Here is another surprise move from the RBI for stopping acceptance of post-dated cheques. PDCs are preferred by lenders as it is considered a “safe instrument” while banking public feels at ease with its usage
The Reserve Bank of India (RBI) while extending the deadline for issuing new chequebooks based on the cheque truncation system (CTS) signalled the end of post-dated cheque (PDCs) era.
In a notification issued on 18th March, the central bank said the system of post-dated cheques and payment via equated monthly instalment (EMI), in either the old or the new format, would be banned from now wherever electronic debit facilities are available. “Lending banks shall make all efforts to convert existing PDCs in such locations into electronic clearance service (ECS) or regional ECS (RECS) for debit by obtaining fresh mandates from the borrowers,” the RBI said.
Lenders across the country are sitting on a pile of huge number of PDCs worth thousands of crore of rupees. Most are them are reluctant to call the borrower, take a mandate for ECS and return all the PDCs. This is not only a time-consuming process but also increases the workload on bank employees.
While on paper the idea looks good, there are several hurdles for implementing these changes. PDCs are the most favoured system by lenders across the country, as it is considered “fail-safe”, in case the borrower defaults. In case of default in repayment through PDC, the borrower can be tried under Section 138/142 of the Negotiable Instruments Act, 1881. Section 138 aims to promote better compliances in terms of honouring cheques and discharging liabilities by imposing a penalty for any default committed in this respect. It is a medium of speedy remedy provided for the protection of the holder/payee of the cheque, where the debtor seeks to discharge his obligation through cheque but does not intend to honour it.
Even the Supreme Court, in a recent judgement, has ruled that stop payment of PDCs issued by a person to discharge his debt or liability could amount to penal offence. A bench comprising Justice MB Shah and Justice Arun Kumar said, “A post-dated cheque will lose its credibility and acceptability if its payment can be stopped routinely.”
Another issue with the RBI's new directive is at present, there are 81 centres or locations that offers local ECS, while there are just nine centres, which offer RECS across the country. National ECS, on the other hand is operated at Mumbai and facilitates the coverage of all core-banking enabled branches located anywhere in the country.
Though our banking system is developing fast, the access to banking today is not available to one-third of our population and ramifications of a hasty decision to penalise usage of cheques will be too catastrophic for a nation like ours, which requires social up-liftment and inclusive banking before forcing technology on our people.
Earlier, while speaking at Chennai in December 2012, Dr KC Chakrabarty, deputy governor of the RBI had said, “Technology has the potential to act as a force multiplier in our financial inclusion efforts, provided it is implemented in a planned manner. There is, however, an increasing realization that mere reliance on technology-enabled non-face to face channels alone would not be sufficient to meet our goal of creating an inclusive financial system. There is a need for opening more brick-and-mortar outlets as delivery points, both as a control mechanism for business correspondents (BCs) and to gain the trust and acceptability of the masses.”
Before asking banks to stop accepting PDCs, the RBI needs to first educate the banking public about using ECS/RECS facility and incentives its usage, if needed.
In the first part of this two-part article we discussed overheating in credit markets. We now take a look at were the problems exist. Like the Junk Bond ETFs the duration mismatch is not an issue. But if investors began to question the safety of WMPs and stopped buying them, then the whole scheme might explode
Governor Stein’s three factors set the stage for a financial crisis but there is one more aspect that can change some bad credit decisions into a disaster. Bad credit decisions in and of themselves would not cause problems. What makes the issue systemic are poor determinations of risk combined with maturity mismatches. The obvious example is the asymmetry of the banking industry. If a bank’s depositors were locked into the same maturities as its debtors, there would never be any runs on banks. But banks often get funding from short-term sources and lend it out for much longer maturities. When the loans become questionable, it is the investor or depositor who can convert their claims into cash first who wins: a bank run. A rush for the exit creates a fire sale of illiquid assets that often tramples the good with the bad.
The example that governor Stein chose as having a high possibility of having a systemic impact are Junk Bond ETFs. He is right to be worried. Junk Bond ETFs have grown enormously. Their assets have grown from $300 million in 2007 to $32 billion. The reason why they are so popular is simple: yield. The most vulnerable of investors, retail investors, have invested in Junk Bond ETFs. With the Federal Reserve suppressing interest rates, many retail investors, often retirees living on income, see Junk Bond ETFs as a safe way to get a decent yield while investing in a diverse pool of assets.
But they are not that safe. Junk bonds do not trade on a regular basis. They are often illiquid and obscure. The largest Junk Bond ETFs are coupled with the iBoxx High Yield Index which is screened for liquidity. Still the very size of these products would make it difficult for the ETFs to adjust if there was even a slight change in expectations. The trigger could be a sign that the American economy is getting healthier. This would eventually lead to an inevitable rise in interest rates. With Junk bond yields at record lows, they would be one of the first things that investors would sell. A dramatic run for the exits in an illiquid product is exactly the type of situation that could result in a systemic collapse.
The issue is not academic. Investments in ETFs can be both short and long. Shorting Junk bond ETFs enables investors to protect their portfolios from an unexpected move in interest rates which is always a possibility since those rates are set by institutional and not market forces. With some doubts, thanks in part to governor Stein’s remarks, short interest in the two largest Junk bond ETFs hit their highest level since October 2007, the last time American equity markets were this high. Although both of the large Junk bond ETFs did survive the 2008 meltdown, they were about a hundred times smaller.
The Federal Reserve Board of Governors are meeting next week and they are presented with a dilemma of their own making. It appears from recent numbers that employment in the US is getting better, but there are areas of weakness. So they might either keep trying to suppress interest rates in the hope that continued stimulus will attempt encourage more hiring.
There are risks. If they continue the programme, more money will continue to flow into Junk Bond ETFs and other risky investments. Money flows into junk bond mutual funds have hit their highest rates this year. The larger the funds, the higher risks whenever the Fed eventually has to end its programme.
In the alternative the Fed could announce a slowing or termination of the QE program. This will slow or stop money into ETFs, but it might provoke a sharp correction. The question is whether they will try to take the risk now or later. Either way they may find that deflating a balloon is much harder than blowing one up.
But there is one example that governor Stein did not discuss although it fits his description perfectly: China. The three factors in governor Stein’s analysis (financial innovation, change in regulations and a prolonged period of easy money) all exist in China. China, like other central banks throughout the world has been flooding its economy with money since 2009. The recent difference has been where the money is coming from. Up until 2012 it came mostly from loans from state-owned banks, but there has been a change in regulations.
In attempt to reform its financial system, the Chinese regulators have been far more tolerant of different financial products. Usually the Chinese banking system has been insulated by captive depositors. These depositors had few other choices. So if the state banks chose to pay low interest rates to increase profits in order cover loans losses, there was little the depositors could do. There weren’t many alternatives, until now.
As the regulations changed, so did the financial products. Rather than straight deposit accounts, Chinese banks could offer Wealth Management Products (WMPs). WMPs were originally tolerated, but not sanctioned. So a vast shadow banking system grew up. Since the exact numbers are not available it exactly represents an example of governor Stein’s fears about the tip of an iceberg.
The one thing that we do know is that it is a very large iceberg. It is estimated to be about Rmb 13.6 trillion ($2 trillion) or nearly 50% of GDP. The backbone of this system are trusts, which were allowed as a way to increase lending to municipalities and real estate developers with loans that are off the bank’s balance sheets. These trusts had over Rmb 3 trillion ($1 trillion) under management at the end of the third quarter of 2012. This is a 54% increase since 2011 and a 500% increase since 2009.
When regulators started to restrict trust activities, Chinese agents did what all financial agents do. They went around them. They started moving money into brokerage houses that passed them on to other borrowers. By the beginning of this year Chinese brokerages had Rmb 2 trillion ($320 billion) of entrusted funds. This is a seven-fold increase since the beginning of 2012. They received Rmb 1 trillion in the fourth quarter alone.
So the shadow banking system created new financial products helped by an era of changing regulations in an environment of cheap money. All of the ingredients according to governor Stein save one: maturity mismatch. But this exists as well.
The new financial landscape allowed banks to funnel money to trusts often through brokerage firms. The trusts make high yield loans to companies such as property developers are considered too risky for regular bank loans. Besides the developers are off the banks’ direct loan approved list, because the Chinese government is trying to cool an overheated real estate market. These loans are not short-term. They are multi year. But the WMPs sold to investors are. The durations are for just one to three months. Like the CDOs supported by sub-prime loans, they are considered very safe investments.
Like the Junk Bond ETFs the duration mismatch is not an issue. As long as there is a continuing demand for WMPs to pay off the maturing ones, just like a Ponzi scheme, there will not be any problem. But if investors began to question the safety of WMPs and stopped buying them, then the whole scheme might explode.
When and whether Junk Bond ETFs or Chinese WMPs cause a new collapse will be clear probably within a few months. Whether there is a general meltdown from these or other products, governor Stein’s warning is clear and simple. Government policies and regulations have three very real limits. First, the limitations arise because of inherent fallibility of regulation as a tool in a world of regulatory arbitrage. Second, the scope of regulations cannot foresee all the ways that its effects will change the financial system. Finally, regulations may ultimately be destructive because risk taking is structured in ways that are not clear. So by the time the elements of a collapse are obvious it is already too late.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)
The PIO of IIT Delhi could not provide complete information, but the CIC said it was without any reasonable cause or any malafide intention. This is the 60th in a series of important judgements given by former Central Information Commissioner Shailesh Gandhi that can be used or quoted in an RTI application