The Reserve Bank of India is the top financial institution in India. Everything related to money is managed by the RBI. Be it the supply of currency and inflation or interest rates in the economy. The central bank, as it is called, also regulates banks. It means RBI ensures that banks follow regulations related to lending and borrowing money.
Last week, two deputy governors of RBI made speeches that outlined the role of RBI and banks in our lives. In one speech, RBI deputy governor Viral Acharya highlighted the importance of the independence of an institution like RBI. It has received significant media attention and commentary. In another speech, deputy governor N S Vishwanathan spoke about the importance of banks and their role in our lives. This one had some key points for individuals to know from a personal finance standpoint.
Banks bring together savers and borrowers. They offer an incentive in terms of an interest rate to those who have money to save. They lend that money to those who need it for personal or business use. Bank deposits stand at close to Rs126 lakh crore or Rs 126 trillion. About two-thirds of that money goes as bank credit or loans to borrowers. That is a lot of money. Banks have a responsibility towards their depositors, who are people like us. They also have a responsibility towards their shareholders.
According to Vishwanathan, we need banks because it is not possible for us (savers and depositors) to monitor borrowers directly. Banks are actually intermediaries between the borrower and the saver. As individuals, it is not possible for you to assess the risk involved in lending. If you are directly giving the money to unknown borrowers, there is a good chance of you losing your money. This is because borrowers have more knowledge about their ability to repay a loan than you. However, when the lender is a bank, they conduct scrutiny of project proposals or loan applications. They are often able to contain defaults and are able to do it at a lower cost than an individual.
The loan agreement
If you have ever applied for a loan, you would have come across the terms and conditions written in the fine print in your loan agreement. You sign at many places, accepting these conditions. A loan agreement with a bank is usually loaded in favour of the lender. The ‘tiny’ print that you sign off on contains well-drafted covenants. It usually protects the rights of banks if the borrower fails to perform on promises of repayment. It lays down a procedure for the enforcement of the covenants. “A well-drafted covenant is to be more of a deterrent in normal times, as it serves to remind the borrower about the consequences of not honouring the loan contract,” Vishwanathan said.
These covenants in the loan agreement that borrowers sign are the outcome of a strong appraisal and monitoring system put in place by banks. Such an appraisal appropriately prices the risk involved in lending. This involves a proper understanding of the sector, which includes potential challenges and risks involved in extending loans. The impact on future cash flows of the business being funded through this loan is also thoroughly looked at. Such a contract helps banks to take appropriate action if there is a delay or a default in the repayment. Vishwanathan says that if banks do not enforce these agreements adequately, the borrower may breach these covenants consistently.
“Banks are not supposed to be shock-absorbers of first resort of the difficulties faced by their borrowers as banks do not have the luxury of delaying payments to their depositors,” he explains. This means banks cannot afford to go easy on borrowers who delay or default on repayments. They cannot tell people who deposit money in the bank like you to delay withdrawals. The only thing banks can do is renegotiate terms of the loans. However, there has to be a good reason for that and this cannot be a norm. Resorting to renegotiation often would endanger the safety of deposits and hurt a bank’s ability to lend further, Vishwanathan added.
The problems with banks
The Nifty Bank index has remained flat in 2018 so far. During the same period, the Nifty PSU Banks index is down 21 per cent. This shows that the financial performance of public sector banks is poorer than the overall performance of the banking sector. The speech by Vishwanathan perhaps explains things that could have gone wrong with public sector banks. An easy approach towards borrowers pushed up non-performing assets in PSU banks. Banks need to act tough and enforce covenants and loan agreements to ensure speedy recovery of the depositors’ money.
Banks aren’t shock absorbers
Banks are not supposed to be shock-absorbers of first resort of the difficulties faced by their borrowers as banks do not have the luxury of delaying payments to their depositors.
(The author is a publisher and editor at Simplus Information Services)