FRB review of the failure of Silicon Valley Bank

The US Federal Reserve Board has published a review of the failure at SVB. The lessons are pretty straightforward. Regulation and supervision have to get tighter. Boards have to do a better job. Managerial incentives need to be aligned to risk-adjusted returns, not nominal returns. With respect to boards, I would add: we need an overhaul of the mechanism of independent directors- we can’t leave it to promoters and CEOs to decide who the ‘independent’ directors should be.

The RBI may want to commission a similar review of the failures at IL&FS and Yes Bank. Regulators unilaterally subjecting themselves to public scrutiny is good for good for the regulator’s credibility and standing- and good for bank stability in the long run.

My article in BS, Anatomy of a bank failure

Anatomy of a bank failure

A radical change is necessary in the appointment of independent directors in India in light of the extensive failures in oversight and management of banks in the US

 

T T RAM MOHAN

 

Silicon Valley Bank (SVB) and its holding company, Silicon Valley Bank Financial Group (SVBFG), failed last March. This resulted in the immediate failure of Signature Bank and, with a lag, of First Republic Bank. More mid-sized banks may follow.

 

The US Federal Reserve Board (FRB) has been quick to commission and publish a review of the failure of SVB. Even more creditable, the review pulls no punches in apportioning blame. The bank’s management failed. The board of directors failed. The supervisor failed. Regulations turned out to be inadequate. Everything that could go wrong went wrong.

 

The Fed review should be compulsory reading for bankers, bank boards, regulators and supervisors. The report will help drive home an important point: It is futile to expect “market discipline” by itself to take care of banking stability.

 

Let us begin with management and board failures. SVBFG’s assets tripled in size between 2019 and 2021. Deposits flowed in. The technology sector was booming, so lending expanded rapidly. Any growth in loans that is way above average loan growth in the sector is a recipe for trouble, a point often lost on managements as well as boards. Management does not have the bandwidth to assess risk properly. Internal controls and systems cannot keep pace with runaway growth.  Reliance on volatile wholesale deposits tends to increase. 

 

Managerial incentives are often linked to profits without adjusting for risk. For CEOs, the temptation to quickly grow the loan book is irresistible. The onus is on the board of directors to apply the brakes.  Rarely does this happen. Boards tend to be mesmerised by CEOs who show dazzling performance for a few years. They find it hard to tell a performing CEO, “Sorry, this is not on.”  

 

At SVBFG, the board was not even responsive to supervisory warnings. The FRB report remarks acidly, “Moreover, the board put short-run profits above effective risk management and often treated resolution of supervisory issues as a compliance exercise rather than a critical risk-management issue.” That could be said of many boards. 

 

Starting in July 2022, SVBFG failed its liquidity stress tests repeatedly. Management moved to increase funding capacity but the necessary actions were not executed until March 2023 when it was too late. Management chose to mask liquidity risks by changing the stress test assumptions. 

 

Interest rate risk too was poorly managed. The bank had breached its interest rate risk limits on and off since 2017. Instead of reducing dependence on short-term deposits, management fiddled with assumptions about the duration of deposits. Hedges on interest rate risk were removed in the interest of boosting short-term profits. Management was massaging earnings by hiding the underlying risks. The Risk Management Committee of the board should have picked up these lapses. It failed to do so, again not a huge surprise. 

 

The supervisors did not cover themselves with glory either. For governance, SVBFG got a “Satisfactory” rating, despite repeated supervisory observations about inadequate oversight.  The bank had large, uninsured deposits that were volatile, yet managed a “Strong” rating on liquidity. Despite breaching interest rate risk limits repeatedly, it got a ‘Satisfactory’ rating on the item.  Clearly, supervisors in the FRB set-up were hard to displease. Banks in India must pine for such a supervisor; they find the Reserve Bank of India (RBI) almost impossible to please. 

 

What accounts for these supervisory failures? The report says joint oversight by the FRB and the 12 Federal Reserve Banks is a factor. The Board delegates authority to the Reserve Banks, but Bank supervisors look to the FRB for approval before making a rating change. Getting a consensus is time-consuming. 

 

But that was not the only reason. In 2018, heightened supervisory standards were made applicable only to banks with assets of more than $100 billion. Moreover, supervisors were under pressure to reduce the burden on banks and to exercise greater care before reaching conclusions or taking action

 

Finally, there were the failures of regulation. The Dodd-Frank Act, passed after the Global Financial Crisis (GFC), provided for stiffer prudential standards for banks above a threshold of $50 billion. In 2018, the Act was amended to raise the threshold to $250 billion. For banks in the range of $100-$250 billion in assets, the Fed was given the discretion as to what standards to apply. When SVBFG reached the threshold of $100 billion, it was subjected to less stringent regulations than would have applied before 2019. Had the dilution in regulations not happened, SVBFG would have been compelled to enhance liquidity and capital before it was too late. 

 

The problem is fundamental. The philosophy of “light touch” regulation and supervision hasn’t quite lost its hold on the US system. Multiple regulators and supervisors are another problem. There is also the “revolving door” syndrome -- regulators join private banks, then jump back to the regulator in a senior capacity. The relationship between regulator and banks is too cosy for comfort, which may explain the kindness shown to SVB. 

 

The RBI, as your columnist argued last month, is well ahead of the regulatory and supervisory curve in the West. Its intrusive approach is a better safeguard for banking stability than the light touch elsewhere. However, supervision can only be a third layer of defence against bank instability. Regulations are the primary layer, followed by the board. The RBI must find ways to get bank boards to do a far better job.   

 

A radical change would be to alter the way independent directors are appointed at banks. At present, the promoter or CEO has the dominant say in the appointment of independent directors (at both private and public sector banks). The RBI may want to insist that, for instance, one independent director be chosen by institutional investors and another by retail shareholders (from a list of names proposed by the Financial Services Institutions Bureau). Until we have independent directors who are distanced from the promoter and management, it’s unrealistic to expect board oversight to improve. 

 

The RBI is hosting a conference for bank directors later this month. Here are two suggestions.  One, in the interests of transparency and accountability, the RBI may want to commission a review of the failures at IL&FS and Yes Bank. Two, it may prescribe the FRB’s review of SVB’s failure as one of the “readings” for the conference. It may also include the report of the UK's Financial Services Authority on the failure of Royal Bank of Scotland during the GFC. At least, bank directors can’t say they weren’t warned.

 

 

 

 

Whom does the current bout of inflation the West hurt?

The rise in inflation in Western economies has caused a massive transfer of wealth from savers to investors, contends Adam Tooze in an article in the FT. 

Higher inflation means the nominal debt to nominal gdp ratio goes down as the denominator rises on account of inflation. The denominator has risen also because of the rebound in real output post Covid.

Borrowers, namely government and corporates gain, but savers lose. The poor face higher inflation and a loss of jobs. Tooze thinks this can lead to explosive discontent. 

I am not so sure. The only net debt in an economy is government debt (corporate and household borrowings are from other household savers, so the net borrowing on these two counts is zero). So whoever has invested in government debt is a loser. The rich are losers and also the middle class. But the poor are not investors in government debt. They are net borrowers, hence stand to gain from the real value of their debt getting eroded. If inflation can be quickly reined in, they could emerge as beneficiaries from the current bout of inflation. 

The notion that inflation hurts the poor is common. Higher prices mean a higher cost of living. True. But this effect could be overwhelmed by the erosion the value of debt that the poor carry. 

 

Crisis? What crisis?

 Last November, there was talk of a serious external accounts crisis staring in India in the face. Maybe, not as bad as the one in 2013 but still pretty bad.

The current account deficit, analysts said, could exceed 3.5 per cent of gdp for FY 23. The rupee would be above Rs 85 to the dollar, could even touch Rs 90. It was futile for the RBI to expend dollars to support the rupee- better to simply let the rupee fall and exports do the trick.

Well, less than six months on, little of that has come true. The current account deficit has narrowed and may end up at under 2.5 per cent of gdp, a comfortable position for us. The rupee is trading in the range of Rs 82-82.7. Foreign exchange reserves are at an eight month high of $579 bn.

Lower commodity prices are a factor. Another is that world economic growth has turned out to be better than forecast, with the US escaping a recession in 2023, again contrary to many forecasts. India's gdp growth for FY 2023 is projected to be slightly below 7 per cent

No sign of any crisis, eh?

Recent bank failures

 The question pops up again: what was the board of directors doing at the spectacular bank failures we have seen recently?

An article in FT is informative. Only one of SVB's directors had banking expertise and he didn't sit it on the Risk Management Committee (RMC). The bank's RMC included a director with considerable experience in the premium wine industry. SVB did not have a Chief Risk Officer (CRO) for months and when the CEO appointed one, it was considered a big enough achievement to be a factor in his outsized bonus. At Silvergate Bank, the CRO happened to be the son-in-law of the CEO.

Questions need to be asked also about governance at Credit Suisse as it hurtled from one scandal to another over several years. Even if they are, we are unlikely to get lasting answers. It does seem that the board of directors of a company is amongst the most unreformable institutions in the world.

Consulting as the Big 'Con'

 

Mariana Mazzucato made a huge splash with her book, The Entrepreneurial State. She argued that there are high-risk, breakthrough ideas such as the Internet that could never have happened with massive funding of the initial creative work. In an interview with FT, she takes on consulting firms, the McKinseys, BCGs and the rest.

Her point is not the usual one about consulting firms not adding much value: as the old chestnut goes, a consultant is somebody who looks at your watch and tells you the time. No, her point is more nuanced. She says that governments are becoming too dependent on consulting firms for ideas. As a result, governments are taking enough responsibility and doing worthwhile work. In the process, the civil services are not attracting the brightest.  

I don’t think that’s true of the IAS. The beauty of India’s competitive exams is that the talent pool is so incredibly large that when you are looking to fill, say, 150 slots out of half a million applicants, you are bound to get incredibly good talent. The IAS, in my view, still gets some of the best talent in the country. But that could also be because our government hasn’t developed the UK sort of dependence on consulting firms! Or, there is so much of work to be done in government that if even if you farmed out work to consultants, there would be a great deal left for government to do.

Four trends that will impact the Indian economy

 

I identify four broad economic trends from which there is no escape for the Indian economy:

1. Government capital expenditure will drive the economy in the medium-term.

2. 2. High fiscal deficits are here to stay.

3. 3. Inflation will be higher than before

4. 4.  Self-reliance and import-substitution are a reality

The macroeconomic outcomes that we can realise will be constrained by these four trends.

More in my BS article, Four economic trends that will impact India.

Four economic trends that will impact India

There are four broad trends that will impact the Indian economy in the years to come. The Budget for 2023-24 affirms these trends.

1. Government capital expenditure will drive the economy in the medium-term: The latest Economic Survey underlines the fact that government capital expenditure has risen from a long-term average of 1.7 per cent of gross domestic product (GDP)in the period FY09 to FY20 to an estimated 2.9 per cent of GDP in FY23. The latest central Budget expects capex to rise to 3.3 per cent of GDP in FY24.

 

This points to an inconvenient fact: Private investment has remained sluggish and the government has had to compensate. The behaviour of private investment is not unique to India. It is part of a trend that is seen in emerging and developing economies (EMDEs). As the World Bank’s Global Economic Prospects (2023) points out, investment growth in EMDEs in 2022 remained about 5 percentage point below the 2000-21 average, and nearly 0.5 percentage point below in EMDEs excluding China. 

 

The World Bank does not see private investment returning to the level suggested by the pre-pandemic trend through 2024. It lists several factors responsible for the slowdown in investment growth in EMDEs: Slower output growth in 2010-19; lower commodity prices; lower and more volatile capital inflows to EMDEs; higher economic and geopolitical uncertainty; and a substantial build-up of public and private debt. Many of these factors apply to India.  

 

The government sees a sharp rise in capex in FY24 as boosting output growth. This overlooks the fact that the fiscal deficit is projected to decline by 0.5 per cent of GDP in FY24. We have a withdrawal of stimulus, something that is contractionary in nature. 

 

True, the composition of expenditure has shifted even more towards capex, and this is expansionary. But this effect can overwhelm the contractionary effect of a fiscal deficit decline only if the rise in capex is greater than the decline in the fiscal deficit.  In  the budgetary projections, the rise in capex is 40 basis points whereas the decline in the fiscal deficit is 50 basis points. The net effect will, therefore, be contractionary

 

2. High fiscal deficits are here to stay: Analysts cheered the finance minister for sticking to the fiscal deficit of 6.4 per cent for 2022-23, and projecting a fiscal deficit of 5.9 per cent for 2023-24. The figure for 2023-24 is a budget estimate. If the Ukraine conflict escalates and the global situation worsens, government subsidies (which have been pruned in FY 2023-24) will rise and we could be back to square one. We must also expect sops to be rolled out in the run-up to elections in 2024.  

 

The fiscal situation can be turned around in a fundamental way only if the tax-to-GDP ratio goes up significantly (say, above 12 per cent of GDP) or if capital receipts from disinvestment rise significantly or both. On either count, the outlook is not promising. The tax-to-GDP ratio   is estimated at 11.1 per cent for 2023-24.  The peak in the past decade has been 11.4 per cent.  

 

As for the proceeds from disinvestment, the Economic Survey notes that total proceeds from sale of equity in public sector units (PSUs) amounted to ~4 trillion in the eight-year period from 2015 to January 2023, or an average of ~50,000 crore in a year. Strategic sales have yielded a mere ~69,412 crore in the entire period. It does look as though the Fiscal Responsibility and Budget Management target of 3 per cent will remain a distant dream. 

 

After the global financial crisis and then the pandemic, we are seeing a rise in government deficits and public debt everywhere. India is no exception. If anything, the rise in debt to GDP ratio from 81 to 85 per cent between 2005 and 2021 looks modest in comparison with the increases elsewhere-- 66 to 128 per cent in the US; 39 to 95 per cent in the UK; 26 to 72 per cent in China; and 69 t 93 per cent in Brazil. India’s public debt position looks even better when we take into account the fact that 95 per cent of the liabilities are domestic, and we have the growth-interest differential working in our favour.

 

3.Inflation will be higher than before: High fiscal deficits can be expected to translate into high inflation. That apart, de-globalisation will happen in a greater or lesser degree. The movement may be gradual, but the direction is clear enough. 

Globalisation was about procuring goods and services at the lowest cost from almost anywhere in the world. Princeton historian Harold James noted recently that there is a historical pattern of globalisation driving disinflation. Alas, it appears the trend towards globalisation is now being disrupted.

Post-Covid and post-Ukraine, every country is reassessing its extent of dependence on outside suppliers from a range of goods and services. The US and its allies are determined to reduce dependence on China to the maximum extent possible as the containment of China has become the West’s strategic priority. 

There has been serious academic discussion in the US about revising upwards the inflation target of 2 per cent so that monetary policy has more room for manoeuvre in the downward direction. In India, the inflation target of 4 per cent threatens to become largely notional. We would be thankful now if inflation falls below 6 per cent.  

4. Self-reliance and import-substitution are a reality: For the reasons cited in (3) above, “make at home” will gain in importance. This will be especially important for leading economic and military powers. As India moves towards becoming the third largest economy in the world with matching military clout, a lurch towards greater self-reliance is inevitable. We need not be unduly apologetic about this trend: We are only falling in line with a worldwide trend. The adjustments in tariffs in the recent Budget, analysts have noted, are aimed at helping domestic industry.

It’s no use bemoaning the trend towards protectionism in various economies, including India. It makes no more sense instead to make a success of schemes such as Production-Linked Incentives. We must find ways to limit abuse of discretion in industrial policy. We need to monitor the effectiveness of the PLI scheme using appropriate metrics. Industrial policy will be integral to economic policy in the years to come.

 Macroeconomic outcomes in the coming years will be governed by the four trends outlined above. 

 

 

 

 

Don't believe the experts!

 Arvind Subramanian, former Chief Economic Advisor in the Finance Ministry, has a cheeky take in today's BS on the judgements on experts on sundry matters:

• China’s zero- Covid policy was hailed as a success until the recent spurt in Covid infections threaten to trigger an insurrection of sorts.
• The US was said to have fared badly in its handling of Covid because it’s a polarised society in contrast to the egalitarian Sweden- “until Sweden became a cautionary tale”.
• In the US, the doves ruled on monetary policy until a few months ago. With the persistence of inflation, the hawks took over. Now with signs of inflation abating, the doves “are flying again”· 
• Economists warned that the confluence of the conflict in Ukraine, soaring inflation and rivalry between US and China would plunge the world into recession. The clouds are receding in recent weeks and it appears, well, we may not end up with a recession, after all.
• Anybody remembers how many times the Chinese credit bubble was supposed to collapse and wreck the Chinese economy?

Subramanian thinks the problem is the media: they are looking for snappy comments all the time and experts are happy to give them quotes for their two minutes of fame.

 The problem runs deeper, methinks. Experts simply lack an awareness of grassroots realities. They are mostly armchair pundits who prefer to operate from the comforts of their air-conditioned offices. How else do we explain the high rate of failure of economic forecasts? It is said that economists can’t even forecast the past correctly. Then, there are the stock price and stock market forecasts, earnings forecasts.

 Political forecasts are worse- I have lost count of the number of times President Putin has been pronounced as seriously or terminally ill- seems fit enough to preside over the conflict in Ukraine. We were told that the Mr Putin would be deposed in a coup, the people of Russia would rise in revolt against the suffering inflicted on them, Russian economy would collapse…. and Ukraine was poised to triumphantly retake the Crimea from Russia. So much hot air.

 Mr Subramanian says experts should stick to their area of domain expertise. Alas, they don’t seem to do wonderfully even in that area. No better example that Mr Subramanian warning that a 5 per cent fiscal stimulus was needed to save the Indian economy from the impact of the pandemic- we seem to have managed quite well with a stimulus of under 2 per cent.

 

Forex reserves and RBI intervention

I pinched myself in disbelief when I saw a news item that said the RBI may have BOUGHT $8 bn dollars in the market in the past month. 

So the RBI is causing the dollar to strengthen vis-a-vis the rupee, meaning it wants the rupee to depreciate In the previous months, the RBI had been doing quite the opposite- it had dipped into its forex reserves to SELL dollars in order to contain the depreciation in the rupee. As a result, India's forex reserves fell by about $ 85 bn in the period April-September 2022. 

But that was not entirely because of sale of dollars by RBI. Dollar sales are said to account for about a third of the decline in reserves. The rest of the decline was because of revaluation of reserves. The RBI holds large amounts of bonds in foreign currency, especially US Treasury bonds. These holdings have been falling in value thanks to rising interest rats.

As you know, we've had people howling about RBI's market intervention. Many were worried about the fall in our forex reserves. They said: why intervene? Let the rupee fall. It would be good for exports. 

The RBI Governor gave a fitting response recently. About the fall in reserves, he said that is what the reserves are meant for- for a rainy day. They are not, he said, meant to be a 'showpiece'. As for export growth, I doubt that rupee depreciation will do much to help in the current situation. The export markets are down, so it's unrealistic to expect a big boost to exports. Our major imports, such as oil, as price inelastic, so imports will shoot up with rupee depreciation. Chances are BoP will worsen, not improve, with rupee depreciation. 

That apart, it makes no sense to let the market dictate the exchange rate entirely. It may dictate the direction of the exchange rate but not the magnitude. The RBI is committed to containing rupee volatility. It has an unstated objective, namely, containing the Real Effective Exchange Rate (REER) of the rupee within a band of plus or minus 5 per cent. Excess volatility in the exchange rate makes investors jittery. 

Net portfolio investment flow into India  turned hugely positive in August reversing the trend of the previous months. It turned negative in September and October but has turned positive thus far in November. If portfolio investors sense that the rupee is in a free fall, they will head massively for the exit, causing the rupee to plunge. Rupee volatility must always be managed.

I wonder what is going to happen to the forecasts of the forex pundits who saw the exchange rate headed towards Rs 85 to the dollar or even above that. The rupee is now less than Rs 82 having touched Rs 83 on October 19. The trend has reversed in recent weeks. Inflation in the US has begun to respond to earlier rounds of tightening. There is a sense now that the Fed may not have to tighten as much as thought until now.  

Overshooting of exchange rates is a well-established phenomenon. There are periods when the rate goes above or below the equilibrium value before returning to equilibrium. Some of the depreciation we have seen in recent months falls in the category. The necessary correction may be happening, helped by perceptions about future rate moves in the US. As interest rates in the US correct downwards, the value of US Treasuries will rise and with that India's FX reserves.

I wouldn't be surprised if the exchange rate at the end of FY 22-23 is closer to Rs 80 than to Rs 85.( Caveat: I'm assuming no serious escalation in the Ukraine conflict).  I won't be apologetic if I'm proved wrong: the tribe of economists has long claimed a divine right to be wrong in its forecasts. 

 

Central banker jokes

RBI Deputy Governor Michael Patra's recent speech on monetary policy transmission will be of interest to many. The part I liked best was where he cracked a couple of jokes at the expense of central bankers.

These are not the best times for central bankers to wax eloquent. From being knights in shining armour during the pandemic, they have become much maligned and are held responsible for the darkening outlook globally. The story is told of a man stuck in a traffic jam in the capital of a major economy. He asks a policeman about what is going on, and is told that the Governor of the central bank of the country is so depressed about the economy that he wants to douse himself with gasoline and set himself on fire. So, in sympathy, the crowd has decided to take out a collection for him. “How much has been collected?” asked the man. The answer: “40 gallons”.

Here's another one:

A man needs a heart transplant. The doctor offers the heart of a five-year old boy. “Too young!” says the man. “How about the heart of a 40-year old treasury head?” “He doesn’t have a heart”. Then how about the heart of a 75-year old central banker?” “I will take it!” “But why?” “It’s never been used!” 

 If a central banker can laugh at himself, there is still hope for the breed.

Missile attack on Poland : no takers for Ukraine story

 A missile landed in a village in Poland yesterday killing two persons. Ukraine was quick to denounce it as a Russian missile attack on a NATO country. If true, it could lead to the invocation of  Article 5 under which the attack would be deemed to have happened against all of NATO and could provoke a suitable retaliation.

Well, that's not happening in this case. Poland says the missile is not Russian. NATO boss Jens Stoltenberg thinks the missile probably emanated from Ukraine. Biden has said it is unlikely the missile was fired from Russia. So, at the moment there is no prospect of NATO getting dragged in. 

Former CIA analyst Larry Johnson provides an interesting analysis. He contends that it was probably a 'false flag' operation by Ukraine intended to get NATO involved

• The missile landed in the Polish village of Przewodów in the east of the country, about four miles from the Ukrainian border. ....
• The closest Russian ground forces, who in theory could have launched this missile, are located east of Kherson. The distance from Przewodow to Kherson is 613 miles. That distance exceeds the capability of the S-300 by a factor of 3.5.

The S-300 was fired by Ukrainian forces located somewhere to the west of Kiev. It is highly likely that U.S. and Russian satellites recorded this launch. In other words, both sides know where the S-300 originated.

It is highly unlikely — hell, impossible — that this was an “errant” missile that Ukraine fired in a moment of desperation trying to take down an in bound Russian missile. Why? The Russian missiles are flying from the south to the north or from the east to the west. That means if Ukraine is firing an anti-missile defense system at those inbound missiles the Ukrainian missile would travel from west to east.

But that is not what happened here. The S-300 traveled east to west. Unless the Ukrainian operator who launched the S-300 was drunk on his ass, it is impossible to “accidentally” fire this air defense missile in the wrong direction.

Johnson provides a possible motivation for Ukraine's misadventure:

I believe this is another indicator of Zelensky’s growing desperation. Think about it for a moment. If Ukraine really had Russia on its heels, why fabricate an easily disproved claim that Russia attacked Poland with a missile? This was sloppy trade-craft. If Ukraine had used another Russian missile capable of flying the distance from current Russian lines to that farm in Poland, then the circumstantial evidence might have ignited the desired fire among the NATO members.

Johnson is among the analysts who believe that Russia is poised for a major offensive and that the end game in Ukraine is probably not very far off.

Global economic crisis? Banks are unfazed

 

The world economy faces, perhaps, the worst shock since the global financial crisis (GFC). But the world’s global banking system seems not have noticed! How come?

During GFC, regulators banks woke up to the realization that they did not have the capital (in particular, equity capital) needed to survive a major shock. Governments everywhere blew up enormous amounts of tax payer money on saving banks.

After the GFC, the Bank for International Settlements (BIS) put in place higher capital requirements. These were pretty modest. For instance, core equity capital (what we understand as equity in accounting terms) requirement was raised to just 4.5 per cent of risk-weighted assets.

Bankers howled at the time. The cleverer ones realized quickly that the market rewards banks with high capital adequacy through higher valuations. So they built up capital buffers well above the regulatory requirements.

The global average for CET 1 (or core equity capital) is now 14.1 per cent, well above the 4.5 per cent mandated by regulation. This means that we can have an economic crisis but that won’t translate into a banking crisis. Banking crises are the most difficult to get out of, so that’s good news for the world economy.

Not to pat myself unduly on my back, but students of my banking courses at IIMA (SPB and MFI) will remember that I had emphasized that higher capital was crucial to competitiveness and valuation in banking post the GFC.

My article in BS, Global Banking is a bright spot.

 

Global banking is a bright spot

 T T Ram Mohan

The Ukraine conflict poses the biggest challenge to growth since the global financial crisis (GFC) of 2007. The world economy will grow at 3.2 per cent in 2022 and 2.7 per cent in 2023, says the International Monetary Fund (IMF).  Growth in 2023 will be the lowest since 2010, leaving aside the pandemic year of 2020.

Slow growth and rising interest rates are bad for banks. Slower growth spells an increase in bad loans. Rising interest rates translate into losses in the bond market.   

The astonishing thing is that it appears that the global banking system does not face any high risk of collapse even in these trying times. There is thus hope that the global economy can get back to normal after 2023. Assuming that we escape nuclear annihilation.

The world’s financial system faces an intimidating set of challenges, apart from slowing growth and rising interest rates. The IMF’s Global Financial Stability Report (GFSR, October 2022) lists these challenges:

• China’s housing market woes: Stringent lockdowns in China have impacted home sales. Buyers do not want to make advance payments for the purchase of properties. As a result, developers face liquidity pressures and many have gone bankrupt.   Banks’ exposure to the property is 28 per cent of total loans. (In India, a bank exposure of more than 10 per cent to the property market is considered risky). The IMF estimates that, in a sample of Chinese banks it looked at,  15 per cent (mostly small banks) could fail to meet the minimum capital requirement.  
• Poor market liquidity: Central banks are tightening monetary policy and shrinking their balance sheets. This has meant less liquidity in the market. Investors would like to sell securities when interest rates rise.   When liquidity is limited, the fall in prices can be steep. Investors trying to exit their holdings of securities end up incurring losses that can trigger panic. 
• Corporate debt at risk: Rising interest rates pose challenges for firms with high debt. The composite picture across advanced and emerging markets is not pretty. The IMF’s sensitivity analysis shows that under conditions of stress 50 per cent of small firms would have difficulty servicing debt. Banks are bound to be impacted. The IMF warns that government support may be required to contain bankruptcies at small firms.
• Leveraged finance under pressure:  Leveraged finance is lending to companies with high debt or a poor credit history. It is, therefore, of the high-yield variety. An increasing share of leveraged finance in recent years is “private credit” or credit that is outside the regulated bank market and the financial markets and is of poor quality. As a result, in the US today, more than 50 per cent of leveraged finance is composed of firms with a B rating or relatively higher risk of default. The leveraged finance market is under increased risk in the present conditions.
• Housing price declines: Rising interest rates could trigger a steep decline in housing prices worldwide. The GSFR estimates that in a “severely adverse scenario”, housing prices could fall by as much as 25 per cent in emerging markets over the next three years; in advanced economies, the fall could be 10 per cent. These orders of declines will have adverse implications for banks.

 

Now, that is a pretty serious set of risks that banks are exposed to. One would think that, in combination, these could spell disaster for banks. The big surprise in the GSFR report is that the world’s banks seem well-placed to cope with the very worst.

All growth forecasts at the moment are predicated on economic conditions continuing pretty much as they are today —that is, the Ukraine conflict remains at the present level, oil prices will be around $92 per barrel, inflation starts coming around to normal levels in the next couple of quarters, etc.

But what if conditions worsen? What if the Ukraine conflict escalates and the US and its partners impose secondary sanctions?  What if the risks listed above materialise together as a result? 

Obviously, global economic growth will be severely hit.  The IMF looks at a nasty scenario. Growth drops from the baseline projection of 3.2 per cent to below minus 3 per cent in 2023 before recovering to around 3 per cent in 2024. The global Common Equity Tier I ratio (the pure equity component) in banking falls from 14.1 per cent of risk-weighted assets in 2021 to 11.4 per cent in 2023 and 11.5 per cent in 2024. These are all well above the regulatory minimum of 4.5 per cent. 

Banks in emerging markets would face a serious problem: Banks accounting for a third of banking assets would lack the minimum capital required. Globally, however, banks that fall below the 4.5 per cent minimum would account for no more than 5 per cent of global banking assets. 

Suppose global growth turned out to be below the IMF projection of 3 per cent plus in 2024 in the adverse scenario. Even then, on the average, one can expect banks globally to be well above the regulatory norm. 

How do we explain these outcomes? Well, there has been a big change in the banking system following the GFC. Bankers have come to realise that it pays to have capital way above the regulatory norm. The market rewards them with higher price to book value ratios because it sees these banks as less susceptible to failure. As a result, banks have raced well ahead of the regulatory curve when it comes to capital adequacy. That is standing the banking system in good stead in these difficult times. 

That is true of the Indian banking system as well. Except that, far from being under stress like their counterparts elsewhere, Indian banks today appear to be on song. The 12 public sector banks together have reported a second quarter increase of more than 50 per cent in profit after tax (PAT) over the previous year. Private banks have reported a growth in PAT of over 65 per cent in the same period. Loans in the banking system are growing at 17 per cent. If the global economic outlook is grim, Indian banks haven’t noticed it!