An existential crisis for the banking sector?

Synopsis: The business model of banks is under threat. Hence, both banking and market regulators must take a close look at the evolving landscape.

Introduction

Corporate India has cut its debt burden. They are replacing high-cost debt with cheap money, raised from the market, and sale of assets.

Since 2016, RBI has been insisting on big corporations raising part of long-term borrowings from the corporate bond market. Bonds allow funds to be raised for the long term, or even forever.

How the business model of banks is under threat?

Priority sector lending: Banks are allowed to raise deposits from the public. Since they raise cheap money, they must have an exposure to the weaker section of society or the “priority sector” up to at least 40 per cent of the loans.

Cost of reserve requirements: banks also need to keep 4 per cent of their deposits with the regulator in the form of cash reserve ratio (CRR), on which they don’t earn any interest, and buy government bonds to the extent of at least 18 per cent of deposits.

High cost of money: The cost of money for the best-managed banks is between 4 and 4.5%. Add to this at least 2 percentage points fixed cost. In contrast, the best-rated NBFCs have been raising one-year money at around 4.2%.

Banks today have clearly a 1.5-2% disadvantage vis-à-vis the best NBFCs.

Power of technology: The use of technology is no longer confined to the payments space and loans. For instance, Amazon Pay has tied up with wealth management platform Kuvera, which is offering users to facilitate investments into mutual funds, fixed deposits, and more overtime. Setu, is offering a similar facility for Google Pay.

Once the popularity of such platforms grows, they can start dictating terms on interest rates. For better earnings, people may start preferring such platforms over banks. It cuts the cost of brokerage and benefits the customers, but it raises doubts on the financial sector stability.

What is the way forward?

Interest on CRR: it is needed because banks have many obligations and banks have access to public money in the form of deposits.

Lower the priority loan target: Those banks that are not able to meet their priority loan targets either buy such loans from others who have excess exposure or keep the shortfall with certain agencies at an interest rate that is far lower than their cost of money.

Source: This post is based on the article “An existential crisis for the banking sector? ” published in Business standard on 20th September 2021.