Banking, as we know, is a very simple business that involves taking your money at a certain interest rate and lending it to another at a higher interest rate to pocket the difference. It is not as skillful as creating technology products to change the world. Neither is it as profound as doctors saving lives or teachers shaping the next generation. For an extraordinarily easy business that needs little intellect, creativity or spirit, banks and bankers fail much too frequently. For one main reason – greed. When making money is as simple as taking from someone, giving to another and pocketing the difference, greed propels human nature to grow faster and higher. Many succumb to this temptation and ultimately break down. Of course, this is not an axiomatic truth, but a good proxy for bank failures. Going faster and higher in the context of a bank simply means its growth in loan book relative to its own size and the growth of the overall industry.
Yes Bank Ltd. was just one more in the long litany of bank failures that capitulated to such greed.
When a new bank is set up, it is small and nimble, which helps it grow much faster than its peers. As the bank’s size increases, relative to its peers, it cannot sustain such high levels of growth and must necessarily slow down. There will be a certain convergence in the loan growth of various banks in the industry as each bank gets bigger. There is, thus, an inevitable inverse relationship between a bank’s size and its loan growth.
Adjusting for a bank’s size, if a bank grows much more aggressively than its peers in the industry, then it can serve as a simple ‘greed warning’ indicator.
Economists Robert Barro and Sala-I-Martin postulated the broader theory of economic convergence for various nations, using a similar idea of the relationship between a nation’s size of the economy and its growth.
A Gauge Of Bank Risk
The chart below is one such simple ‘greed warning’ detector, inspired by the Barro, Sala-I-Martin convergence framework. It plots loan growth in the decade from 2009 to 2019, relative to a bank’s size, for nine large banks that account for more than half of the entire Indian banking industry. As expected, there is an inverse relationship between loan growth and a bank’s size, measured as assets. The line shows what is the norm for the industry. In other words, the line depicts, for a given size of a bank at the starting year of 2009, what should be the expected decadal growth in loan book for the Indian banking industry at large. A bank that falls above the line grew faster than the norm while a bank that falls below the line grew slower in this time period.
Put simply, banks much higher than the line are the ‘greedier’ ones.
Yes Bank is clearly much above the line while Axis Bank Ltd., Punjab National Bank, and ICICI Bank Ltd. grew much slower and were more conservative. Banks like IndusInd Bank Ltd., Kotak Mahindra Bank Ltd., HDFC Bank Ltd. are bang on the line indicating that they are no outliers while State Bank of India is slightly above the line.
But what stands out in this chart is how far above the line RBL Bank is. Just viewed in this framework, RBL Bank is perhaps the greediest bank in this set of banks, over the last decade. RBL Bank was a new bank that was infused with fresh capital and management in 2010 which some may argue, explains the aggressive growth. But this framework accounts for all of that and shows how much of an outlier a bank is in terms of its loan book growth relative to its own size, the overall banking industry, and the larger economy. Of course, this by itself does not imply that RBL Bank is on the verge of collapse, but it is a sign that it needs to be closely watched.
We know that Yes Bank, which was also above the line, collapsed. How did the RBI and credit agencies miss this lucid warning signal is a pertinent question.
A Moment Fraught With Danger
The collapse of Yes Bank comes at a time when the global economy is at its vulnerable worst, some say, since the 1929 Great Depression, due to the Covid-19 virus pandemic. Economists expect the global economy to contract, not a mere slowdown in growth, but go into negative territory. India’s financial system was already weak even before the virus epidemic. Now, there is a real danger of more banks and institutions collapsing simply because businesses that they have lent to are unable to honour their loan obligations. It is thus important for the RBI and the government to be prepared with enough arsenal to save more institutions.
But, the method of the rescue of Yes Bank has only diminished the RBI’s capability to rescue more financial institutions, should the need arise.
When banks collapse, they believe it is their birthright—or death right—to be rescued by the government. Else, they scream ‘systemic risk’. Government and society cave in and rescue them. Typically, they merge the failing bank with one larger bank and the failing bank ceases to exist. This has been the practice, across the world for many decades.
Yes Bank, however, is being rescued differently. Inexplicably, Yes Bank is not being merged but will continue to function as a stand-alone bank, on life support provided by almost the entire banking industry. There are eight healthier, larger banks that have been coerced into supporting Yes Bank. Yes Bank is just one-tenth the size of the State Bank of India and hence, it would have been easier to merge it with SBI to protect depositors and the system.
Where The RBI Erred
Given the fragility of the overall economy, I believe that the RBI should proactively strengthen seemingly shaky banks and institutions and not wait for them to come to the brink of collapse. The economy cannot afford similar collapses like Yes Bank at this critical juncture. In which case, ideally, the RBI would talk to larger, healthier banks to subsume smaller, shakier banks individually. But almost all the healthier, large banks have already been dragged into Yes Bank’s rescue which would diminish their appetite for more such transactions. It would also not be ideal for their shareholders.
Had they not been involved in the Yes Bank rescue, then each of them could have been a potential saviour for another weak bank.
With this model of rescue, the RBI has left itself with only one option – to have the same consortium of eight healthy banks save other weaker banks together. Should this fructify, then the Indian banking industry would have been transformed into a community banking industry at the end of it with every bank owning every other bank.
Was it not more prudent for the RBI to merge Yes Bank with SBI and keep its powder dry for other similar cases, given the fragility of the economic system currently? What was so special about Yes Bank that the RBI had to indulge in a never-seen-before type of rescue?
There are too many questions around the rescue plan of Yes Bank. While it was the right decision to rescue Yes Bank, it was certainly not sensible at this vulnerable state of the economy to indulge in such bravado of a rescue. As always with India’s regulators, it is a case of a ‘Yes’ and a ‘No’.
Published on March 20, 2020 in Bloomberg Quint