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Markose Arackal
How are banks maintaining their capital ratios? And should this matter for the economy? The decision rests, largely, on where they expect the economy to take them. Raising new capital, retaining earnings, or in other words increasing their stock of regulatory capital is easy in an economic expansion. But in a downswing, banks may find it easier to decrease the total risk weighted assets in their portfolios. And this might make all the difference between an industrial recovery and stagnation tomorrow.
This distinction is increasingly likely to become important to us over the next two years. Banks will be required to raise their Capital Adequacy ratios to nine per cent by March 2000 and to 10 per cent by March 2002. The norms for classifying bank assets have also been tightened considerably, with government guarantees no longer counting for much.
Government debt had, so far, been classified a zero risk asset which, given the amount of government securities banks held, benefited them. From next year onwardsthough, government debt will carry a risk weighting of five per cent. This means more money, equal to five per cent of the value of the government debt held, will have to be kept aside as regulatory capital. In addition government guaranteed loans which have turned sticky, will have to be classified in the same manner as any other loans from next year. A fair amount of these loans will have to be classified as non-performing assets. Twenty-five per cent of such guaranteed loans will have to be kept aside as regulatory capital.
What all of this might mean is, effectively, banks will have to increase their capital adequacy ratios by at least another three per cent or so over the course of the next two years. How they do this will have a role in determining the growth path of the economy over the next few years.
This is because a fall in banks' lending might lead to a fall in investment demand. An implicit assumption of the Basle accord, from where we have adopted our norms on capital requirements, was thatany shortfalls in lending caused by regulations on the banking system would be made up by other forms of lending in the economy.
This may hold true for the banking systems of the OECD countries for which the Basle accord was devised, but it is clearly not a very realistic supposition for our economy with our imperfect information and capital markets. The strength of the traditional relationship between borrowers and banks in India has meant that it has always been cheaper for savers to leave monitoring of borrowers in the hands of the banks. But this has also meant that, at least for the smaller private sector firms, access to our capital markets have been highly restricted. If banks start cutting off lending to this sector, it will force them to start employing more costly credit. This will lead to a decline in investment demand, or at least a delay in investment s, which has a contractionary effect on out put.
The distribution of such lending is also an important factor in the likely effects of capitalconstraints. In India, certain sectors such as the construction sector are especially dependent on bank financing. Any cut in bank lending will affect these sectors more than others. It is also likely that such sectors are more dependent on the less prominent banks, which might be facing the worst problems in non-performing assets. A raise in the required capital ratio will obviously affect these banks more severely, and therefore investment demand.
There are already signs that banks may opt to cut lending rather than expand their equity. For one thing, the climate for equity expansion is less favourable than banks would have liked. Incentives given to mutual funds in the last budget has made bank stocks less attractive than they would have been. Not withstanding the recent rally in bank stocks, Investors might prefer to wait till banks have met their prudential norms requirements before committing themselves.
Look also at how banks have been investing their money of late. Non-food credit expansion hasbeen very unimpressive at around 12 per cent. At the same time, banks have increased their investments in "safe assets" bank investments in corporate securities have gone up a massive 45 per cent over last year's levels. Thirty-seven per cent of all assets held were government securities, against a required 25 per cent. All this in spite of the fact that such investments typically earn less than funds lent out at prime lending rates.
Not everybody agrees that the fall in credit offtake might be caused in part by credit rationing. They point out that between 1994 and 1996,even though banks had to meet Capital Adequacy norms, credit still expanded at a healthy 20 per cent per annum. But this ignores one difference between then and now. As the Bank for International Settlements points out, banks alter their method of attaining an adequate capital ratio according to the conditions in the economy. It was easier then, with double-digit industrial growth, to raise capital. More than 13,000 crores were raised forrecapitalisation through budgetary resources. But now, raising such capital will be much more difficult, so banks will have to rely more on internal mobilisation of funds. This might mean a reduction in their risk-weighted assets. Prudent bankers might decide to cut out risky lending. We would then have a stable banking sector, but where will this leave the demand for investments?
Copyright © 1999 Indian Express Newspapers (Bombay) Ltd.
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