“Bank chiefs want no more interest rate increases as further hikes will intensify strain on their asset quality”. That headline was almost simultaneously accompanied by the downgrading of State Bank of India's (SBI's) financial strength rating.
A notable deterioration in asset quality, higher provisioning, lower profits, lower than the stipulated CAR (capital adequacy ratio) and, to top it all, some ambiguity on capital infusion from the Government were the key reasons cited for the downgrade.
A securities firm says that delinquencies have risen almost 10 per cent in the first quarter of financial year 2012 on account of “an economic slowdown” and rising interest rates.
As can be seen, higher interest rates have been identified as the villain behind the intensifying strains on bank balance-sheets.
The solution or relief sought therefore is: no more monetary tightening and higher interest rates as stable to softer rates would (hopefully) help keep assets — primarily loans — on bank balance-sheets in the performing category (investments being largely insulated from interest rate risk).
Long and short terms
The key question is: Will that provide enduring relief or will it only postpone problems to a later date?
It is unfortunate, in this context, that much of the public discussion which has followed the SBI downgrade has lost sight of the larger and long-term macroeconomic issue(s) involved here.
The downgrade, in fact, is only symptomatic of the underlying problem which the Indian economy and, in the instant case, the financial system faces — that without stable (and preferably low) inflation and a history of consistently producing such a price environment, we are vulnerable to overall economic and financial sector instability.
In the real sector, a manufacturing balance-sheet — say, of a cement company — could probably remain healthy only if it faces a broadly stable demand and price environment which enables it to service its liabilities smoothly.
High and volatile inflation and the uncertainty this generates is certainly not conducive to that outcome. Likewise, in the financial sector, a bank balance-sheet can remain healthy only if both the quality of its (existing) loans and the demand for fresh loans are good.
The long-term and enduring solution therefore is to produce low and stable inflation on a sustained basis.
The short-term fix, of course, is to generate (successively) higher inflation which keeps all balance-sheets “healthy”. It is not difficult to understand, in this backdrop, the requests of various industry associations in the recent past as well as the reported request now from bank chiefs that the RBI should desist from further monetary tightening.
reminiscent of the US
As the appeal against higher interest rates gathers momentum (ahead of the RBI's upcoming monetary policy review), one cannot but note the eerie similarities between the Indian financial sector/financial markets situation now and that of the US in the second half/late 1970s and early 1980s.
In India now, if the RBI refrains from further strong monetary tightening, bank balance-sheets could quite well escape severe short-term pain. To put it in more macro terms, if the RBI were to somehow engineer a policy now that keeps inflation high and rising for the ensuing period, that could be a big relief for bank balance-sheets.
That is, having significantly expanded their assets in the past decade through a period of rising inflation, bank balance-sheets now need higher — or at least inflation stable at current levels — to maintain asset quality.
Somewhat similarly, if the US Fed in 1979/1980 had desisted from the all-out monetary tightening and attack on inflation which it launched in October 1979, the US financial sector could probably have escaped the severe contraction and pain it experienced then.
Starkly highlighted by the S&L (Savings and Loan) crisis, when thousands of long-term mortgage lenders collapsed as their liability costs rocketed suddenly well above their asset returns, short-term funding markets became strained, asset quality deteriorated in the recession — all of which combined to render them financially insolvent. (The subsequent resolution of the S&L crisis involved a total bill of some $250 billion in current dollars.)
Back in the 1960s and 1970s, as inflation moved stubbornly higher in the US, tough policy action — primarily monetary policy action — to push it back was routinely ignored. The US Federal Reserve also maintained a notably upward sloping yield curve — keeping short-rates soft and providing enough of an incentive (and comfort) for financial institutions and long-term lenders — primarily thrifts or the S&Ls — to do long-term fixed rate housing mortgages.
The easy monetary policy stance meant that inflation moved successively higher over the years — and with nominal rates not catching up with the level of inflation, real rates were quite attractive from the borrowers' as well as a consumption perspective. Bank and financial sector balance-sheets, of course, remained “healthy” in that environment.
Matters came to a pass in the late 1970s with double digit inflation and the adoption of a radically different policy by the US Fed under a new Chairman. The Fed then resolved to squelch inflation at all costs. Short-term rates were engineered to unheard of levels (then and now) as the Fed broke the back of inflation and ushered in a long period of low and stable inflation through the 1980s and 1990s and well into this decade.
(Frequently, this achievement on low inflation is juxtaposed against the financial / credit crisis of 2008 and it is pointed out that while the Fed delivered on inflation, the cost was financial instability. The credit crisis was the result or effect of a colossal failure of the Fed's supervisory and regulatory functions. To mix it up with its success on keeping inflation under check does not appear acceptable).
Affects All Financial Intermediaries
Variable and generally intensifying inflation over the past many years has so far seemed to have a negligible — if not completely benign — influence on banks' asset quality and the strength of their balance-sheets.
How unstable and rising inflation could adversely impact the health of banks' — and more generally all financial intermediaries' balance-sheets — be it a life insurance company or a general insurance company apart from pure lending institutions such as banks and non-banks — has probably received scant attention in the past many years. This is because the financial sector's balance-sheet expanded at a significant pace and everything seemed hunky-dory. Now, as inflation seems to have taken hold stubbornly, the weaknesses in this model seem to be getting highlighted quite starkly.
(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. The views are personal.)