This is not a formal club. There is no club house, no plush restaurants or leather and mahogany bars where the high and mighty schmooze. Yet, with only nine membership cards punched out in the last 20 years, those in possession of them can justifiably feel more equal than others.
Yes, we are talking about the business of banking in India. With the Reserve Bank of India (RBI) at the head of the table, flanked by nationalised banks on one side, private sector banks on the other, along with primary dealer make this cosy club complete.
How It Works
The central banker is the chairman and protector of the members. RBI keeps supplying unlimited funding to the members through its Repo Window (though with a cap, currently). This allows banks to keep their deposit and lending rates low. This in turn helps government and top notch corporate houses to borrow at low rates. Obviously funds at low rate of interest enables some corporate firms to misallocate resources. In doing so, if they land in trouble, there is always the option of restructuring loans. Everyone is happy!
From time to time, some banks do get a little greedy, as it did during the last bull phase (2003-2007), when it was fashionable to grow faster and faster. Some banks discovered the magic of derivatives. They used it on many unsuspecting cash rich corporates. The thrill was in selling more and more exotic products. Most of the CEOs and CFOs were completely out of their depth and were out smarted. Rather than admit their ignorance, they went and sold options. Little realising that the exotic sounding structure (Snowball, Ratchet, Wig-Wam for example) in which they sold options for $1 million actually behaved like a $20 million short position when the market turned against them! Many cash rich corporates landed up with massive debts and many went bankrupt. RBI estimated at that time the loss to corporates at Rs 33,000 Crores (mark-to-market). Very little was heard on the repercussions except fines on banks for amounts ranging from Rs 10-15 lakh.
If the banks land in trouble due to a runaway market like in July- September this year, no problem, RBI is always around for forbearance. Any other investor caught with his pants down will have to grin and bear it, but banks were allowed to transfer assets from available for sale (AFS) /trading book to held-to-maturity (HTM) at valuation prior to the market turmoil (July 15th)! Bond prices move inversely to yields. When the yields go up, prices go down and vice versa. Holders of bonds would lose money if the yields go up as happened in July. No provision is required to be made for bonds held in HTM in case of lose in value. Banks are allowed to move bonds from AFS and “held-for-trade” (HFT) to HTM once in a year, usually in the beginning of the year. This year they were allowed to do so out-of-turn to help them reduce loss in September, effective July 15.
Coming to primary dealers, many of them are subsidiaries of banks. They are supposed to underwrite and make market for government bonds. In reality few of them have any presence out- side Mumbai and hardly do any “market making”. Their focus has instead been to quote unrealistically low fees for underwriting bonds and waiting for RBI largesse at the time of interest rate cut to make a pile of money. No wonder when things go completely out of hand like it has currently, some like Royal Bank of Scotland (RBS) chose to exit the business.
It is not common knowledge that there is only one way to make money in Bond market. When yields are going up (and price coming down), every one holding bonds in India loses money. Only way to make money is by taking a view that interest rates are at a near term peak ( price at a Low) and pile in and ride the yield down (price up). If your view is wrong, God help you! There is no way for ordinary investors to short rates in India.
Obviously those who gain from it are bankers, corporates and the government. Bankers, because they are fortunate to have got into the club. Corporates, because they are the second largest creditor after government. Government, because it can fund its ever increasing deficit at rates far below rate of inflation.
Savers and taxpayers. Only over last two years the savers have become smarter and started retaliating by refusing to be suppressed and opting for gold instead. Thus, triggering a massive current account deficit which in turn disrupted the status quo.
Why Are Things Changing?
In a single word: Governor. Markets cheered when the Dr. Raghuram Rajan was announced as the new governor in a surprise choice. The surprise was not about the ability of the person, but the choice of the person in a pre-election year. He was no dove by any stretch of the imagination and hence not likely to open the tap to suit the party in power. Perhaps the compulsions of possible rating downgrade forced the choice.
He comes across as a person who not only understands the way the system works but also the compulsions and motivations of various stakeholders in maintaining status quo while not really taking sides. For those looking for more insight, please read his seminal book Fault Lines: How Hidden Fractures Still Threaten the World Economy.
RBI’s resistance to change stems from the fear of losing control. The fear is evident in the tight control it chooses to have on the system. It has always been loath to leave the levels of either the currency or interest rate to market forces.
During May-July this year when the rupee dropped sharply from 60 to 68 against the dollar, the first impulse of government and central bankers was to clamp down on speculation.
Winds of Change
The announcements and guidances so far under the current Governor, raises hopes of more transparent system which throws open the windows to allow some much needed fresh air in. Some of the announcements which give raise to such hope are: aspirations of banking license on tap, prodding banks to focus on retail deposit, removing capital control measures brought in to defend the rupee (except gold, which also is likely to be removed), launching of properly designed interest rate futures (which looks very promising) and pushing for inclusion of sovereign bonds in global bond indexes to name a few. The general sense that one gets is that of confidence in allowing market forces to find proper levels instead of hesitant half measures which passed for reforms hitherto. There is little doubt there will be pressure from well entrenched old club members at every step. Doing the “right thing” will mostly probably be very painful in the short run and would not win “Likes” on the Club’s Facebook page. But for greater good of the country, there is little doubt that the path of transparency and competition, which dislodges and purges inefficiencies, is the way to go.