SVB lessons

Inflation management versus public debt management - the RBI's two roles are at odds with each other

The commentators are right in saying that there is no likelihood of any contagion impact of Silicon Valley Bank’s (SVB’s) collapse on the Indian banks. Though some more banks in the US have subsequently fallen, they all are small banks involved in niche activities and the Indian banks have limited exposure to them. As for Credit Suisse, it had its own set of problems that were known for quite some time; the episode may have some impact on the Indian financial market, but once again nothing much to worry about.

Unlike the trigger for the 2008 financial crisis, there was no credit quality issue in SVB’s investments. At the time of the crisis, about half its assets were investment in bonds, including the US treasury bonds, considered the safest investment in the world. As of now, it doesn’t look like the bank invested in sub-standard assets or was involved in any fraud.

Where SVB went wrong was that it didn’t pay adequate attention to the interest rate risk while managing its assets portfolio. In addition, the bank had a homogeneous set of depositors, which were firms with similar business interests. The average deposit size was large, with over 90 per cent of deposits above the limit of $2,50,000 insured under the Federal Deposit Insurance Corporation.

Here are some of the lessons, direct and inferred, to learn from this episode. There would be many more as the situation evolves.

The first one is a grim reminder that the inflation management framework of the central banks needs much improvement. Forget about a small bank like SVB; which bank in the US could have anticipated a year ago that the Federal Reserve would get so aggressive as to increase the interest rates in a short period to a level not seen in many decades? The fact of the matter is that the central banks around the world kept interest rates too low for too long after the Covid pandemic. Then all of a sudden, the stance changed from being extra dovish to extra hawkish. They ought to have gradually changed their stance beginning the middle of 2021, when it had become reasonably evident that the rising inflation was not transitory, and was likely to stick around.

More importantly, did the central banks evaluate whether their stress testing methodology for banks took into account the scenario of such a sharp increase in interest rates in a short period? This applies more to the smaller banks as the big systemically important banks are generally on the radar of the regulators. 

Back home, the Reserve Bank of India (RBI) started the interest rate raising cycle only in May 2022; that too by convening a special Monetary Policy Committee (MPC) meeting instead of taking this decision in its regular meeting held just a month earlier, signalling that the central bank was behind the curve. The repo rate, now at 6.5 per cent, was increased by 2.5 percentage points during FY23.

Now, the world over, the debate whether the interest rates need any further increase is gaining momentum. Those contemplating a soft landing of the economy feel that any further increase would seriously impact growth and may cause more SVB-type accidents. Despite all the arguments and lobbying, even after the recent bank episodes, the European Central Bank, US Fed, Bank of England and Swiss National Bank have increased the interest rates in their jurisdictions by 0.5, 0.25, 0.25, and 0.5 percentage points, respectively. In India, the CPI inflation has once again been over 6 per cent during the last two months. This leaves the RBI with little choice at its forthcoming MPC meeting in April; decoupling narrative notwithstanding.

 The second learning is that even safe assets like government bonds could steeply lose their value in case interest rates rise rapidly. When one says that an investment in government bonds is risk free, one is talking about the credit risk, ignoring the interest rate risk.

In India, under the statutory liquidity ratio (SLR) mandate, the banks are required to hold a certain minimum portion of their assets in the form of G-Sec investments. Though this requirement has somewhat come down over the period, it is still as high as 18 per cent of the bank’s net demand and time liabilities. Mandating commercial banks to hold G-Secs is financially repressive and sooner this policy is done away with, the better.

The RBI allows the banks to keep the bond portfolio in three categories, viz., “held to maturity”, “available for sale” and “held for trading”. The bonds available for sale and held for trading are required to be marked-to-market in the accounting books. Thus, this portion of the portfolio results in unrealised losses in an increasing interest rate scenario. As against this, the bonds held till maturity are not marked-to-market, thereby hiding the unrealised losses. In 2020, the RBI increased the limit to which the banks could hold the SLR securities in the held to maturity category. This was with a view to encouraging banks to invest in G-Secs, thereby helping the government in its borrowing programme.

As of March 31, 2022, the combined holding of the scheduled commercial banks in G-Secs was Rs 48.38 trillion, about 22 per cent of their total assets. In addition, they had an investment of about Rs 11 trillion in non-SLR debt securities. The RBI may consider asking banks to quickly assess the impact of the increase in interest rates during FY23 on their bond assets, and the extent to which the reduction in their value would erode their capital under various scenarios of banks’ selling a portion of these assets.

This brings us to the issue of the RBI acting as the debt manager for government borrowings. This is an investment banking role demanding raising government debt at the cheapest possible rates. This is in direct conflict with the RBI’s mandatory and the most important role under the law— of keeping inflation in check. The government may consider revisiting the existing arrangement and relieve the RBI of its public debt management responsibility.

The third learning is about the oft-repeated asset-liability mismatch issue with the banks. The chances of an asset-liability mismatch emerging now and then are inherent in the banking business model.

On the asset side, among other things, the banks should refrain from lending to long-gestation projects, which are best suited for raising capital from the markets. As for the liabilities, apart from diversifying their depositors, the banks should periodically report the percentage of their deposits above the limit of Rs 5 lakh insured under the Deposit Insurance and Credit Guarantee Corporation Act. The banks having a relatively high proportion of such deposits may perhaps be mandated to keep a higher risk capital. After all, there is a limit to bailing out banks from taxpayers’ money or forcing other commercial banks to do so!

The writer is a former IAS officer and Sebi chairman