It is doubtful whether there would be even a single reader of this article who would not have a deposit account with a bank. In all probability, he or she would have multiple relationships with various banks and would be availing various banking products and services such as remittances, overdraft and loan facilities, safe-deposit lockers, cash management services and demat account.
Banks are a matter-of-fact and everyday part of our lives and they impinge on our sensibilities only if something goes wrong, such as, when an expected credit is delayed, or there is too large a crowd at the branch, or the media reports a major bankruptcy or fraud. And of course the large and growing level of non-performing assets (NPAs) of the Indian banking system is never far from our conscience.
Everybody agrees that banks and banking are an important part of our economic life, but it is strange that few appreciate how their operations are rather counter-intuitive.
For example, in the business of lending money, banks may achieve any decent level of profitability only if they focus on lending to those who are perceived to be less than the best quality borrowers! The better-quality borrowers have so many banks running after them that they can play one against the other and command extremely fine pricing.
At the same time, charging higher interest rates for higher-risk debt is not an option as no amount of interest income can make up for a loan which has gone bad. A bank which pursues such a strategy would soon be holding only uncollectable toxic debt, as only those who have no intention of repaying loans would gravitate to such a lender while freely agreeing to pay any level of financial charges.
A bad loan delivers a double whammy to a lender. Not only does the loan not yield any interest income, but the bank also has to provide from its profits (and if that is insufficient from its net worth) for the principal loss expected because of the bad loan.
Similarly, depending on legal means or selling security as the primary means of recovery would push up transaction costs to the extent that it would make banking business unviable. Virtually, the only security a bank has is a customer who can continue as a going concern and has enough cash-flows to service its debt in a timely manner.
Having legal rights and mechanisms for enforcing them (through mechanisms such as the Insolvency and Bankruptcy Code - IBC) reduce the risk of financial transactions without which financial markets would either fail to develop or function poorly.
Depositors should also be wary of banks (and others) offering higher rates of interest on deposits (compared to general market conditions), since this is, often a fairly good indicator of deep underlying problems. Bank deposits are held primarily to fulfil transaction motives – therefore, quality and range of deposit services is much more important than the interest rate in attracting deposits.
An oft-repeated piece of received wisdom prevalent in relation to functioning of banks is that, since their liabilities are short term, they should focus only on lending on short-term basis; and the natural scope of their operations is lending for working capital purposes.
This logic completely ignores the fact that one of the key functions of financial intermediaries is to manage and profit from maturity mismatches between assets and liabilities. In doing so, banks transform deposits from millions of short-term depositors into much fewer longer maturity loans and advances.
That is, they offer safety, liquidity and convenience to short-term depositors and use the funds so garnered for making larger and longer term loans. In addition, they offer their appraisal and monitoring services for loans made as an assurance that they would be able to repay their depositors.
Banks make working capital loans not because their liabilities are short term but because in some hoary past financing trade is what they understood well.
One of the most critical roles played by banks, which is hardly ever discussed or recognised, is that they maintain the credit history of various players in the real economy in their institutional memory. This is what ensures that the economic cycle keeps moving. The moment this credit cycle is broken for any reason, the real economy collapses.
The moment a bank closes shop, this information is as good as permanently lost. This is the reason not only why no government can afford to let even small banks collapse but also why banks and other financial intermediaries need to be so closely regulated.
The critical role played by financial markets is well captured in these words of the Nobel Laureate Joseph Stiglitz who remarked that financial markets “can be thought of as the ‘brain’ of the entire economic system, the central locus of decision-making: if they fail, not only will the sector's profits be lower than they would otherwise have been, but the performance of the entire economic system may be impaired.”
Trying to understand these nuances and translating it into useful products and services which adds to human welfare may be as challenging, interesting, adventurous, and pleasurable as what Thor Heyerdahl achieved through the Kon Tiki Expedition or what Ernest Hemingway found in bull fighting or big game hunting.
Welcome to the World of Banking!
(The author worked with various banks - public, private, and foreign both in India and abroad - for nearly 30 years and is currently on a self-imposed sabbatical to try and understand as to what ails Indian banking and what, if anything, can be done to improve its functioning.)