Context
Author tries to justify the RBI’s continuance of the cash withdrawal limits
What is a bank run?
A bank run occurs when a large number of customers of a bank or another financial institution withdraw their deposits simultaneously due to concerns about the bank’s solvency. As more people withdraw their funds, the probability of default increases, thereby prompting more people to withdraw their deposits
- A bank run is typically the result of panic rather than true insolvency on the part of the bank. However, the bank does risk default as more individuals withdraw funds; what began as panic can turn into a true default situation
How Bank runs happen?
Because banks typically keep only a small percentage of deposits as cash on hand, they must increase cash to meet depositors’ withdrawal demands. One method a bank uses to increase cash on hand is to sell off its assets, sometimes at significantly lower prices than if it did not have to sell quickly. Losses on selling the assets at lower prices can cause a bank to become insolvent. A bank panic occurs when multiple banks endure runs at the same time
How RBI prevents Bank run?
Author states that in the view of financial crisis of 2008, central banks world over are engaged in the issue of financial stability and pre-emption (predicting beforehand) of bank runs.
- Financial stability reports: RBI has started bringing out half-yearly Financial Stability Reports (FSR) since 2010, in which one section is devoted exclusively to the commercial banking sector. These reports contain sophisticated tests that gauge the risk to the banking system
- Review of the reports: These reports are reviewed by a subcommittee of the Financial Stability Development Council that functions under the Finance Ministry.
Risky business
Author states that banking is a risky business with the following risks always looming large over its head
- Liquidity risk: Banks work on the presumption that all the depositors won’t demand all their money back at the same time. If such a scenario happens. It can lead to a bank run
- Credit risk: Banks lend money and a credit risk occurs if the bank is unable to recover its loans
RBI’s role in mitigating risks
RBI as a regulator ensures that a bank is prepared to meet liquidity and credit risks.
- The capital to risk (weighted) assets ratio (CRAR) is a safeguard that the capital base of a bank is not eroded
- CRAR: The CRAR is the capital needed for a bank measured in terms of the assets (mostly loans) disbursed by the banks. Higher the assets, higher should be the capital by the bank
- The statutory liquidity ratio (SLR) is a safeguard that a bank is able to return deposits of customers on demand
- SLR: corresponds to the percentage of liquid reserves each banks have to keep as cash reserve with themselves corresponding to the deposits they have. Banks have to mandatory keep reserves corresponding to SLR locked with themselves in the form of gold or government securities
- Adoption of international standards: In order to further mitigate these risks, the RBI is adopting international standards prescribed by the Basel Committee on Bank Supervision and the Financial Stability Board
- It has directed banks to give up forbearance in the classification and reporting of non-performing assets (NPA) from April 1, 2015
What is credit risk?
As explained earlier, banks lend money to big borrowers like corporate houses etc. Credit risk covers possibilities of defaults by such individual borrowers and borrower groups
- Default by one borrower affects multiple banks: If because of borrower default, one bank fails, it is likely to trigger a domino effect across banks — since banks have financial linkages with each other besides exposure to the same big borrower groups. However, a bank with adequate CRAR would be able to withstand this credit shock.
- Linkage of borrower default &corresponding CRAR fall : The December 2016 FSR reveals that CRAR would fall below 9% for two banks if there is default of the top 1 borrower group; five banks if the top two borrower groups default; 12 banks if the top five borrower groups default and as many as 22 banks if the 10 top borrower groups default
Liquidity risk scenario
A typical liquidity risk scenario covers unexpected deposit withdrawals (10% withdrawal in 10 days or a 15% withdrawal in 5 days) in banks on account of loss of depositor confidence
- The December 2016 FSR analyses the liquidity risk to the banking system on the assumption of increased withdrawals of the uninsured 10% deposits (presently these are 69% of total deposits) and unutilized portions of 75% sanctioned working capital limits
- It concludes that 11 out of the 60 banks will fail the liquidity test
Reform needed
A study titled “State intervention in banking: the relative health of Indian public sector and private sector banks” concludes the following,
- The Indian banking system needs radical reform
- It further recommends repealing the SBI Act, SBI (Subsidiary Banks) Act, and Nationalisation Acts 1970, 1980
Conclusion
Author concludes by stating that although the tests conducted under FSR reports are not fool proof but these tests do indicate that the banking system is apparently not even prepared for the withdrawal of 10% of depositors’ funds. Hence, RBI’s stand of withdrawal limit is justified.
Read More: CRAR
