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Home > Business > Columnists > Guest Column > A V Rajwade

Banks and the share markets

August 02, 2004

John Kenneth Galbraith made an incisive comment in his famous book on the stock market crash of 1929.

He stated that, after the crash, extremely elaborate prospectus regulations were introduced; however, no way could be found to persuade an intending investor to read the prospectus before taking a decision on the investment.

Not much on the subject has changed over the past 75 years: while a million trees will be destroyed to make the paper needed to print the offer document or prospectus of the forthcoming issue of Tata Consultancy Services, how many of the millions who may invest are likely to read it?

The immediate provocation for this thought is the reported comment of the auditors on the 2003 accounts of the Global Trust Bank. The auditors had agreed to the accounts being on a "going concern" basis, even though the net worth had been substantially eroded, only on the basis of the management's assessment of growth in business and the prospects for infusion of fresh capital.

While the language is guarded, there is little doubt that the auditors had questions about the bank's status as a going concern. Despite the reservations, GTB's size actually grew in 2003-04.

Clearly, the Indian depositor is not a coward and has great faith in the wisdom and effective supervision of the central bank.

(Even the Indian investor has similar faith in the regulator -- I remember reading a letter in Business Today that said that the market would not have fallen sharply in mid-May, but for the absence of the Securities and Exchange Board of India chairman! If only he had been present in the country at the time!)

The root of the bank's problem was its over-exposure to the equity markets. At one stage, as much as 30 per cent of its assets represented such exposure, directly or indirectly. Its troubles started when the market collapsed in Q1-2001. Remember Ketan Parekh?

It is worth emphasising that all the three recent major bank failures can be attributed to large exposures to equity markets. Apart from GTB, there was the Nedungadi Bank, which was apparently being run by a cabal of share brokers and had to be taken over by the Punjab National Bank.

The case of Madhavpura is, of course, too well known -- Rs 1,000 crore (Rs 10 billion) exposure to Parekh and his companies, representing more than 40 per cent of the bank's total loan portfolio.

As it happened, almost simultaneously with the suspension of business of GTB, the RBI issued another communication, this time to the urban cooperative banks.

With the headlines grabbed by GTB, this communication does not seem to have received as much media attention. In it, the RBI has asked all cooperative banks having deposits with Madhavpura to classify them as non-performing assets.

Reportedly, there are 160 urban cooperative banks with deposit exposures totalling Rs 700 crore (Rs 7 billion)s to Madhavpura. One wonders how many of them will remain viable entities after writing off the Madhavpura deposits.

What all three cases evidence is the obvious riskiness of banks' exposures to equity markets. More generally, financial intermediaries who explicitly or implicitly guarantee returns to those who place funds with them, as banks do, have no business to invest those funds in equity markets.

Apart from the three banks, the cases of US-64 and many other guaranteed income funds should not be forgotten. Capital adequacy norms need to be far more stringent and deterrent for commercial banks' exposures to equity markets.

The reason for labouring on the risks of exposures to equities is the suggestion some are making that, since risk-free bonds cannot give the guaranteed return on provident funds, such monies should be invested in equity markets.

The logic is that, first, these are long-term funds and, second, the returns would be higher than in the bond market "in the long run".

The worry is that, given the political difficulties in reducing the return on provident funds, the authorities may see equity investments as a way out. It needs to be emphasised that the only certainty about the long run is that, in it, all of us are dead anyway.

Another point worth pondering is that too many economic liberals point to the inefficiency and weaknesses of public sector banks and advocate their privatisation. The record of private sector banks, even the newer ones promoted and managed by professionals, has not been much better -- GTB is the third wicket to fall after Times Bank and Centurion Bank.

In fact, worldwide, banks are private so long as they make profits, and the liabilities have to be picked up by the exchequer when they go bad -- whether in Japan, the US, or anywhere else in the world for that matter.

Banks are special and no government dare put their depositors into loss.

To my mind, there is a strong case for Indian banks to consider a change in the way the prime lending rate is operated.

As of now, the new PLR becomes applicable to all PLR-linked assets with immediate effect. Life would be much easier and simpler for asset:liability managers, and indeed borrowers, if the banks review the PLR on a designated day once a quarter, and not on any day in between.

This practice will convert floating rate assets into assets re-priceable on predetermined dates.

To be sure, this would be an interim measure until the term interbank money market becomes liquid and, say, the 6-month Mumbai Interbank Offered Trade becomes the loan pricing benchmark. But, in the meantime, the suggested change will be useful.

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