Need For A Bench Mark Rate of Interest for entire economy
What is the real rate of interest? and what is the average cost of funds in our economy? Is it the whole sale price index or the consumer price index to be reckoned to assess the real rate of interest by investors and savers ? What is the central rate which influence various other rates? These are some of the questions lingering in the minds of many associated with the economy and finance.
The major problem faced by Indian Financial System is that there is nothing called Bench Mark Rate of Interest/Prime rate which can influence liquidity in various markets like Money Market, Forex Market, Securities Market, Credit Market, etc. Like wise, it is also difficult to identify the average cost of funds in the economy which basically determines investments, production, exports, imports, supply and demand for goods and services. The cost of funds in any economy has to be necessarily linked to inflation index whether it is WPI or CPI so that one can assess the real rate of interest and take investment decisions. At present there are several rates operating in the economy without having much of relevance to inflation, real rate of interest and any sort of alignment to each other. Banks offer uniform savings rate at 3.5% fixed decades back without having any link to inflation rates i.e. -1.3% or their own cost of funds ranging between 5% and 6%. The rates offered by the Government on PPFs or savings deposits with post offices or rates offered by banks on their fixed deposits or the yield on government securities have no relationship with each other and are not linked to any benchmark rate. Similarly there are other interest rates like Bank Rate, different Prime Lending Rates of various commercial banks, Treasury bill Rates, Government of India Securities Rate, General Provident Fund Rate, Repo and Reverse Repo Rate, Call Money Rates, Commercial Paper and Certificate of Deposits rates, Mumbai Inter-bank Offered Rates, Corporate Bonds and Debentures Rates etc; operating in the system. In the absence of a central rate to which other rates can hover around depending on the dynamics of various markets, there is some ambiguity in arriving at the cost of funds in the economy in general and banks’ inability to arrive at their own cost of funds and lending rates on a scientific basis in particular.
In a growing economy, particularly where fiscal deficit and revenue deficit are on the high side and Government resorts to heavy market borrowings at market determined rates of interest crowding out private investments, the interest rates are bound to increase and the cost of funds will naturally be high. This year, the fiscal deficit is projected to be at 6.8% of GDP and the borrowings are estimated to be at Rs 4, 51000 crores.
Rate of interest in an economy has to necessarily influence savings and encourage investment in the productive sector. From this point of view, the rates of interest prevalent at present cannot be said to be doing justice both to savings and investment. Very fact that despite inflation at an unimaginably low level and a very large bout of stimulus packages both from Fiscal and Monetary segments, the lending rates, borrowings and investments have not moved favorably should vouch for this. Comparatively, Rate of Savings particularly in banks continues to be high for want of better alternatives. However, there seems to be an inherent weakness other than the recessionary trend influencing savings and investments. Real rate of interest has never been real is a fact which cannot be ignored for long, and the existence of parallel economy which inhibits smooth transmission of monetary policy has to be recognized fast.
The following table would indicate the rate of inflation and various rates in the financial system.
INFLATION: _1.55% as of June 2009.
Interest Rates in the Financial System
(Per cent per annum)Week ended June 12, 2009
Bank Rate 6.00
I.D.B.I.(1) 10.25
Prime Lending Rate(2) 11.00 – 12.25
Deposit Rate(3) 6.50 - 8.25
Call Money Rate (Low/High)(4)
- Borrowings 2.20 – 3.30
- Lendings 2.20 – 3.30
Savings Bank Rate 3.50
Public Provident Fund 8.00
Employees Provident Fund 8.50
Certificate of Deposit 3.75 – 11.50 in 2009
Commercial Paper 2.83 - 14.00 in 2009
Repo Rate 4.75
Reverse Repo Rate 3.25
(1) Minimum Term Lending Rate (MTLR)
(2) Prime Lending Rate relates to five major banks.
(3) Deposit Rate relates to major Banks for term deposits of more than one year
maturity.
(4) Data cover 90-95 per cent of total transactions reported by participants.
Source: Reserve Bank of India Bulletin- Weekly Statistical Statement, June 26, 2009
It may be observed from the table that interest rates both on savings and lendings have no bearing with inflation rate. There should be some relationship among the interest rates and inflation rate although rates may vary based on competition and market dynamics. Average cost of funds in an economy and average cost of funds of intermediaries should move around Savings rate, Real rate of interest i.e. after adjustment for inflation and average lending rate. Banks’ lending at rates below their cost of funds and very much above the cost of funds is something fishy. Herein lies the need for having a bench market rate of interest to which all rates whether it is average cost of funds, savings rate, borrowing rate and lending rate should be linked. The Bench Mark Rate of Interest has to be arrived at on a scientific basis reflecting on the threshold rate of inflation, GDP growth, Fiscal deficit, Borrowings, and Current Account Deficit. This rate should be evolved as a reference rate for all purposes and different rates presently operating in the economy should necessarily be linked to this rate of interest. Such an arrangement will facilitate smooth transmission of monetary policies and prove to be a boon to the economy in understanding the dynamics of interest rates and arriving at appropriate macro level policy decisions. The fact that interest rates in the system have apparently no alignment whatsoever and operate in a disjointed manner can affect the cost of funds and distort the whole gamut of funds related assessments in the economy. Ignoring this fact does not change the fact has to be recognized?
Bank rate which has been inactive or ineffective in influencing various other rates prevalent in the market can perhaps be developed as a reference and benchmark rate of interest. Such a rate if evolved may turn out to be beneficial to the economy in the long run in implementing both monetary and fiscal policy. There will be better coordination in framing fiscal and monetary policies and taming inflation both WPI and CPI apart from influencing liquidity, investment and production. The real strength of the economy lies in lowering the average cost of funds and making it affordable and available for investments. This is possible only if there is a Bench Mark Rate of Interest for the entire economy.
Dr.T.V.Gopalakrishnan
Wednesday, July 29, 2009
Tuesday, July 21, 2009
Deficit and Disinvestment
Deficit and disinvestment
This refers to your editorial on the captioned topic( Business line,July!7,2009).
The approach of the Finance Minister to tap the disinvestment route to partly make up the borrowings Rs 400,000 envisaged in the budget is welcome. It is also heartening to observe that SBI capital could manage to tie up more than Rs 70000 crores through debt syndication and structured finance in the first quarter itself indicating a shift in investment climate to high gear.
These are only indications that there are resources in the economy and the government and other intermediaries have to initiate appropriate measures to tap the resources .
There are umpteen ways for the Government to raise resources from both domestic and external market. The measures include well planned and scheduled disinvestment of capital of Public Sector Undertakings, leasing out waste lands belonging to Government, encouraging Public Private Partnership with built in incentives to attract private capital, resorting to massive external borrowings on the present and future strength of the economy and encouraging FDI in areas where investment is badly needed and not so far allowed on some technical grounds.
Prudence in Fiscal Management should continue to be the policy of the Government All said, the proposed borrowing will have its adverse effect in the economy in the form of higher interest rate, inflation and less money for private investment.
(This appeared in Business Line on 20/07/09.
Dr.T.V.Gopalakrishnan
This refers to your editorial on the captioned topic( Business line,July!7,2009).
The approach of the Finance Minister to tap the disinvestment route to partly make up the borrowings Rs 400,000 envisaged in the budget is welcome. It is also heartening to observe that SBI capital could manage to tie up more than Rs 70000 crores through debt syndication and structured finance in the first quarter itself indicating a shift in investment climate to high gear.
These are only indications that there are resources in the economy and the government and other intermediaries have to initiate appropriate measures to tap the resources .
There are umpteen ways for the Government to raise resources from both domestic and external market. The measures include well planned and scheduled disinvestment of capital of Public Sector Undertakings, leasing out waste lands belonging to Government, encouraging Public Private Partnership with built in incentives to attract private capital, resorting to massive external borrowings on the present and future strength of the economy and encouraging FDI in areas where investment is badly needed and not so far allowed on some technical grounds.
Prudence in Fiscal Management should continue to be the policy of the Government All said, the proposed borrowing will have its adverse effect in the economy in the form of higher interest rate, inflation and less money for private investment.
(This appeared in Business Line on 20/07/09.
Dr.T.V.Gopalakrishnan
Wednesday, July 15, 2009
IS IIP growth sustainable?
This refers to your edit ‘Recovery Round the corner’ (ET,july13).The growth in IIP at 2.7%is encouraging, but will it sustain and grow further in the context of poor monsoon observed so far and not so encouraging budget is a major question. The borrowings of the government projected at Rs 4,51,000 crores will have adverse implications on private investments, interest rates and inflationary conditions. The time lag involved between investment and production also needs to be factored in for arriving at the IIP. To what extent the spending by the government on infrastructure, farm and social sector will create demand for industrial products is again dependent on several variables like employment generation, availability of credit at affordable rates etc. Besides domestic consumption and demand alone cannot contribute for enhanced IIP which require exports and imports to pick up considerably.
(Appeared in Economic Times 15 July,2009)
Dr.T.V.Gopalakrishnan
(Appeared in Economic Times 15 July,2009)
Dr.T.V.Gopalakrishnan
Saturday, July 11, 2009
Interest Rate and Monetary Policy
Interest Rate and Monetary Policy
There is a paramount need to reduce the interest rates of bank loans and reduce the cost of funds in the economy to boost investment and production, but the fact remains that banks are not in position to effect any reduction in interest rates due to some compelling reasons.
Their Net Interest Margin hovers around 3% which they do not want to touch what ever may be the compulsions.
Historically, banks get subsidized by depositors and the government and the borrowers get subsidized by all stake holders.
The Prime lending rates and Bench Mark Prime Lending rates do not seem to have been arrived at on scientific basis and their alignment with Whole Sale Price Index and Consumer Price Index is a far cry.
There is a close correlation between high interest rates and Non Performing Advances. The good borrowers have to necessarily take care of the losses arising from out of bad loans. Monetary policy has its own limitations to reflect on the lending rates of banks due to various reasons, the prominent among them being prevalence of administered interest rates in respect of certain segments and the inability of depositors to find alternative avenues of investment.
(This write-up appeared in Business Line on 3rd July 2009)
Dr.T.V.Gopalakrishnan
There is a paramount need to reduce the interest rates of bank loans and reduce the cost of funds in the economy to boost investment and production, but the fact remains that banks are not in position to effect any reduction in interest rates due to some compelling reasons.
Their Net Interest Margin hovers around 3% which they do not want to touch what ever may be the compulsions.
Historically, banks get subsidized by depositors and the government and the borrowers get subsidized by all stake holders.
The Prime lending rates and Bench Mark Prime Lending rates do not seem to have been arrived at on scientific basis and their alignment with Whole Sale Price Index and Consumer Price Index is a far cry.
There is a close correlation between high interest rates and Non Performing Advances. The good borrowers have to necessarily take care of the losses arising from out of bad loans. Monetary policy has its own limitations to reflect on the lending rates of banks due to various reasons, the prominent among them being prevalence of administered interest rates in respect of certain segments and the inability of depositors to find alternative avenues of investment.
(This write-up appeared in Business Line on 3rd July 2009)
Dr.T.V.Gopalakrishnan
Friday, July 10, 2009
Monetary Policy at the crossroads
Monetary Policy at the crossroads
“Monetary policy at the crossroads”(Business Line,July2) brought out some stark realities on issues inhibiting the influence of monetary policy on determining the interest rates on bank loans. The wholesale price index and consumer price index do not move in tandem .
Monetary policy which aims at facilitating economic growth and maintaining price stability often tends to ignore retail prices perhaps expecting the consumer price index to fall in line with the whole price index. This seldom happens as the variables influencing WPI and CPI are at total variance.
The factors influencing CPI have to be identified and need to be suitably factored into the monetary policy. Expecting bankers to take into account the divergence between WPI and CPI while reducing interest rates is neither feasible nor practicable.
The fact that depositors and not the shareholders are the real owners of the banks is well illustrated. That depositors subsidise the borrowers and good borrowers subsidise the bad borrowers are ground realities and it is time the rates on deposits and lending are arrived at on a realistic basis .
The system of making banks lend at concessional rates to exporters and small enterprises irrespective of their earning potential and profitability makes the fixation of BPLR rates unrealistic.
It is also necessary to have a bench mark rate of interest in the economy to influence various other rates. Monetary policy has to necessarily recognize the inhibitions prevailing in the economy and the banking system for its effectiveness in influencing economic growth and price stability .
( This has appeared in Business Line on 4th July , 2009).
Dr.T.V.Gopalakrishnan
“Monetary policy at the crossroads”(Business Line,July2) brought out some stark realities on issues inhibiting the influence of monetary policy on determining the interest rates on bank loans. The wholesale price index and consumer price index do not move in tandem .
Monetary policy which aims at facilitating economic growth and maintaining price stability often tends to ignore retail prices perhaps expecting the consumer price index to fall in line with the whole price index. This seldom happens as the variables influencing WPI and CPI are at total variance.
The factors influencing CPI have to be identified and need to be suitably factored into the monetary policy. Expecting bankers to take into account the divergence between WPI and CPI while reducing interest rates is neither feasible nor practicable.
The fact that depositors and not the shareholders are the real owners of the banks is well illustrated. That depositors subsidise the borrowers and good borrowers subsidise the bad borrowers are ground realities and it is time the rates on deposits and lending are arrived at on a realistic basis .
The system of making banks lend at concessional rates to exporters and small enterprises irrespective of their earning potential and profitability makes the fixation of BPLR rates unrealistic.
It is also necessary to have a bench mark rate of interest in the economy to influence various other rates. Monetary policy has to necessarily recognize the inhibitions prevailing in the economy and the banking system for its effectiveness in influencing economic growth and price stability .
( This has appeared in Business Line on 4th July , 2009).
Dr.T.V.Gopalakrishnan
Thursday, May 28, 2009
BUDGET 2009
Budget 2009
The budget 2009 is very special. It is from a new government which has a backing from parties which cannot dictate terms. It is coming at a time when the economy is having problems both from domestic and international scenario. The world is in financial turmoil and economies particularly advanced economies are struggling to put up a brave show to survive the crisis without adequate success despite resorting to conventional and un conventional measures. The expectations are very high from all sides and there are severe constraints to present a budget satisfying every one. Fiscal deficit is mounting and has surpassed the tolerance limit prescribed under the FRBM ACT because of liberal measures announced with all justification by the previous government to withstand the shocks arising from global economic crisis. General confidence level on the performance of the economy needs to be considerably improved and the general budget is only the way out for the same. This is going to be a major task for the new Finance Minister .Economy has to grow at least at 7% if not more to sustain the confidence level and the other macro economic conditions on an acceptable level.
Although FM has limited avenues to raise revenue for the present, but he has umpteen ways to raise resources for investments to raise revenues for the future. He has only to be innovative in his approach. Some of the areas where innovation is possible perhaps and some areas where a little bit of tinkering can be attempted are as under.
Real Estate Transactions:
This is an area where maximum black money is generated. Land mafias and black money thrive in real estate. Speculation as in capital market although well known and not desirable ethically has been the order of the day in land deals and it needs to be curbed in the interests of the society and the economy. Similarly purchases of flats and buildings taking advantages of tax incentives and interest rate concessions genuinely meant for providing shelter for those who do not have one are on the increase and create inequality in society, help generate black money, evade taxes, use scarce resources unjustifiably and straining government resources. More than the revenue loss to the government, the system in vogue to have the transactions is questionable and unethical. The deals in land and buildings need to be thoroughly reviewed and streamlined. The easiest way is to link the transactions and tie up with banks ,Registration authorities, Governments and Income Tax authorities through IT. This way, the strength of the Indian IT sector can be well encashed and an excellent data base with regard to land deals, money transfers, revenue collections for the Governments can be created with an eye on future policy formulation. A small percentage say 0.05% of high value real transactions taking place in any part of the country can go to Central Government Kitty under a special head which can be used for providing subsidy for poor people to acquire land.
FM can consider to have a fund opened exclusively to attract black money by paying 5% interest and offer some tax incentives on interest earned for two or three years .This tap can be kept open for a few years till Government get a feeling that substantial portion of black money has come to Government's kitty. The subscribers to this fund should also be linked separately to the data base created under land deals.
Transaction Tax:
The securities transaction Tax now in vogue needs to be reviewed and rationalized. In order to broad base the holding of shares among the retail investors and reduce the volatility in share market prices, transactions by individual shareholders should be exempt from this tax or the rates should be the bare minimum. The STT in respect of companies where share holding by retail investors are more than 50%, should be comparatively low. Such a measure will help to broad base the share holding pattern and bring down the frequent speculative nature of transactions. The objective of capital market inter-alia is to find resources and provide liquidity. STT should emerge as a tool to help capital formation, restrict volatility and speculation in the capital market. STT FOR RETAILERS AND INSTITUTIONS should also be at different rates. Instead of having a uniform rate of STT irrespective of the volume and value of transactions ,different rates linked to volume and value also can be thought of.
The concept of transactions tax can be gradually extended to other markets like commodities like gold, silver, currencies, real estates and futures market. In the long run STT should replace capital gains tax both short term and long term in respect of all transactions.STT is administratively convenient and devoid of any possible irregularities. Revenue earning potential is very high through STT.
Income Tax:
The present approach treating individuals and institutions alike for income tax needs a relook. Even among individuals, Tax rates for ordinary citizens earning only salaries and pensions and industrialists, businessmen earning in crores of rupees are the same. The inequity in the rates does not stand justice or reason. An individual earning a salary of Rs 15000 per month has to pay a tax @10% ,where as an individual who earns crores o f Rs as dividend need not pay any tax. An individual’s family budget gets seriously affected when even a Rs 100 is deducted towards tax, where as in the case of another individual having different sources of income is not affected even he is asked to pay a few Rs more towards tax. All are equal before law, but acceptance of law should stand justice, prudence, rationale and reason. Broader shoulders should carry heavier weight is the basic canon of income tax and this seems to have been ignored in our approach to income tax. There should be visible difference in income tax rates for individuals having only salary/pension as income and individuals having income from different sources. The potential to enhance the income and the capacity to spend should also be be the criterions in deciding the tax rates.
Institutions have to be brought under a separate treatment. Small cap, midcap and large cap companies have to be brought under different tax rates. Companies having larger share of retail investors with more than 50% capital holding should be given tax incentives. Companies earning beyond a cut off limit and having retail share holding pattern less than 50% of capital should attract comparatively higher rate of income tax. Regular payment of dividend, Percentage of retail share holding, transparency in accounting standards, corporate governance standards, compliance to regulatory requirements, standards of corporate social responsibility etc should attract tax incentives and also help to improve capital formation, develop healthy capital market and overall improvement of revenues based on principles of equity, justice, financial discipline and prudence.
Dr.T.V.G.krishnan
Although FM has limited avenues to raise revenue for the present, but he has umpteen ways to raise resources for investments to raise revenues for the future. He has only to be innovative in his approach. Some of the areas where innovation is possible perhaps and some areas where a little bit of tinkering can be attempted are as under.
Real Estate Transactions:
This is an area where maximum black money is generated. Land mafias and black money thrive in real estate. Speculation as in capital market although well known and not desirable ethically has been the order of the day in land deals and it needs to be curbed in the interests of the society and the economy. Similarly purchases of flats and buildings taking advantages of tax incentives and interest rate concessions genuinely meant for providing shelter for those who do not have one are on the increase and create inequality in society, help generate black money, evade taxes, use scarce resources unjustifiably and straining government resources. More than the revenue loss to the government, the system in vogue to have the transactions is questionable and unethical. The deals in land and buildings need to be thoroughly reviewed and streamlined. The easiest way is to link the transactions and tie up with banks ,Registration authorities, Governments and Income Tax authorities through IT. This way, the strength of the Indian IT sector can be well encashed and an excellent data base with regard to land deals, money transfers, revenue collections for the Governments can be created with an eye on future policy formulation. A small percentage say 0.05% of high value real transactions taking place in any part of the country can go to Central Government Kitty under a special head which can be used for providing subsidy for poor people to acquire land.
FM can consider to have a fund opened exclusively to attract black money by paying 5% interest and offer some tax incentives on interest earned for two or three years .This tap can be kept open for a few years till Government get a feeling that substantial portion of black money has come to Government's kitty. The subscribers to this fund should also be linked separately to the data base created under land deals.
Transaction Tax:
The securities transaction Tax now in vogue needs to be reviewed and rationalized. In order to broad base the holding of shares among the retail investors and reduce the volatility in share market prices, transactions by individual shareholders should be exempt from this tax or the rates should be the bare minimum. The STT in respect of companies where share holding by retail investors are more than 50%, should be comparatively low. Such a measure will help to broad base the share holding pattern and bring down the frequent speculative nature of transactions. The objective of capital market inter-alia is to find resources and provide liquidity. STT should emerge as a tool to help capital formation, restrict volatility and speculation in the capital market. STT FOR RETAILERS AND INSTITUTIONS should also be at different rates. Instead of having a uniform rate of STT irrespective of the volume and value of transactions ,different rates linked to volume and value also can be thought of.
The concept of transactions tax can be gradually extended to other markets like commodities like gold, silver, currencies, real estates and futures market. In the long run STT should replace capital gains tax both short term and long term in respect of all transactions.STT is administratively convenient and devoid of any possible irregularities. Revenue earning potential is very high through STT.
Income Tax:
The present approach treating individuals and institutions alike for income tax needs a relook. Even among individuals, Tax rates for ordinary citizens earning only salaries and pensions and industrialists, businessmen earning in crores of rupees are the same. The inequity in the rates does not stand justice or reason. An individual earning a salary of Rs 15000 per month has to pay a tax @10% ,where as an individual who earns crores o f Rs as dividend need not pay any tax. An individual’s family budget gets seriously affected when even a Rs 100 is deducted towards tax, where as in the case of another individual having different sources of income is not affected even he is asked to pay a few Rs more towards tax. All are equal before law, but acceptance of law should stand justice, prudence, rationale and reason. Broader shoulders should carry heavier weight is the basic canon of income tax and this seems to have been ignored in our approach to income tax. There should be visible difference in income tax rates for individuals having only salary/pension as income and individuals having income from different sources. The potential to enhance the income and the capacity to spend should also be be the criterions in deciding the tax rates.
Institutions have to be brought under a separate treatment. Small cap, midcap and large cap companies have to be brought under different tax rates. Companies having larger share of retail investors with more than 50% capital holding should be given tax incentives. Companies earning beyond a cut off limit and having retail share holding pattern less than 50% of capital should attract comparatively higher rate of income tax. Regular payment of dividend, Percentage of retail share holding, transparency in accounting standards, corporate governance standards, compliance to regulatory requirements, standards of corporate social responsibility etc should attract tax incentives and also help to improve capital formation, develop healthy capital market and overall improvement of revenues based on principles of equity, justice, financial discipline and prudence.
Dr.T.V.G.krishnan
Thursday, April 23, 2009
Balance sheet Risk
Balance sheet Risk.
Balance sheet of a bank carries many risks and one of the major risks not discussed or figuring in the regulatory and supervisory system presently in vogue is the total disconnect between equity or pure capital and intangibles expanded in the form of toxic assets. There does not exist an ideal or acceptable ratio between equity and intangibles. The formation of intangibles particularly in the form of exotic products unfortunately in the garb of better risk management brings in more hidden risks in balance sheet without being managed and without adequate coverage and accountability.
Initial Capital of a bank is generally decided based on ownership and area of operation. Capital is the base based on which business expansion generally takes place, but banks enjoy a special status and are allowed to expand their business without any linkage to the initial capital . They derive business through raising of deposits and creating advances out of such deposits and because of this they are known as derivative institutions. This exclusive privilege of banks to raise deposits repayable on demand and creation of advances out of deposit funds freely allows them to intermediate between savers and borrowers in an economy and they have over a period achieved the status as major intermediaries enjoying the confidence of public and authorities as well. They have graduated themselves as providers of the support system for economic development and occupy a very key and sensitive position interlinking various markets within and outside economies of different countries. It is important to note that under liberalization and economic integration, forms of banking have undergone sea changes and many innovative products have been introduced to meet the demands of fast changing dynamics of the economy.
Maintenance of adequate capital on a continuous basis is an exercise by itself and expansion of business operations is dependent on the extent of capital adequacy position. Banks maintain capital as per basel i and basel ii guidelines depending on their risk perception, risk formation, risk assessment and management capabilities. Expectation is that capital as per Basel II will enable banks to cover risks of exposure in terms of advances and other balance sheet and off balance sheet items in a more meaningful manner factoring there in all market realities and fluctuations. Greater transparency of risk management will be the end result.
Although the initial capital gets increased over a period with retention of profits, it is a matter of serious concern that the size of equity or Pure Capital excluding the retained portion of profit and reserves and surpluses ie only capital contribution by promoters of any bank compared to its total balance sheet size is literally not significant. The position is still worse when this capital is linked to off balance sheet figures which have a direct bearing on balance sheet figures. Pure Capital as a percentage of balance sheet and off balance sheet figures is something negligible and this should be construed as a major risk investors have to worry about. Financial stability in any economy is the major casualty in the absence of adequate pure capital in Financial institutions and banks. In these days of close integration of different economies financial stability is sine qua non and instability through weak banks is something undesirable and totally unacceptable . The present financial crisis the world is experiencing is on account of inadequate pure capital. The capital adequacy ratio presently in vogue based on either BaseI or Basel II requirements ie taking into consideration the reserves and surpluses as part of capital is therefore inadequate and to that extent risk management through capital adequacy ratio cannot said to be reliable /acceptable in the interest of strong banking for economy and financial stability. This has been more than proved in the financial melt down and failure of many banks the world over. Re capitalization of banks is one of the solutions suggested and implemented. Bringing in the concept of only Pure capital ratio to intangibles, total balance sheet, off balance sheet and balance sheet plus off balance sheet items will prove to be a better approach with more accountability, commitment and involvement on the part of both management and regulator. This should be in addition to the present system of arriving at the capital adequacy to risk weighted assets ratio. Expansion of balance sheet and off balance sheet without relating to pure capital ( ie. excluding reserves and surpluses )can only lead to disaster over a period of time and owner stakeholders in particular are allowed to escape from their responsibility. Reserves and surpluses which get added to capital to arrive at the prescribed capital adequacy ratio, come out of accounting practices followed and the authenticity of these figures is subjected to so many ifs and buts . These reserves and surpluses include high profits earned from toxic assets and may carry hidden risk of additional provisions to be provided for bad debts. In the absence of acceptance of international accounting standards uniformly through out the world and implementation of corporate Governance standards in letter and spirit the figures reported under capital ,reserves and surpluses cannot and should not be taken at face value. Further, the Competence of top management, executive level management, genuineness and effectiveness of auditing and accounting practices in vogue , integrity of data collection, analysis and interpretation of data, reporting of information and transparency standards adopted, effectiveness of regulatory requirements and supervisory and follow-up methods vary from country to country and bank to bank and the figures of reserves and surpluses which are in a way derived have to be discounted and should not be linked to leveraging business too much. In the present system of leveraging business without having any link to pure capital, there is a disconnect between owners whether it is government, public or private and top management. In other words, involvement commitment and accountability which are the basic ingredients of ownership management are virtually missing in the present system of capital adequacy ratio.
It is advisable to bring in additional contribution of pure capital as and when balance sheet size and off balance sheet size crosses certain limits. There should be clear cut linkage between Pure capital and business expansion particularly in the form of toxic assets. There should also be an acceptable ratio between equity and intangible assets. The present Capital adequacy ratio which includes profit derived from toxic assets linked to the risk assessment based on certain models alone has not proved to be fully successful although the overall efficiency of the banking system has improved. The realizable value of assets and erosion of capital excluding reserves and surpluses if any need to be introduced in the regulatory frame work to strengthen the the banking system.
Dr.T.V.Gopalakrishnan
Initial Capital of a bank is generally decided based on ownership and area of operation. Capital is the base based on which business expansion generally takes place, but banks enjoy a special status and are allowed to expand their business without any linkage to the initial capital . They derive business through raising of deposits and creating advances out of such deposits and because of this they are known as derivative institutions. This exclusive privilege of banks to raise deposits repayable on demand and creation of advances out of deposit funds freely allows them to intermediate between savers and borrowers in an economy and they have over a period achieved the status as major intermediaries enjoying the confidence of public and authorities as well. They have graduated themselves as providers of the support system for economic development and occupy a very key and sensitive position interlinking various markets within and outside economies of different countries. It is important to note that under liberalization and economic integration, forms of banking have undergone sea changes and many innovative products have been introduced to meet the demands of fast changing dynamics of the economy.
Maintenance of adequate capital on a continuous basis is an exercise by itself and expansion of business operations is dependent on the extent of capital adequacy position. Banks maintain capital as per basel i and basel ii guidelines depending on their risk perception, risk formation, risk assessment and management capabilities. Expectation is that capital as per Basel II will enable banks to cover risks of exposure in terms of advances and other balance sheet and off balance sheet items in a more meaningful manner factoring there in all market realities and fluctuations. Greater transparency of risk management will be the end result.
Although the initial capital gets increased over a period with retention of profits, it is a matter of serious concern that the size of equity or Pure Capital excluding the retained portion of profit and reserves and surpluses ie only capital contribution by promoters of any bank compared to its total balance sheet size is literally not significant. The position is still worse when this capital is linked to off balance sheet figures which have a direct bearing on balance sheet figures. Pure Capital as a percentage of balance sheet and off balance sheet figures is something negligible and this should be construed as a major risk investors have to worry about. Financial stability in any economy is the major casualty in the absence of adequate pure capital in Financial institutions and banks. In these days of close integration of different economies financial stability is sine qua non and instability through weak banks is something undesirable and totally unacceptable . The present financial crisis the world is experiencing is on account of inadequate pure capital. The capital adequacy ratio presently in vogue based on either BaseI or Basel II requirements ie taking into consideration the reserves and surpluses as part of capital is therefore inadequate and to that extent risk management through capital adequacy ratio cannot said to be reliable /acceptable in the interest of strong banking for economy and financial stability. This has been more than proved in the financial melt down and failure of many banks the world over. Re capitalization of banks is one of the solutions suggested and implemented. Bringing in the concept of only Pure capital ratio to intangibles, total balance sheet, off balance sheet and balance sheet plus off balance sheet items will prove to be a better approach with more accountability, commitment and involvement on the part of both management and regulator. This should be in addition to the present system of arriving at the capital adequacy to risk weighted assets ratio. Expansion of balance sheet and off balance sheet without relating to pure capital ( ie. excluding reserves and surpluses )can only lead to disaster over a period of time and owner stakeholders in particular are allowed to escape from their responsibility. Reserves and surpluses which get added to capital to arrive at the prescribed capital adequacy ratio, come out of accounting practices followed and the authenticity of these figures is subjected to so many ifs and buts . These reserves and surpluses include high profits earned from toxic assets and may carry hidden risk of additional provisions to be provided for bad debts. In the absence of acceptance of international accounting standards uniformly through out the world and implementation of corporate Governance standards in letter and spirit the figures reported under capital ,reserves and surpluses cannot and should not be taken at face value. Further, the Competence of top management, executive level management, genuineness and effectiveness of auditing and accounting practices in vogue , integrity of data collection, analysis and interpretation of data, reporting of information and transparency standards adopted, effectiveness of regulatory requirements and supervisory and follow-up methods vary from country to country and bank to bank and the figures of reserves and surpluses which are in a way derived have to be discounted and should not be linked to leveraging business too much. In the present system of leveraging business without having any link to pure capital, there is a disconnect between owners whether it is government, public or private and top management. In other words, involvement commitment and accountability which are the basic ingredients of ownership management are virtually missing in the present system of capital adequacy ratio.
It is advisable to bring in additional contribution of pure capital as and when balance sheet size and off balance sheet size crosses certain limits. There should be clear cut linkage between Pure capital and business expansion particularly in the form of toxic assets. There should also be an acceptable ratio between equity and intangible assets. The present Capital adequacy ratio which includes profit derived from toxic assets linked to the risk assessment based on certain models alone has not proved to be fully successful although the overall efficiency of the banking system has improved. The realizable value of assets and erosion of capital excluding reserves and surpluses if any need to be introduced in the regulatory frame work to strengthen the the banking system.
Dr.T.V.Gopalakrishnan
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