All the banks and financial institutions (Non-Banking Finance Companies, or NBFCs) are interconnected. If one of them fails, it can paralyze the entire banking system. And not just of a country, it can potentially take down banks and financial institutions all around the world.
It is exactly like the mind f**k interlinking in the most popular series on Netflix, Dark (a word-play on how these banks operate)?
Recently, top private banks in India have been announcing fund-raisers.
HDFC Bank may raise Rs 14,000 crores. Kotak Mahindra Bank already raised ~Rs 7,442 crores last month while ICICI Bank raised Rs 3,090 crores by selling stakes in two of its insurance ventures. Even Axis Bank is looking forward to raising ~7,000-7,500 crores.
Why this frenzy for raising money? Why now?
Let’s take a look.
In 2008, the financial system was brought to its knees by the failure of Lehman Brothers (an investment banking company), leading to a global recession.
While there are some great Hollywood movies explaining the entire scheme of events resulting in the crash (The Inside Job, The Big Short are our top picks), there is not much material explaining the impact on India.
Did Indian banks collapse too, as a result of the recession? No.
We fared well during that time. RBI was still in great hands and operated freely.
Also, India did not have a lot of exports. We were producing and consuming within our own borders (yes, Atmanirbhar or Self-reliant India is not a new concept; just good packaging of old products. Marketing 101).
Something that had been called a ‘structural weakness’ in our economy by economic ‘scholars’ proved to be the saving grace.
There was obviously a short term shock when foreign investors panicked and withdrew their money, but things went back to normal pretty soon.
India had also cut down its policy interest rate from 7% to 3.25%. How does that matter?
Imagine RBI giving loans to Axis Bank @7% per annum. Then it allows the banks to take loans at just 3.25% p.a. What would someone do when given such an opportunity? Yes, take the cheaper rate loans and lend out more. Borrowers also quickly availed these cheaper loans and paid off their old, costlier loans (re-financing is what jargon lovers call this).
However, the 2008 crisis was devastating enough for Central Bankers around the world to scratch their heads. Millions lost their jobs, insurance and faith in the banking system.
The sheer stupidity and greed of these bankers spooked sapiens the world over. It now became imperative to supervise these Big Bullies and put some guardrails that safeguard the public.
This gave rise to Basel III norms - a set of measures developed to strengthen the supervision of banks (Basel is a place in Switzerland. Policy-makers just name a legislation/agreement basis the name of the place in which it was agreed upon. They clearly lack creativity).
You can imagine banks as students studying in a school named Basel III. They have to follow the guidelines laid down by their school. Just like all students have to score a minimum of 33 marks (CBSE) to clear an exam, banks too have to maintain certain minimums so that they don’t, well, fail (at least in theory).
Now, let’s again take a step back to understand how banks work and what the banks did during 2008 to deserve such a reprimand from regulators.
Banks take money from you and lend it to others. Now, banks also have an obligation to pay back your money (it is a liability for them). What happens if someone who has taken money from the bank does not pay them back? The bank’s ability to pay you back reduces.
The people the banks lend to are also profiled basis their ‘credit rating.’ Someone with a good credit score has a higher chance of getting a loan, and at a lower interest rate. Now, such great borrowers are obviously limited. So, the banks decide to take a little more risk and lend to people with lower credit scores (albeit at a higher interest rate). They also ask you (the borrower) to keep some asset as collateral, which can later be sold off if you don’t pay them back.
Between 2006-08, the banks gave loans on loans on loans to super bad borrowers (who already had a lot of debt) on the back of rising prices in the housing market. The highly-priced houses were kept as collateral with the banks.
And then, the housing market collapsed. There was no demand for houses, and everybody suddenly wanted to sell. Those who had bought these houses for say $10Mn (on loan) would now get only $100K for the same. Hence, they were unable to repay their loans, and banks couldn’t get a decent enough price by selling these houses.
Since all the banks were interconnected, and each lent to the other, this led to a systemic failure in the banking system. US Central Bank (Federal Reserve) had to step in and save the banks using tax-payers dollars.
So, what does this Basel-III norm require of the banks? They require the banks to maintain:
Some minimum capital (own money, saved from profits and brought in by investors to ensure that during a rainy day, they don’t have holey umbrellas)
Some minimum liquidity (liquidity implies having lots of assets that can be quickly converted into cash)
A limit on risk-taking (giving out loans less aggressively and to better borrowers)
A source of stable funding (to ensure predictability and confidence in being quickly able to raise money).
Now, the pandemic has left banks in a stressful condition. With an increasing number of people opting for a moratorium (a temporary stop on EMI payments, while the interest accumulates), the banks are worried that these loans will turn bad. Some of these borrowers may not be able to pay back. Moreover, real estate assets kept as collateral with the banks may turn out to be worth lesser, now that there is no demand.
If a lot of people stop paying interest, it hurts the banks. They have lesser cash available to meet their obligations. Plus, those Basel-III norms are hanging over their head like a knife about to fall.
When borrowers stop paying interest for 90 days straight, the banks call them Non-Performing Assets (NPAs) and it is usually quoted as a percentage of the total amount the bank has lent out.
Now, Financial Express reported that the banks could see these NPAs growing to ~11% (which is HUGE).
Let us understand this better.
Assume that a bank has loaned out INR 100 (INR 80 came from deposit holders like us, and INR 20 was the bank’s own money). The bank gives loans at 10% and borrows at 8%. If things were good, the bank would have earned 100 x 10% - 80 x 8% = 10 - 6.4 = INR 4.6
Now, assume that the bank may not get back INR 11 back (11% NPAs). It will get only INR 89 + 10% (INR 8.9) interest = INR 97.9.
It has to pay INR 80 + 8% (INR 6.4) = INR 86.4.
Thus, it will make a profit of only INR (8.9 - 6.4) = INR 2.5.
That’s like a 45% reduction in profits. Plus, the fact that it will have lesser money to pay back the deposit holders.
When the lockdown started, most of us thought that it would end in a month or so. So did the banks. No one knew that this would be extended to a six month period.
The banks are thus facing liquidity issues and hence, looking to raise funds. They need to maintain the basic Basel-III norm requirements and prepare for the worse.
What’s thankfully working in their favour right now is the euphoria in the stock markets. It is the best time for them to get a decent price for the shares they sell (they understand the basic logic of buy low, sell high).
As they say, hit the iron when it’s hot. And the stock markets are super hot right now. Too hot? No comments.
What happens if they don’t raise money? If they fail? If even one of them fails? They will all come crashing down. Like a house of cards.
Remember, everything is connected. The beginning and end, they are the same.
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Anmol is an economics undergrad, who's passionate about everything Finance. He believes in moving the world but in a very gentle way, and hopes he can do so by his words. He has taken a step towards realising this dream, and so should you :)