Despite Moral Hazard, Central Banks Have No Choice But To Save Banks

Three years ago when the Reserve Bank of India and the government stepped in to reconstruct Yes Bank, there were many voices that were critical of the move. After all, Yes Bank was a private sector bank and many believed it should have been allowed to fail to send a message to errant bankers and promoters of banks. 

Today, when banks such as Silicon Valley Bank and Signature Bank are facing stress in the U.S., we are seeing quick intervention being sought from the regulatory authorities, but stopping short of a bailout. 

As a spillover, Credit Suisse has openly sought and received support from Swiss National Bank to tide over the crisis of confidence and liquidity that it faces. 

The question that emerge then are: 

1. Why don’t central banks just let a bank fail?

2. Isn’t there a moral hazard involved in stepping in every time a bank is in trouble? 

3. Aren’t we showing that banks cannot fail, thus providing a carte blanche to bankers to indulge in risk-taking behaviour that they will never bear losses for?

The answers differ depending on which country and situation you are in. It also differs based on how large you are and interconnected to the rest of the banking universe in your country and beyond.

To illustrate, when Yes Bank was hit by a crisis in early 2020 and there was a moratorium imposed on its activities, albeit briefly, the impact was worst on the startup and fintech ecosystem. This was because as a new-age bank that wanted to build its business in areas that were less tackled by other banks, Yes Bank had created a critical niche within the startup space. This meant that even though, it may not have been tagged as a systemically important bank in India, it was playing a critical role in some segments and was deeply connected to the rest of the banking system through borrowings. 

Another great example is that of the management fraud perpetrated at Punjab and Maharashtra Co-operative Bank, which eventually played its part in unravelling the link with Wadhawan Group. The Wadhawan family had promoted the country’s second largest housing financier Dewan Housing Finance Corp. and also realty major Housing Development and Infrastructure Ltd. 

This means that even when a bank may be relatively smaller in size, its ripples may spread out across the banking system in a contagion effect that cannot fully be comprehended by analytical models.

The key difference between India and the U.S. is that Indian banks cannot be dealt with under the bankruptcy laws, which means that the RBI plays an integral part in how a stressed bank is dealt with.

While it is true that there is deposit insurance in place up to Rs 5 lakh per depositor as per law, that is only available once the bank has been deemed as a failure.

If you leave out co-operative banks, then the last major bank failure in India was Palai Central Bank in 1960. And the only reason to look at co-operative banks separately is that until the PMC Bank failure, these banks had been under dual regulation, and the RBI only had limited powers to tackle problems at such banks.

To RBI’s credit, the banking regulator has always stepped in to save the depositor’s money by either merging the beleaguered bank into a larger one, or effecting a bailout by bringing in institutional support.

In the case of Global Trust Bank and Lakshmi Vilas Bank, the RBI forced them to merge into Oriental Bank of Commerce and Lakshmi Vilas Bank, respectively. In the case of PMC Bank, which was more complicated, Centrum Group was granted a small finance bank licence specifically so that they can take over PMC Bank’s books. And in the case of Yes Bank, the RBI conjured up a bunch of institutions led by State Bank of India as an anchor to invest in the bank for a committed period to help it recover.

In the case of RBL Bank, it effected a management change and appointed its members on the board to see through the transition phase.

Why should a banking regulator bother with so much effort when allowing a failure would send a lasting message across the system?

The answer lies in the fact that India’s banking sector remains a bank-led system. Banks are special. Bank licences are special and granted to just a few, based on stringent ‘fit and proper’ criteria verification. Most Indians continue to save through deposits in banks, and if there is a bank failure then the ‘trust’ in the banking system breaks down.

And if trust breaks down due to a bank failure, then there is little to stop the spillover into a run on deposits at other banks, which could have a catastrophic impact on financial stability as a whole.

Over the last two decades, when there have been rumours of banks being in trouble, then the RBI has been quick to issue a clarification before the rumour turns into a reality. 

There is also the aspect of the RBI being the key regulatory and supervisory authority over banks, and any failure in the system despite its efforts needs to be first rectified and learning extrapolated to prevent a repeat.

It is the way that the RBI has dealt with errant banks and promoters of banks recently that there seems to be a sign of things to come. Earlier, the central bank used to levy fines for any failures to adhere with norms, and the small quantum of fines that could be levied meant that banks literally shrugged off these fines as a disclosure item in their notes to accounts.

The recent shift by the RBI to impose restrictions on operations has been instrumental in making banks and financial institutions sit up and take notice. If you couple that with the RBI now insisting on a formal process for reappointments for bank chief executives—which means there is an incentive for management and promoters to not play around with regulations—then there is greater compliance. 

This approach by the RBI, in the absence of a law that deals with failure of banks, allows for tailored solutions that quickly work to prevent a systemic episode. 

Whether there should be a one-size-fits-all law that deals with bank failures is a question for another day. We have already seen the problems that bankruptcy laws have faced when dealing with more complex cases involving companies. 

In such a scenario, at least for now, there is merit in the RBI coming up with boutique solutions that address the specific bank and its problems effectively. 

• Is there a moral hazard that the RBI faces when it steps in? Yes.

• Is there a bigger moral hazard at work of hurting public faith in the banking system by not saving a bank? A much more resounding yes. 

There are no easy choices here. Go after the errant bankers and promoters, but protect the depositors’ interest at all costs.

After all, if you take away trust from banking, what would we really be left with? 

T Bijoy Idicheriah is a senior financial journalist who has been writing on the world of banking and central banking for 17 years.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.