Where's all the money?

There have been lots of seminars, discussions and numerous articles on the recent “liquidity” crisis in our banking system. Rising imports, stagnating exports, capital flight and unspent capital expenditures, among others, have been identified as the primary reasons for the current crisis. Some have also identified the currency note shortage last Dashain when depositors could not withdraw adequate amounts of cash from their respective banks as being another critical reason for the current liquidity problems because many depositors could have lost faith in the commercial banks’ ability to meet their demand for deposits. In this article, I will try to shed some light on the role of banks as financial intermediaries where they take short-term deposits and provide long-term loans, and the potential liquidity crisis that banks could face from this inherent mismatch between their assets and liabilities.

A commercial bank is primarily involved in mobilising deposits and providing loans, i.e., they channel deposits from individuals into loans for borrowers. In the process, they earn a profit from the spread between the average cost of their deposit aka “cost of funds” and the average lending yield. The higher the spread between the lending yield and the cost of funds, the higher will be the bank’s profit. Banks can mobilise deposits either through low-cost current and savings accounts (CASA) or through high cost fixed deposit (FD) accounts. So it’s in a bank’s interest to mobilise as much deposits as possible from low-cost CASA to widen their interest spread. However, since there is no withdrawal limit on CASA (as they are demand deposits), the average deposit on such accounts can be highly volatile. FD accounts, on the other hand, have fixed tenures, so banks can plan beforehand when and by how much there could be potential deposit withdrawals from these accounts. Because of the respective trade-offs between the cost and volatility of both CASA and FD accounts, commercial banks try to find the optimum balance between the two whereby they can minimise their cost of funds.

When a commercial bank mobilises deposits, it can invest that amount either in liquid assets such as government bonds or lend it out to borrowers who are interested in either meeting their working capital needs or investing in manufacturing businesses, real estate, hydro power and so forth. Generally, government bonds (read T-bills) have a lower yield than the average lending rate on the loan portfolio of commercial banks. So it’s in a bank’s interest to allocate as much of their assets to higher yielding loans than government bonds. However, because most of these capital intensive manufacturing plants, hydro projects and real estate ventures have long durations, banks have to wait for a substantial period before they get their principal back. T-bills, on the other hand, have a lower maturity period, and they can even be used as collateral to borrow funds from the central bank. Hence, like in the case of deposits, banks try to find the optimum balance between high yielding but longer duration loans with low yielding but liquid government bonds.

Now, as mentioned above, it’s in a bank’s interest to mobilise as much deposits from low-cost CASA as possible. As a demand deposit, funds in CASA have immediate maturity; however, banks believe that depositors’ unpredictable needs for cash are unlikely to occur at the same time. With this belief, they are able to make loans to projects with a long duration. In the process, banks are borrowing short-term and lending long, which results in an asset-liability mismatch. Almost all banks have some sort of an asset-liability mismatch on their balance sheets. When banks do lend out demand deposits for long-term projects, a systemic risk can arise in the banking system if an individual bank cannot meet the withdrawal demand of its depositors. Trust is paramount in the banking system. Every depositor trusts banks to deliver cash when they come forward with a withdrawal slip. If the depositors feel that their savings is at risk, then a sudden surge in deposit withdrawals and the bank’s inability to meet the unexpected demand can lead to the self-fulfilling crisis of “bank run”.

One way out for banks would be to follow a “narrow bank” concept, i.e., invest all their demand deposits in short-term assets. However, this not only affects the profitability of a bank due to lower yields on short-term assets but also reduces its ability to lend out to productive sectors such as manufacturing, and that affects the overall economy. Hence, the concept of narrow banking has been discredited in most countries (however, because of the recent financial crisis, voices have emerged to move towards narrow banking).

In the context of the ongoing liquidity crisis in Nepal, the trust of depositors in the banking system has been undermined due to the currency shortage last Dashain. As a result, many depositors who had to haggle with bank officials to withdraw their own savings during the festival haven’t channelled their savings back into the banking system. According to Diamond and Dybvig’s seminal research on banking crises, one of the most potent tools to build the general public’s trust in the banking system is deposit insurance. As of now, there is no provision of deposit insurance from the government side although the last budget did mention it.

To address the problem of an asset-liability mismatch in Indian banks, which is stifling infrastructure development, the Indian government announced the concept of “take-out” financing during the last budget of 2009/10. Under the Indian government’s take-out financing scheme, India Infrastructure Finance Company Limited (IIFCL) — an Indian government owned entity — will buy out long-term loans from banks. Minimising asset-liability mismatches, this scheme enables banks to enter into long-term project financing as they can sell their loans to the IIFCL after a certain time frame. Though the recent initiative of Nepal Rastra Bank to provide refinancing is a welcome step, a similar kind of take-out financing scheme is necessary to mitigate the liquidity problems that arises from an asset-liability mismatch in banks as well as encourage banks to lend towards productive sectors.

From the bank’s side, there should also be proper and rigorous focus on asset-liability management. Most commercial banks in Nepal don’t follow the concept of duration management in their balance sheets. Much of their senior management’s focus is towards increasing the absolute volume of deposits and loans rather than properly managing asset-liability to maximise profits. When mangers focus only on increasing the deposit or loan volume, adverse interest rate movements can seriously undermine a bank’s profitability and its asset quality.

However to be fair to bankers, they also don’t have tools to properly manage the mismatch between assets and liabilities. Generally, interest rate derivatives, currency derivatives and swaps are used extensively by foreign banks to match their assets with their liabilities. With Nepal Rastra Bank’s recent decision to allow commercial banks to use derivative instruments, I am hopeful that in the days ahead, banks will be better equipped to deal with asset-liability mismatch problems.


This article was first published in The Kathmandu Post on April 12, 2010

Link: http://www.ekantipur.com/the-kathmandu-post/2010/04/11/Oped/Wheres-all-the-money/207127/