Banking for the braveheart

Former banker and academic Moorad Choudhry has produced a useful if heavy-going textbook for all bankers

BY:    A Seshan  February 07, 2013 Last Updated at 00:25 IST

Giving more capital to a bank is like giving another bottle to a drunk; you know what will happen, but you don’t know which wall it will happen against - Euromoney 

The book under review is by a banker with great experience in his field and academics. The testimonials in the blurb from the leading lights of the profession testify to the author’s expertise. It took me quite some time to go through the whole book; it contains many features of a technical nature not known to me despite my five decades of experience in central banking vis-à-vis commercial banking. There are 18 chapters and an Afterword. Broadly, the book addresses the following concerns of bankers:

• how to implement consistently successful asset-liability management practice, the cornerstone of every bank business model;
   
• tools and methodology for business best practices for liquidity risk management; and
   
• recommended long-term capital strategy and corporate governance principles.

In these days of specialisation, no one can claim to know all aspects of banking. In that sense, the book demystifies the field even for those who have knowledge of it. But it could also be forbidding for the run-of-the mill banker who looks at the mathematical formulae and innumerable ratios included in it. The book is not for the faint-hearted. As the author says, it is for senior staff and for juniors aspiring to reach higher positions in their institutions. He has done justice to the three aforementioned objectives. The volume should be in the library of every bank. I would urge serious students of banking to read it to gain a complete understanding of their field.

Since bank nationalisation, banking in India has become increasingly politicised. Non-performing assets will become worse before the general election in 2014. There is already an expectation of yet another write-off of loans by a government desperate to improve its image after being riddled with scams and scandals. In that context, stress tests based on different probabilities of defaults described in the book are useful.

There is no point in dealing with what has been covered well. In the limited space available, in view of the large compass covered, I can offer only a few critical comments on what I consider the limitations of the volume. I hope it will not be construed as nit-picking and does not detract from the book’s contribution to the growing literature on banking.

The book rightly emphasises the importance of a strong capital base for a bank to survive in times of distress. But, often in the general literature on the subject, it is overemphasised. If there is a run on a bank, no amount of capital can bail it out of difficulties. This is because, while deposits are repayable immediately, assets take time to be materialised and collected. The history of financial crises, including the one of 2007-09, is littered with cases where, despite a strong capital base, many banks faced insolvency or financial difficulties serious enough to warrant state support. As the book points out, Lehman Brothers was capitalised at 11 per cent Tier I capital at the time of collapse — a level that was acceptable to regulatory authorities while it was still in operation. The quote from Euromoney at the beginning of this review is appropriate in this context. In my view, in the ultimate analysis the success of a bank’s operation depends as much on the proper appraisal of loans and projects as on any other factor.

Surprisingly, in this otherwise comprehensive book, there is no mention of this fundamental aspect of banking. There is a discussion on the appraisal of portfolios, but it is post facto. Two elements are noteworthy in this context: the appraisal of applications for short-term working capital and those for long-term capital projects. Each requires a different technique. The risk elements are fundamentally different for both. How can a bank management take a view, say, on a loan for 20 years for housing to an individual or a project consortium? In the distant past, this problem was not serious since Indian banks’ business was focused on short-term loans. In fact there were times when the Reserve Bank would advise commercial banks not to involve themselves too much in long-term loans that could result in asset-liability misalignment, in view of the fact that their liabilities were all short-term in nature. There were separate development finance institutions to provide long-term loans. One such institution, for example, was the Industrial Development Bank of India.

But ever since the idea of universal banking – in a limited sense – came to be accepted, Indian banks have been increasingly involving themselves in long-term finance. It is in this context that concepts such as discounted cash flow, internal rate of return, and so on need to be understood. I hope the author will devote some space to these points in the next edition. The importance of the evaluation of the loan proposal cannot be overemphasised in the context of the subprime crisis, which resulted in the recent international financial imbroglio.

http://www.business-standard.com/article/beyond-business/banking-for-the-braveheart-113020600999_1.html

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The reviewer is an economic consultant and former officer-in-charge, Department of Economic Analysis and Policy, RBI