos in terms of revaluation of bonds by banks. This is definitely a risk carried given the turbulence witnessed in the markets on account of the recent shutdown, debt ceiling crisis and tapering activities in the US.

Second, banks can continue with such trade outside the American geography, which means that a GS or JPM can continue doing so through its subsidiary in the European continent. Third, banks can take positions for clients in markets but have to hedge the same by taking an opposite position. In fact, even market-making is permitted where buy and sell orders are placed simultaneously. As the The Economist has pointed out in a lighter vein, to understand and interpret this rule, one would require the help of psychiatrists and not lawyers. How does one distinguish whether it is being done for clients or on the banks' own account as the money becomes fungible after a point of time

While these issues have to be straightened out, a more pertinent issue for India is the extension of the principle of limited risk-taking to lending. How much are banks responsible for their lending, because as NPAs build up, the brunt is being borne by the deposit holders Banks, both private and public sector, are continuously looking at valuations in the market and are very particular about making profits to reward the shareholdersthe Government of India earns a lot through dividend payments (around R10,000 crore). The Indian system is robust and chances of things going out of control are remote. This holds all the more because of deposit insurance as well as the fact that 70% of the banking system is still owned by the government. But at an ideological level, how much risk can banks take in the name of earning profits for the shareholders

Today, there is considerable concern over the build-up of NPAs. Banks have often adopted sub-prime lending to prop up home loans. Should there be a check on such lending, because while it is not an issue today, one would tend to guess that in a couple of years time our system too would resemble those in the West where structured products would become more prominent Basel talks of capital and Volcker, of trading risk. But lending risk is an issue worth discussing.

Looking at the banking system in India, two immediate signals of risk carried by banks on their books would be the lending to sensitive sectors and the contingent liabilities. Commodities, capital markets and real estate are deemed sensitive sectors because their very natures make them vulnerable as prices could fluctuate quite perceptibly affecting the collateral value as well as the borrowers' ability to service their debt. This ratio has been coming down, albeit, very gradually in the last 3 years from 18.6% in FY10 to 17.4% in FY13. The bulk of this is in real estate, which does signal the system to be cautious. The ratio of contingent liabilities to total liabilities has been fluctuating, from 174.7% in FY10 to 192.6% in FY11, and down to 175.9% and 138.5% respectively in FY12 and FY13. These two ratios need to be monitored more regularly by RBI at the micro level.

Quite clearly, one needs to evaluate the risk being carried by banks as they become bigger and more diversified. The government too will have to, at some point of time, let go of its holding to infuse capital. The solution is really to have more transparency in the operation of banks and this is what may be suggested. Banks could provide more details on the structure of their lending which would include data on industry-wise lending, proportion of lending at various interest rate bands, lending according to their own rating bands, NPAs in different segments as well as CDRs. These would indicate to the deposit-holders the risk being taken by the banks allowing them to choose their bank accordingly.

Volckers Rule, though not very tight in scope, should be taken in the right spirit and structures built to ensure that banking should be free from high risk-taking. Trading activity is within the preserve of fund managers, investment banks, hedge funds and the like and should not be mingled with core banking where savers put their money based on an assumed safety of principal and interest. This should never be compromised when other options are there for banks to become traders.

The author is chief economist, CARE Ratings. Views are personal