N S Vishwanathan: Some thoughts on credit risk and bank capital regulation

Speech by Mr N S Vishwanathan, Deputy Governor of the Reserve Bank of India, at XLRI, Jamshedpur, 29 October 2018.
Central bank speech  | 
05 November 2018

It is a privilege to be welcomed within the precincts of one of the premier management institutes of the country and, more importantly, to get an opportunity to engage with some of the promising young minds and aspiring future leaders. All of you are going to enter the job stream at a very interesting point in our country’s economic history. We are all meeting today in the wake of a number of landmark economic reforms, of which I would like to touch upon two in particular– the Insolvency and Bankruptcy Code (IBC), 2016 and the RBI circular dated February 12, 2018 on the Revised Framework for Resolution of Stressed Assets. I will attempt to give you a regulator’s perspective on the above reforms, and about banking industry in general while debunking a few fallacies. Using this background, I will also segue into another contentious issue of adequacy or otherwise of prudential capital for banks, particularly for credit risk.

Let us start with the fundamentals. Banks bring together the liquidity surplus agents in an economy with the liquidity deficit agents by establishing an intermediation channel, thus aiding the flow of savings in an economy towards investments. The banking licence issued by the regulator allows these institutions to raise uncollateralised funds from the public in the form of demand deposits. It is primarily from these deposits that banks give out loans to the borrowers. Thus, it is not that banks have a huge coffer like that of Uncle Scrooge, holding their own money, from which they make loans, but it is the funds that they raise through deposits that are used for making loans.

Do we need banks?

The above description, though, does not immediately make it clear why we need banks to do this intermediation function – why the savers cannot directly lend to the borrowers, and why we need an intermediation infrastructure.