India's state-run banks should have no illusion about their new boss.
Urjit Patel, the incoming central bank chief, has every intention of taking away their $100 billion pacifier. Instead of just sitting there waiting for the government to give them more mother's milk -- sorry, capital -- they can start using their smarts, and their risk calculators, to earn that money for themselves.
It's going to be a messy fight. But if Patel's own research is any guide, it's safe to assume that sometime after his elevation to Reserve Bank of India governor early next month, the Oxford- and Yale-educated economist will make an attempt to take his predecessor Raghuram Rajan's war against the nation's state-dominated, bad loan-plagued banking system to its logical conclusion.
That final battle must involve taking away from spoiled lenders the soothing comfort of investing in government bonds, which is what they do when they want to erase the consequences of their lending mistakes by earning a dribble of risk-free profits.
To see the enormity of the challenge, and why it will be crucial for Patel to succeed, start with banks' $1.57 trillion of net liabilities to depositors.
New Delhi demands that lenders invest 21 percent of these funds in government securities and other "approved" assets. From the point of view of banks earning a decent return on capital, that diktat is bad enough.
But when lenders go ahead and plonk 27 percent of their deposits in such risk-free securities -- roughly $100 billion more than the so-called statutory liquidity ratio -- it's clear they aren't even trying. India's three largest state-run banks alone held 7.6 trillion rupees ($113 billion) of government bonds in March, or more than a quarter of what the entire banking system, including private-sector lenders, owned.
Such banker apathy is "very damaging" in a developing economy starved of investment resources, Patel and his co-author wrote in a working paper published in December 2015, in which they also showed how to calculate the opportunity cost.
On average, banks in India make loans at a spread of about 4 percentage points to government-bond yields. By sitting on $100 billion in surplus public debt, they may be giving up $4 billion in potential profit. With banks' returns on assets having turned negative, that once bitten, twice shy approach to credit risk is a costly mistake:
Under Basel III, banks are required to demonstrate that their daily liquidity coverage ratio -- high-quality liquid assets divided by total net cash outflows over a 30-day stress period -- is always more than 100 percent. But the idea behind India's liquidity requirement has got nothing to do with protecting lenders from unforeseen shocks. The motivation is simply to make sure the government gets funded cheaply, even if corporate and individual borrowers are scrambling to borrow.
Patel gets three years to persuade Prime Minister Narendra Modi's government that the socialist era has passed. Authorities don't need to force banks to buy their bonds; there will be enough investor demand as long as a modicum of fiscal discipline is maintained.
If Modi is convinced, and lenders are freed of the mandate to hold sovereign securities, the more efficiently run private-sector banks could easily take a big chunk of the loan and deposit business away from their government-owned counterparts. The latter badly need a crash course in credit risk, and they need it before Patel comes for their soother.
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