Banks in India need to get rid of dependence on retail loans

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As India’s largest bank with the best governance is feeling some heat, the question is how the second wave of coronavirus will affect other banks on the NPL front. While bad loans remain a concern, there is a structural problem at the heart of Indian banking. This could limit their expansion in the coming years.

As of May, bank lending to industry accounted for 26.8% of non-food loans. Retail lending by banks accounted for 25.9% of non-food loans. A food loan is money lent to the Food Corporation of India and other agencies to help them primarily buy rice and wheat directly from Indian farmers. If we subtract this from the total bank lending, we get a non-food loan.

As of March 2013, lending to industry accounted for 45.8% of non-food loans, and lending to individuals – 18.4%. This gap has narrowed since 2013 and this is the main problem in Indian banking. Banks are happy to lend to individuals, but seem reluctant to lend to industry.

Before we dive into this, it’s important to understand how banks actually work. Banks take money from depositors and lend to borrowers. While this sounds logical, it is not true. As the Bank of England points out in a document titled “Making Money in the Modern Economy”: “When a bank gives a loan … to someone who takes out a mortgage to buy a house, he usually does not do it, giving them thousands of bills worth pounds. Instead, he credits their bank account with a bank deposit the size of a mortgage. At this moment new money is created. “

Consequently, the conventional wisdom about banks is wrong. In fact, as Josh Ryan-Collins, Tony Greenham, Richard Werner and Andrew Jackson write in their book Where Does the Money Come From? It is quite the opposite: lending creates a new deposit in the borrower’s account … thus it creates the illusion that the borrowers have made deposits. “

So what actually happens is that when banks lend, the borrower taking the loan spends this newly created money, which, as a result of a number of other transactions, eventually ends up in the bank as a deposit. Consequently, the savings are a consequence of accounting.

With this in mind, commercial banks are a much more important part of the economy than most people think. As Collins and others have noted, “The main factor in determining how much [banks] a loan is not interest rates, but the confidence that the loan will be repaid. ” In addition, potential borrowers must be confident in their ability to repay their loans. They also need to be confident in the state of the economy.

How does it all fit together in Indian banking? The Reserve Bank of India has cut interest rates over the past couple of years in hopes that corporations will borrow and expand. But this did not happen because commercial banks are not in the mood to create new money by lending to corporations. In addition, many businesses are also unsure whether to borrow money, given the state of the economy and / or their past rampant borrowing.

In this scenario, banks continued to generate fresh money through retail lending. As Collins and others write, “The incentives they face often lead them to prioritize lending against collateral or existing assets over lending for investment in manufacturing.”

Most retail loans, such as home or vehicle loans or equity loans, fixed deposits, etc., are secured against collateral or existing assets.

This has resulted in banks being reluctant to lend to small businesses in the country. Bank lending to micro and small enterprises was at the level 3.8 trillion as of March 2015, and barely rose to 3.84 trillion, as of March 2021. Over the same period, lending to industry as a whole grew by 1.6% y / y to $ 29.2 trillion Meanwhile, retail lending by banks rose 15.8% per annum to 28.1 trillion

Corporations can borrow from other sources, but banks remain their main source of long-term funds. This has created a serious problem for the Indian banking sector.

As Mark Carney, a former Governor of the Bank of England, said in the context of the rampant borrowing that took place before 2008: “These borrowings were mainly for consumption and investment in real estate, and not for businesses and projects that will generate the profits necessary to service these clients. obligations “.

Something similar is happening now in India. There is no reason to suspect that retail loans will not be returned. But the real question is, can banks continue to disburse new retail loans at the same rate as in the past few years? After all, it is economic activity that creates the opportunity to take out new loans and pay them back. And economic activity occurs when industry borrows to expand, thereby creating jobs and income.

Vivek Kaul is the author of Bad Money.

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