Here is how Vulcans* would run their banks and handle bank crises. A bank in trouble would be liquidated. All assets would be realised. Depositors would be paid from the asset realisation. If the depositors got their deposits in full, the surplus left would go to shareholders of the bank. In case of a shortfall, Deposit Insurance and Credit Guarantee Corp. would pay up to Rs.1 lakh to each depositor to cover the shortfall and the shareholders would get nothing. (*Humanoids from planet Vulcan. Mr. Spock of Star Trek being the most famous one. They are characterised by their rationality and complete lack of emotion.)
On planet earth, we do banking differently. It is said that “History does not repeat itself but it does rhyme”. So, while we do not know the future, it may be instructive to look at the past actions of governments and central banks on earth to have some understanding of how the future will pan out for banks in India.
No government or central bank likes a systemic banking crisis. Even the strongest proponents of free market capitalism yield when it comes to saving bank depositors as we have seen in the US in 2008 and 2009. In India, where public sector banks have the most market share, depositors have the least to worry. Governments and central banks have concluded (and rightly so) that the costs on the economy far outweigh the costs of bank bailouts and, thus, do not like bank failures. Those who hold shares of listed companies in India are not a large enough vote bank and usually the government or the central bank would not worry too much about them. But in the case of public sector banks, the government itself is a majority shareholder. Also, letting shareholders take a hit would mean that the message goes out loud and clear to the public that the bank is in trouble, which is not what they want to do.
Wisely used, bank crises can give opportunities to shareholders to make good returns at the time of peak pessimism. Let us look at some of the means of bank bailouts.
Widen credit spreads: When the banking system goes through a credit crisis, credit becomes difficult to obtain. (Look at the shift from corporate bond funds to gilt funds in the Indian mutual fund space after the Amtek crisis). While interest rates in the deposit market, money market and on government bonds come down, lending rates to corporate borrowers and households remain at elevated levels.
This results in high yield spreads for banks, which use the higher income to write off bad loans over a period of time. The interesting point here is that this benefit comes to all banks whether the bank is in trouble or not. So, this may be helpful for the better quality banks.
Treasury bond gains: In the last cycle, interest rates on 10-year government bonds had fallen to sub-5% levels and banks had used treasury gains to write off a lot of accumulated credit losses.
