Finding ways to revive our banking system

The decision by the Reserve Bank of India (RBI) to grant banks the option to spread provisioning equally over up to four quarters for mark-to-market (MTM) losses on investments is one that merits discussion.

These investments are those held in Available for Sale (AFS) and Held for Trading (HFT) accounts for the quarters ended December 31, 2017, and March 31, 2018. This step has been taken to assist the banks in dealing with declining profits from both the rise in yields on government securities in the past few months and Non-Performing Assets (NPAs).

While in the short run such a step might assist in alleviating the pain in the banking system, in the long run, it needs to move towards creating a more robust framework based on stringent MTM regulations. We need to enforce MTM clauses on financial institutions such as banks with regards to securities across the spectrum, including loans and not just bonds.

Situations that allow banks to spread losses and display profits up front may encourage poor risk-taking by the banks and should be discouraged. The "Held to Maturity" accounts with the banks have the requisite bond holdings that they can hold to maturity without having to account for MTM valuations.

Banks should not assume that they can indulge in trading strategies to show upside immediately and show downside gradually. Instead what the banking system requires now are accountability and transparency. We are sure the RBI has thought through this temporary policy change. However, it should be made clear to the banks that it will not grant them such relief on a regular basis.

In the broader macro-economic picture, it is crucial for banks to brace themselves for a period of increasing interest rate volatility. As global interest rates move higher, bond yields in India will reflect the global volatility to some extent. Market participants should not expect regulatory changes to shield them from market volatility in financial instruments they hold for trading accounts. Banks need to account for the increased volatility in their pricing, risk limits and risk management and not expect the central bank to bail them out of stressful situations.

Given the growth of the Indian economy and the increased importance of the country in the global economic system, banks will have a crucial role to play as facilitators of trade and business. It is essential that they prepare themselves to face global macro-economics-driven volatility through robust internal mechanisms that help them both mitigate and manage risks such as rising bond yields on government securities.

In addition to MTM valuations for the bond market, India needs to push for such valuations of bank loans going forward. The policymakers need to come up with a framework that allows for bank loans to be regularly valued, hence pricing in credit quality gradually.

A framework for MTM valuations for bank loans would require a central agency to create indices for loans based on commonly shared information from the banks based on actual loan repayment information. All bank loans would have to be marked against this index, hence ensuring transparent valuation.

Eventually, the aim would be to develop a robust and functional secondary market for corporate loans, to provide correct pricing and management of risk. A functional secondary market would eliminate information asymmetry from the system such as in the US loan market, an excellent template from which to learn.

India should learn a few lessons from the Japanese Banking crisis of the 1990s. Poor lending combined with delayed recognition of losses ended up creating "zombie banks" in Japan. The economic and social implications of a poorly functioning banking system was there for everyone to see as Japan struggled to regain growth rate of the past decades.

It is essential that the banking system adheres to strict regulations around transparency. A transparent banking system assists in higher lending standards and better dissemination of information regarding corporate credit quality. The Indian banking system must make strides towards greater transparency so as to provide an efficient system that is so essential for economic growth.

(By: Taponeel Mukherjee heads Development Tracks, an infrastructure advisory firm)