How Banking Business Works: A Banking Lawyer’ Perspective

[Pramod Rao is Group General Counsel, ICICI Bank. He sets out a simplified explanation of a very complex system, broken down to basics. This post represents his personal views]

Banks take deposits and pay interest on them. Banks lend money and receive interest on them. The difference between the two is margin. The margin pays for costs, such as employees’ salaries, branch rent and infrastructure (including operating core banking systems and 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 a mandate of having to spend on corporate social responsibility (largely in the form of charitable or philanthropic activities), after which the shareholders may be paid dividend.

In this context, it is reasonable to ask what “loan loss” is. When a borrower of the bank does not repay the money borrowed or interest on that money, it results in a loss. Here is an example. The bank takes a deposit of 100 and pays interest of 3.5%. The bank then gives a loan of 100 and receives interest of 9%. The difference of 5.5% between the two rates of interest pays salaries, rent and infrastructure and helps build reserves of the bank. Let us assume the borrower who took 100 defaults. The bank still has to incur its expenditure and meet all other demands on margin described earlier. The bank still has to pay interest on the deposits and also repay deposits on demand. In such circumstances, where is the possibility of profit? It is a risk that is rarely factored. As an aside, for depositor safety, there is deposit insurance, now pegged at rupees five lacs. One is eligible to obtain that from the Deposit Insurance and Credit Guarantee Corporation (DICGC) when the bank has failed.

Hence, for the sake of prudence, loans are diversified. The bank does not offer a single borrower the entire 100, but it may extend loans of 10 each to 10 different borrowers. This diversification means if one out of 10 default, only 10 is lost. Of course, a loan loss of even that one person who took 10 is greater than the margin across the entire portfolio of 100, a point which usually gets missed. Therefore, the 90 lent to the balance 9 borrowers has to support the salaries, rent, infrastructure and, of course, paying the depositors for the full 100. If more borrowers default, the risk of the bank not being able to pay salaries, rent, for infrastructure 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 enforcement. The recovery takes time, typically upwards of five to seven years just to recover the 10 that was lent. 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; hence, this reduces profits. When recovery occurs, it is added back to the profits. This is really the bank’s funds that were lent out which came back, and should not be mistaken for the margin which the bank uses to meet costs and only after that to make profit.

Pandemic Response & Relief

The Covid-19 induced moratorium scheme, which the Reserve Bank of India (RBI) has permitted banks to provide to its borrowers, is not waiver, and nor should it be. It is meant for liquidity to be created at the hands of borrowers who require the same. Yes, it attracts interest – which, as explained above, is part of the margin required by a bank – and hence has to be paid and the loan repaid. Those who do not 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 a possibility being raised that moratorium would become a loan waiver scheme. Therefore, even borrowers who can service their loan have opted for moratorium. There is also a case filed seeking waiver, which has since been reported to be focused on interest on interest (itself a question settled by the Supreme Court almost two decades ago, recognising the necessity and rationale for the same).

Loan Waivers

In the past farm loan waivers have captured considerable attention. Such waivers essentially involve the relevant government paying the banks on behalf of the farmer. It is also not something bankers or the RBI favour – 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 due to such expectations. The government which provides the waiver does so risking its own fiscal prudence and the burden ultimately paid for by the tax payers is forgotten, and again disliked by bankers and the RBI who every so often have to fund the government.

Hence, even a Covid-19 moratorium being converted to a waiver will mean the public exchequer, and in turn the taxpayers at large, bearing the burden. So a waiver does not come from banks. It comes from the government paying the banks; else, it raises the spectre that the bank would default on its salary, rent, fees or interest on deposit or even refund of deposit. That will destroy the fundamentals of the societal compact of how people save money or, for that matter, how confident they feel about the economy.  

Returning to some explanatory aspects of banking business, consider the following layers of complexity.

Capital Structure

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, the 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 it is 100%. This changes the amount of capital to be held by a bank. When the risk weight is 100%, it means the bank must hold a capital of 9. 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, the RBI has stopped banks from paying dividends in order 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.

Asset Liability Mismatch

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 banks (say in terms of having the highest quality borrowers) will not survive if all the depositors want their money back at the same time. For this, liquidity is important as also managing asset liability mismatches.

Unique Mandatory Requirements on a Bank

A bank’s business has several mandatory requirements imposed on it. For every 100 deposited with a bank, about 25 needs to be invested in government securities or held as cash. In the example above, only 75 can be lent out to earn the margin. On cash reserve, banks earn nothing, and on government securities the government pays the least level of interest possible (usually 4-6%) as it is considered the best possible borrower.

On the 75 being lent, a bank has to ensure that at least 40% is lent to the priority sector (e.g., agricultural loans, affordable housing, loans to weaker sections, and loans to MSMEs) at the best rate possible and the least possible margin. Hence, the balance 45 (75 less 30) has to earn enough to pay for salaries, rent, infrastructure, loan loss reserves and of course the interest to depositors, apart from being ready to repay the deposit on demand.

The above explains why 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. That the risk taken on a borrower goes awry will of course also mean criticism of the bank for having lent to that borrower. 

In such a scenario, it is necessary to underscore that when defaults occur, banks look to the judiciary, whose mills grind very slowly and who, more often than not, view banks unfavourably. Equally, the polity does not want recovery, but it emphasizes on resolution (as within the framework of the Insolvency and Bankruptcy Code). At its heart, resolution is about banks forgoing interest and postponing recovery of principal.

Concluding Remarks

Banks and their services are so ubiquitous and have evolved considerably, by adopting technologies including automated teller machines (ATMs), internet banking and mobile, banking that it is quite easy to overlook the basic underpinnings of a bank. A bank aggregates deposits. Therefore, safeguarding depositors is also among the primary role that banking regulators play when they regulate the functioning of a bank, starting right from licensing a bank to even acting as a liquidator if a bank is to be wound up.

The other side of the bank’s balance sheet is lending, and again there are prudential norms (on diversifying lending, or on how much capital to maintain, as described above) and loan loss provisions being taken. There are other unique mandates placed on banks as described above. Keeping banks healthy, strong and as financial fortresses is key to keeping both the society and economy flourishing. Ensuring prevalence of good credit culture (by avoiding loan waivers) backed by an effective judicial process for recovery of debt will keep banks functioning well and serving the communities they operate in.

– Pramod Rao