The RBI should step into a more aggressive market development mode and require banks to allocate capital for asset-liability mismatches beyond a particular level, says Jamal Mecklai.
Indian banks are healthier than they have ever been. With average NPAs under 2 per cent, they have been posting strong profits and steady profit growth over the past four or five years. This is further evidenced by how well they weathered the recent global crisis, albeit with the mothering of RBI's conservative policies.
It is clear that as long as RBI continues to ensure reasonable insulation from global headwinds, Indian banks don't need the kind of protection they have enjoyed, which has come at a real cost to the rest of the economy.
RBI should step into a more aggressive market development mode and require banks to allocate capital for asset-liability mismatches beyond a particular level.
Currently, most (public sector) banks use asset-liability management (ALM) in a passive manner, as a result of which significant risk could build up on their balance sheets, weakening their asset value.
Indeed, the trigger for the global meltdown was the asset-liability mismatches on the balance sheets of investment banks, insurance companies et al which had been funding securitised assets with short-term (in some cases, overnight) commercial paper rollovers.
If banks were compelled to allocate capital beyond a particular level of mismatch risk, they would naturally become more active in managing this risk, improving their own risk-adjusted profitability and giving a boost to liquidity in the interest rate derivative market.
A parallel move should be to immediately force-feed banks to link their PLRs to market rates.
While I have long heard the arguments that since there are so many administered rates it is difficult, if not impossible, for banks to lend at fully transparent rates - i.e., rates linked to, say, the 5-year G-Sec yield.
And while there is certainly merit to the argument for dismantling the administered rate structure, it can no longer be an excuse for continuing to delay the necessary - and inevitable - shift to market rates.
Banks should be required to define their PLR in terms of a spread over G-Secs. As an example, SBI [ Get Quote ] should announce its PLR as, say, 5-year G-Sec plus 4.5 per cent instead of PLR 11 per cent. Incidentally, the average of the daily difference between the 5-year G-Sec yield and the SBI PLR prevailing that day over the past 10 years was 4.62 per cent.
The spread over G-Sec, which could be changed from time to time (say, quarterly) would provide banks with sufficient cushion to protect their bottom lines from the terrors of administrative pricing.
It would also make bank operations that much more transparent and compel greater efficiencies to reduce this in-your-face spread. I mean, if a company could borrow in the global market at US Treasuries plus, say, 250 basis points, why should they pay 450 basis points over risk-free rates here?
Equally importantly, such a change would enable companies to hedge their interest rate risk.
Today, non-food credit is a huge 29 lakh crore a 1 per cent increase in the prime rate, which is certainly possible during this year, would lead to an increase in interest cost of Rs 29,000 crore (per year).
As of now, there is precious little any borrower can do about it. The fact that they have to carry this risk, which is unhedgeable, makes Indian companies - particularly those in infrastructure with large and long-term liabilities - that much less creditworthy.
If the borrowings were linked to G-Sec, as I am suggesting, companies could - and would - immediately look to proactively hedge their interest rate risk, just as they do their forex risk. It would kick-start the interest rate swap market and breathe life into the moribund interest rate futures as well.
Of course, there would be hiccups in this - as in any new - dispensation, and banks would need to find the right mix between aggressiveness and caution in entering these newer markets. The good news is that as the banking sector has strengthened so have the skills at operational levels in most public sector banks.
This enhanced transparency in pricing of assets and liabilities should be extended to all banking operations. In particular, banks should be compelled to disclose their margins on ALL transactions.
RBI already requires banks to disclose their margins in distribution of mutual funds, etc. It should also require disclosure of margins and costs in other transactions.
For example, companies that have lines for forward cover should know how much of their collateral is being used by these lines, so that they would be able to straightforwardly compare this cost with the cost of initial margin for hedging on the futures exchanges.
Again, companies that need to buy structured products - e.g., infrastructure companies with long-term liabilities that need, say, a forward start cap on Libor - should be given a clear picture of all the costs incurred, including bank margin, additional credit cost, etc.
Calculation of the market price of the instrument should be explained, and if it is too complex - "our model is proprietary" -then the product should not be offered.
The Indian banking sector is as strong as it has ever been. It's time for RBI to cut them loose from its apron strings so that they can deliver increased value to the economy.