A stop sign is displayed on the barrier of a railway crossing as a train travels past a railway station in India. (Photographer: Dhiraj Singh/Bloomberg)

What Happens When A Bank Stops Lending?

The Reserve Bank of India has told Dena Bank to stop lending. It has told Allahabad Bank that it can’t expand its ‘risk weighted assets’, suggesting that it can only do very small amounts of fresh lending.

If the banking regulator is imposing these restrictions based on quantitative indicators such as capital, bad loans and return on assets, then it’s quite possible that some other banks will face similar restrictions.

But what happens when a bank stops lending? Does it help the bank recover quicker or does it push the institution into a deeper malaise?

What Does A Bank Do?

To understand the impact of a lending freeze on a bank, it useful to remember what it is that a bank actually does. It takes deposits from customers and from the markets, it sets aside a part of those for regulatory requirements like statutory liquidity ratio and cash reserve ratio, and then it lends out most of what is left.

Sure, a bank does much more. It provides payment services, wealth management services etc. But a bank’s core income comes from lending.

“Banks exist to lend, so stopping them from lending is generally not a good idea. It will hurt them and their customers,” R Narayanaswamy, professor of finance and accounting at the Indian Institute of Management, Bangalore told BloombergQuint in an emailed response. “This will actually hurt rather than help the troubled banks.”

Should a bank be told to stop fresh lending, it would typically direct most of its incremental deposits into government securities. While, over time, this would reduce the credit risk on the bank’s book, it may add interest rate risk incurred in the process of investing in fixed income, Narayanaswamy explained.

Karthik Srinivasan, Senior Vice President at ICRA told BloombergQuint that putting a stop to lending at a bank will also lead to a fall in net interest income. “Continuation of high operating expenses and a fall in net interest income are inevitable but the extent of this impact can be ascertained only when further details emerge,” Srinivasan said.

Theory vs Practice

In theory, what the RBI is doing is not unheard of. While the regulator is taking these actions under its prompt corrective action framework, the direction is similar to a concept called ‘narrow banking’.

In 1997, a Committee on Capital Account Convertibility led by late SS Tarapore, had discussed this option in the context of those times and said:

Noting with concern that some of the weak banks are growing at rates faster than the system, the Committee recommended that weak banks should be converted into narrow banks, i.e., banks whose incremental resources are deployed only in investments in government securities; in extreme cases of weakness, restraints should be applied on liability growth.

By ensuring that all incremental deposits flow into the government securities, the lender’s loan book growth reduces and a stronger safety buffer is created due to the increased investment in government securities, the committee had noted.

But subsequent research had questioned the practicality of such measures.

A 1998 research paper by Saibal Ghosh and Mridul Saggar published in the Economic and Political Weekly noted that experimenting with such a framework in the real economy could be costly. While parking incremental deposits in risk-free assets would help minimise any future liquidity mismatch if there was to be a run on the bank, such a move would erode profitability quickly and significantly, the paper had noted. It added that conversion to narrow banking may also lead to heightened market risk for these lenders, said the paper.

Venkatesh Panchapagesan, associate professor of finance, at IIM Bangalore says that while under normal circumstances, stopping a bank from lending completely is not advisable, the situation in India is different. Firstly, since these are sovereign entities, the risk of a run on the bank is limited. Also, banks are bleeding and it is important for the RBI to take decisive measures, he said.

There are other reasons to think that it may not be a bad idea as well: (1) if RBI believes that the bank’s days of independent existence are numbered, then it is important to preserve assets and not lend it out.  Buyers of banks would view cash in hand more valuable than money lent out (even to good borrowers) especially when the bank is distressed.
Venkatesh Panchapagesan, Associate Professor of Finance, IIM Bangalore

Will RBI’s Restrictions Help Or Hurt?

The RBI’s decision to enforce stricter controls on Dena Bank and Allahabad Bank comes after the two lenders failed to improve their financials despite being put under the PCA framework last year. For the quarter ended March 2018, Dena Bank reported a net NPA ratio of 11.95 percent. Allahabad Bank reported a net NPA ratio of 8 percent.

Eleven government lenders are currently under this framework due to their high level of bad loans. Most are likely to see further deterioration in the quarter ended March 2018 due to the RBI’s decision to enforce a tougher stressed asset framework starting February.

On Friday, Business Standard reported that the government may ask the RBI to revisit its PCA framework to avoid a situation where small and medium businesses are not starved of capital.

“The PCA should be interpreted as the fact that the bank has been moved to ICU and is following a special diet, as things are not normal,” Charan Singh, visiting professor at UCLA Anderson School of Management told BloombergQuint in an email. “To recover to good health, sometimes, a holiday is necessary or even fasting which leads to healing.”

Singh, however, added that it is important for the RBI to conduct a deeper analysis on the PCA framework and put it out in public domain. Such an analysis is necessary because by placing banks under PCA, general public is impacted if restrictions are placed on making deposits or borrowings from respective banks, Singh said.

Should PCA be invoked and would it be productive  when tide is low and many banks are barely able to manage staying afloat amongst the rocks?
Charan Singh, Visiting Professor, UCLA Anderson School of Management

Ashvin Parekh, managing partner at Ashvin Parekh Advisory Services believes that the success of a framework like PCA or, in its extreme form, narrow banking, will also depend on the economic environment and the strength of the individual financial institution.

“If the economic environment shows promise of higher growth then narrow banking may not be an effective remedy. The said narrow bank may lose opportunity to build fresh assets in the portfolio to reduce the risks in the portfolio on a weighted average basis,” Parekh told BloombergQuint in an email.

However, if an institution does not demonstrate the ability to build more quality assets, nor the ability to recover from existing exposures, then narrow banking will work very well, Parekh added.