How banking business works

This is a simplified explanation of a very complex system, broken down to basics, and represents my own personal views - comments and feedback welcome!

Banks take deposits & pay interest on them.

Banks lend money & receive interest on them.

The difference between the two is margin.

The margin pays for costs, such as employees’ salaries, branches rent, infrastructure, (including operating core banking systems & servers). The margin also covers loan loss and creation of reserves and provisions. Taxes are paid from such margin. What remains thereafter is profit. Even on profit, there is mandate of having to spend on CSR/charitable/philanthropic activities, after which the shareholders may be paid dividend.

What is loan loss you ask? When a borrower of the bank doesn’t pay back the money borrowed and/or interest on that money - it results in a loss.

Here’s an example:

Deposit taken by bank of 100, and paying interest of 3.5%

Loan given by bank of 100, and receiving interest of 9%.

The 5.5% difference between the two rates rate pays salaries, rent, for infra and reserves.

The borrower who took 100 turns defaulter.

What happens now?

Bank still has to pay salaries, rent and for infra and all other demands on margin mentioned above.

Bank still has to pay interest on the deposits and also repay deposit on demand.

Where’s the possibility of profit? It is a risk no one factors in or thinks about.

As an aside, for depositor safety, there is deposit insurance, now pegged at Rupees 5 lacs (Rupees 500000/-) – one is eligible to get that from DICGC when the bank has failed.

So for sake of prudence loans are diversified - one person is not given entire 100 but may be 10 people are given 10. This diversification means if one out of 10 default, only 10 is lost.

Of course, that a loan loss of even that 1 person who took 10 is greater than the margin across the 100 is a point which usually gets missed.

So the 90 lent to balance 9 has to support the salaries, rent, infra and of course paying the depositors for the full 100.

If more people default, the risk of bank not being able to pay salaries, rent, for infra or all the other demands on margin and most importantly, repaying the depositors keeps rising.

For dealing with the defaulter, the bank looks to the judiciary for assistance - the recovery takes time; upwards of 5-7 years just to recover the 10 which was lent and the interest on that 10 is usually lost forever. Often, the amounts recovered may be as low as 2 out of the 10 lent due to deterioration of value of the borrower’s assets and business over time.

Since a bank needs to be a financial fortress - which gives confidence to the depositors that their money is safe and will be repaid - every loan loss requires provision being created from its margins and hence reduces profits. When recovery happens, it is added back to the profits. This is really only the bank’s money that was lent out which came back and shouldn’t be mistaken for the margin which the bank uses to meet costs and only after that make profit.

The Covid-19 induced moratorium scheme which RBI has permitted banks to provide to its borrowers is not waiver, and nor should it be. It is meant to for liquidity to be created at hands of borrowers who require the same. Yes, it attracts interest – which, as explained above, is part of margins required by a bank – and hence has to be paid and the loan repaid. Those who don’t need liquidity and can continue to repay the loan and pay the interest should not avail of the moratorium.

However, there is a pent up expectation of a free lunch – of possibility being raised of moratorium becoming a loan waiver scheme - so even borrowers who can service their loan have opted for moratorium. There's also a case filed seeking waiver.  

So a bit about waivers: We all would have read from time to time about farm loan waivers. Such waivers essentially are the relevant government paying the banks on behalf of the farmer.

It is also not something bankers or RBI like – because the credit culture weakens with each loan waiver scheme – as the expectation builds that sooner or later a waiver will be provided, and the borrowers start defaulting with such expectations.

That the government which provides the waiver does so risking its own fiscal prudence and ultimately is paid for by the tax payers is forgotten, and again disliked by bankers and RBI who every so often have to fund the government.

So even a Covid-19 moratorium being converted to a waiver will mean the public exchequer bearing the burden and in turn the taxpayers at large. So a waiver doesn't come from banks - it comes from government paying the banks else the spectre would be of telling the bank's  employees, landlords, infra providers and most importantly, depositors that they won’t get salary, rent, fees or interest on deposit or even deposit back. That will destroy the fundamentals of our societal compact of how people save money or for that matter how confident they feel of the society they live in.  

Back to banking business explainer.

Consider this layer of complexity:

• A bank needs to maintain capital that is pegged to its risk weighted assets (loans given by banks) and is about 9%
• As a prudent measure, RBI can change the risk weights on loans given - so for example it may say for commercial real estate or for project loans, risk weight is 150% or for home loans is 100% - this changes the amount of capital to be held by a bank. When the risk weight is 100% it means 9 of capital is to be held.
• This capital in good times needs to be serviced by payment of dividend and in bad times, becomes the buffer for taking loan loss reserves and for ensuring depositors money is repaid
• This year RBI has stopped banks from paying dividends to further strengthen the financial position of banks
• It also explains that if loans go bad and loan losses increases, capital gets eroded or even wiped out

Of course, another important item to note is that deposits taken by banks are repayable on demand while loans given are usually for a fixed term. This creates a classic asset liability mismatch which banks need to safeguard against.

The best bank (say in terms of having best borrowers) won’t survive if all the depositors want their money back at the same time. For this, liquidity is important as also managing asset liability mismatches.

Bank’s business is also more complicated than above:

• For every 100 deposited with a bank, about 25 needs to be invested in government securities or held as cash.
• So in the example above, only 75 can be lent out to earn the margin. On cash reserve (CRR), banks earn nothing, and on government securities, government pays least level of interest possible (usually 4-6%) as it is considered the best possible borrower.
• The 75 being lent out, a bank has to ensure that at least 40% is lent to priority sector (think agricultural loans, affordable housing, loans to weaker section, and loans to MSME) at the best rate possible and the least possible margin.
• So the balance 45 (75-30) has to earn enough to pay for salaries, rent, infra, loan loss reserves and of course the interest to depositors apart from being ready to repay the deposit on demand.
• The above should also tell you margins vary (lowest for government securities followed by priority sector lending and thereafter risk adjusted normal lending, itself broken into consumer, corporate and project lending), and where sometimes risk is not equal to reward (priority sector can be risky but get best rates since that’s the societal requirement). That the risk taken on a borrower goes awry will of course also mean criticism of the bank for having lent to that borrower. 
• Back to underscoring that when defaults happen, banks look to the judiciary, whose mills grind very slowly (if that) and more often than not view banks as shylocks (Thank you Shakespeare!) and of course the very Indian imagery of moneylender (thank you Bollywood!).
• Equally, the polity doesn’t want recovery but emphasizes on resolution (read as IBC framework) – what does that really mean? At its heart, resolution is about banks forgoing interest and postponing recovery of principal.

Oh yes, banks have successful borrowers too - and it is said that among all the professionals, a banker seeks a borrower's prosperity (admittedly somewhat selfishly, so that loan is serviced, interest is paid and loan is repaid!).

Consider this: after having given a home loan, the value appreciation of home is of the owner/borrower, not the bank; after having given a project loan, the entrepreneur/borrower turns billionaire and is celebrated as among India’s or even Asia's richest, and the bank doesn’t participate or realize that value appreciation, or even appreciation in general!

Views are personal - comments and feedback welcome!  

#banking #explainer