Two issues have dominated concerns regarding the financial system in the last couple of weeks. One is the lack of liquidity and associated problems in the market; the other is the health of ICICI Bank and the issue of public confidence. To deal with the second first, it is obvious that there should be no reason to worry about the bank’s health, or the safety of its depositors’ money. Its financial X-ray, published in this newspaper on Saturday, shows that on all the key parameters (capital adequacy ratio, non-performing assets, return on assets, etc), the bank is broadly in line with the rest of the banking system — which, as a whole, is healthier than it has ever been. The Indian banking system, including ICICI Bank, has the additional safety of a quarter of its money being mandatorily invested in government securities — a practice that is missing in markets like the United States. To be sure, ICICI Bank has booked some losses on its international operations, but the total exposure and the scale of risk are tiny when compared with the size of the bank, which is the second largest in the country. There is, therefore, every reason to believe the Reserve Bank and the finance ministry when they assert that the bank is safe. Reports that the bank has borrowed short-term money at 20 per cent must be seen in the context of the state of the call market (which saw 20 per cent interest rates late last week), and the fact that others too have therefore borrowed at the same or comparable rates. Indeed, the bank has usually been a lender on the overnight call market, not a borrower — which should establish its usual state of liquidity.
If the bank has a problem, it is one of image. Its origins go back to an earlier identity as a development financial institution, a business model that is now mostly discredited. To deal with the poor quality of its inherited assets, the converted bank choose to drown the problem in new, healthier assets which it acquired with a vengeance, thereby also registering record growth rates — which in turn may have created the impression that the bank takes riskier bets than others. The impression in some minds that the bank may not be as safe as others resulted in a brief bout of depositor nervousness in Ahmedabad some years ago, and in the last fortnight in some Tamil Nadu towns and Hyderabad — with local media channels fanning the flames of uncertainty. The rush for withdrawals has abated, but there is still probably some doubt that remains in depositors’ minds.
Meanwhile, banking observers have wondered about ICICI Bank’s focus in recent years on retail credit (which now faces rising delinquency rates), as well as its dependence on wholesale sources of money rather than broader dependence on retail current and savings accounts (which are more stable sources of finance). The ICICI Bank management argues that it made sense to depend more on wholesale money in an environment of falling interest rates. But recognising the problem, it has already announced a shift away from retail lending, and has dramatically upped the share of money that it gets from current and savings accounts (from 16 per cent to 28 per cent in the last 18 months). Along with other course corrections, and with healthy ratios, the bank should be able to improve the confidence level in its operations so that the Gujarat, Tamil Nadu and Hyderabad episodes are not repeated. That is what will help the bank’s stock trade at more than book value, as other banks do and as ICICI bank itself did till last week.
The real problem is not with ICICI Bank but with the level of liquidity in the banking system. If the banks don’t lend, the entire commercial world will get sand in the wheels and the economy will be forced to slow down. Entities that are short of cash could even start defaulting on their obligations — and the resulting disruptions would make matters worse. It is therefore vital that the liquidity issue is addressed fully and quickly. The Reserve Bank did its bit last week by dropping the cash reserve ratio and releasing Rs 60,000 crore into the system over the week-end. Earlier, it dropped the statutory liquidity ratio by 1 percentage point, releasing another Rs 40,000 crore. The government has done its bit by postponing Rs 10,000 crore of borrowing. But this combined liquidity enhancement of Rs 1,10,000 crore may not be enough when advance tax collections of about Rs 45,000 crore went out of the system in mid-September, and when dollars are flowing out as FIIs sell in the stock market (a development that sucks out rupees from the market). Also, the government has not yet compensated banks for the losses on mandated agricultural loan write-offs, and the oil and fertiliser companies have used bank finance to compensate for the shortfall in government subsidy pay-outs. These payments (which could total up to something approaching another Rs 1,00,000 crore) can be released by the government only after Parliament meets in a few days and approves the spending, and it is vital that these are done as soon as possible. By all accounts, that should be able to deal with the liquidity problem — except for the additional possibility that when it comes to project finance, bank credit may have to make up for the drop in capital raised through share issues.
However, even that will leave another issue to be tackled — which is to do with the core issue of trust. Both banks and non-banking financial companies (NBFCs) have substantial exposure to the real estate sector, which includes malls, hotels and the like, and (to a smaller degree) to the capital market. With stock prices having halved in eight months, and with anecdotal evidence suggesting that many real estate firms are in a cash squeeze, doubts about these sectors are coming in the way of the free flow of credit. The RBI will therefore have to figure out how to deal with the issue of potentially toxic assets and even some fear of counter-party risk when it comes to the NBFCs. These are not easy issues to even assess with regard to scale and nature, but the first task is to fix the liquidity problem, and then assess the scale of the other problems if there is no revival of normal banking operations.
Meanwhile, a new development is the increasing rate of default on retail debt, including the rising level of credit card delinquencies. What this suggests is that individuals have borrowed more than is wise, for either asset acquisition (like homes and shares) or for buying consumer durables. In a business environment where companies in many sectors are downsizing, and people are therefore losing jobs, the fact is that the music may have stopped for many people who are deep in debt and have significant commitments on monthly instalment payments. All banks would therefore be well advised to de-emphasise retail lending, as many have already done.