Saving Banks from a Black Swan
- March 23, 2022
- Posted by: OptimizeIAS Team
- Category: DPN Topics
Saving Banks from a Black Swan
Subject : Economy
Section: Banking and Monetary policy
Context:
Government-provided recapitalisation packages to save banks from a black swan.
Concept:
Black Swan event?
Nassim Nicholas Taleb, a former Wall Street trader, in his book ‘The Black Swan: The Impact of the Highly Improbable’ formulated the black swan theory.
A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.
Black swan events are characterized by their extreme rarity, severe impact, and the widespread insistence they were obvious in hindsight.
- Is so rare that even the possibility that it might occur is unknown
- Has a catastrophic impact when it does occur.
- Is explained in hindsight as if it were actually predictable
There are no limitations in the way a Black Swan event can manifest itself. It could be anything from a natural disaster to a war, a financial crash or the outbreak of a virus.
Trade-offs of bank recapitalisation
Recapitalisation of Banks is injecting additional capital into state-owned banks to bring them up to capital adequacy standards. The government injects capital into banks that are short on cash using a variety of instruments. In India recapitalisation is achieved through 3 major ways:
Recapitalisation bonds Banks subscribe to bonds issued by the government. As the government raises its part of equity ownership, the money collected by the government is used to shore up banks’ capital reserves in the form of equity capital. Banks’ money invested in recapitalisation bonds is classified as an investment that pays interest. As a result, the government is able to stick to its budget deficit target because no money is taken directly from its coffers. Special Zero-Coupon Recapitalisation Bonds These are unique bonds issued by the central government to a specific institution. Nobody else, only those banks, who are designated, can invest in them. It is neither marketable nor transferable. It is restricted to a single bank and is only valid for a short time. There is no coupon, it is a zero-coupon, it is issued at par, and it will be paid at the end of the term. The interest that an investor receives on a bond is known as a coupon. According to RBI requirements, it is held under the bank’s Held-To-Maturity (HTM) category. HTM securities are purchased with the intention of holding them until they mature. These are products that are similar to recapitalisation bonds but serve the same objective, and they are issued in accordance with RBI regulations. The issuing of these special bonds will have no impact on the fiscal deficit while also providing the bank with much-needed equity capital. |
- Firms may benefit from improved discounted lifetime profits
- Households may be worse off because of lower government expenditure in social sectors:
- As, government recapitalisation from budget allocation reduces funds available for social spending directly,
- while issuing recapitalisation bonds reduce social spending indirectly through interest spending and crowding out private investment.
How to make it more effective?
Banks’ recapitalisation could be most effective when followed with measures with increases monetary policy transmission, thus not reduce households and investment demands
- Flexible deposit / lending rates
- Linking repo rate with deposit rate can address the issue and some banks are currently moving towards this system.
- High dependency on bank deposits for lending has resulted in interest-rate stickiness. Banks also need to look at other sources to fund lending such as issuance of debentures/commercial papers and borrowings from the capital market.
- Banks can move over to a variable interest rate structure on longer term deposits.
- To strengthen monetary transmission, the government needs to proactively peg the small savings rate with the G-sec bond yields.
- The asset resolutions are expected to strengthen bank balance sheets and improve banks’ willingness to change their lending rates in tandem with the change in the policy rates.
- Faster implementation of linking interest rates under external benchmarks at least once in three months from the earlier practice of resetting interest rates once in a year under MCLR will greatly help in transmission of the RBI’s monetary policy.
- Less dependency on deposit interest income for lending
- Demand revival policies (via tax cuts or monetary expansion through an interest easing cycle) with appropriate and calibrated supply-side reform measures to achieve an optimal policy mix.