This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?
Welcome to the mid-week edition in which we write essays on a public policy theme. The usual public policy review comes out on weekends.
Indian banks aren’t lending enough despite the efforts of RBI. How do you get someone to do something which they otherwise wouldn’t? The simple answer in public policy is to align their incentives. The RBI has been aligning the incentives of the Bank for the last month. But these incentives don’t address the core of the issue.
The result is a limited transmission of all the liquidity it has injected into the system. There are two lessons here. First, for incentives to work, the problem should be identified accurately. The wrong diagnosis will lead to failed incentives. The second lesson is a bit more convoluted. It goes like this – if you can’t solve what you must, solve whatever you can. Suppose you know the real diagnosis and who can solve it. But you can’t suggest it because it won’t be palatable to anyone at the beginning. So, you choose another diagnosis and exhaust all options solving it with utmost sincerity. Soon, everyone will concede you have done your best and the unpalatable is the only option. You get what you wanted without ever raising it yourself, albeit a bit later. The whole RBI monetary stimulus saga seems to be following this script. It is only a question of time when everyone accepts the unpalatable option.
Solving what you can
If you are a bank, you are in the business of lending. What do you need to lend? Access to cheap capital and borrowers who want the money. Besides, if you want to be successful at it, you need to make sure the borrowers can return your money with the interest you had agreed upon. Else, the loans go into default and you lose some money. Now, this is like any other business. You manufacture something (loan products), the customer buys them, and you have some returns (defects). Except here in the lending business, your product doesn’t have a defect. The customer has them. So, the quality control at the time of selling doesn’t have to be done on your product but on your customer. This makes it a bit difficult because you won’t ever know enough about your customer. This is the information asymmetry problem. You can ask for all kinds of details, yet you can never be sure. This gives rise to credit rating business who solve for this information asymmetry with risk assessment and ratings of your likely customers. Even with this support, you have to contend with business cycles and macro environment deviating from your estimates which lead to defaults. Simply put, and I know this isn’t a blinding insight, lending business needs demand, supply and the ability to assess future risks for it to work.
Now, the accurate diagnosis of the problem of banks not lending at this moment is they don’t want to take the credit risk because the economy has paused. They already have loan books that have persistent slippages and new accounts that keep getting added to the ‘watchlist’. They have no special ability to predict the future in the current haze and they don’t know how to assess the creditworthiness of a sector or a company in these times. Moreover, the markets have given a premium to the quality of loan book than to growth. Why would any bank management team (including listed PSU banks) want to take the risk of lending more in these uncertain times?
However, over the last month, RBI has diagnosed the problem to be the supply of funds for banks. So, it has done a lot to increase the funds available to the banks to lend - Rs. 4.24 lakh crores in terms of TLTRO, CRR reduction, given some temporary relief to borrowers - repo rate cut, a moratorium for borrowers, relief on NPA recognition, and it has provided enough ‘disincentive’ for the Banks to sit on their money without lending it. This includes reducing reverse repo rate (the rate at which the banks park money with RBI) to a low of 3.75 per cent. Banks have an average daily surplus liquidity parked with RBI to the tune of Rs. 4.36 lakh crores in the past month. This would mean banks will earn 3.75 per cent from RBI while paying a higher interest to the depositors for SB and FD accounts. It doesn’t make any sense for the banks to do this. Banks have responded quickly by bringing down their interest rates for depositors. But that isn’t reason enough not to lend. The yield on the 10-year government bond is 6.2 per cent and the banks know the government will borrow soon to fund a big fiscal relief package. So, the banks are keeping the funds waiting for the government to come to them.
RBI believes banks should think it is in their interest to pump liquidity into the system and get the economy back on rails. Banks know if they go easy with credit now and things go well, they will benefit as much as anyone else. However, if things go badly, banks will be left holding the can alone. This is borne by the usual caveat the RBI has put in their notice which states RBI will inspect all accounts that are provided relief by banks to verify their ‘justifiability on account of the COVID fallout’. The banks have said thanks, but no thanks.
Solving what you must
If the RBI instead went with the accurate diagnosis of the problem, that is, banks don’t want to take credit risk in this crisis, they would have arrived at a very different set of incentives. These would include:
a. Credit backstop for loans given to SME/MSME sector in some kind of risk sharing ratio between the government and the bank (75-25 might be acceptable to some banks; 90-10 to most). There are a lot of companies with sound business models ready to borrow at rates that should be attractive to banks. A portfolio risk limited to 25 per cent with likely portfolio NPA of 25 per cent should find takers among banks. Plus, government as a backstop will mean a strong signal for banks to participate
b. RBI monetising fiscal deficit by entering the primary market and subscribing to government bonds directly (bypassing banks). This would make banks think twice about sitting on the reverse repo rate of 3.75 per cent and waiting for the government. They might have a greater incentive to deploy excess capital elsewhere.
c. A TARP-like programme administered by a Special Purpose Vehicle (SPV) to recapitalise stressed banks and shadow lenders or separate their stressed assets. Till this overhang exists, the banks won’t lend with any degree of freedom.
The accurate diagnosis and these incentives shouldn’t be unknown to the RBI. But suggesting these are outside their remit and unpalatable to the government. The government has to solve for them. The RBI doesn’t want to be the one pointing at the obvious. So, they continue to exhaust all options solving for the inaccurate diagnosis with tremendous earnestness while remaining in hope there are enough voices who will call for the right diagnosis and incentives for the government to act.
Sir Humphrey would have been proud.