Indian banks must stop relying on personal loans

As India’s large, best-run bank is feeling a bit of heat, the question is how the second wave of covid will impact other banks on the bad debt front. While failed loans remain a concern, there is a structural problem at the heart of India’s banking system. This could limit their expansion in the years to come.

In May, bank loans to industry represented 26.8% of non-food credit. Retail bank loans accounted for 25.9% of non-food credit. Food credit is money loaned to the Food Corporation of India and other agencies to help them purchase much of the rice and wheat directly from Indian farmers. When this is subtracted from the aggregate bank credit, we get a non-food credit.

In March 2013, loans to industry represented 45.8% of non-food credit, while loans to individuals represented 18.4%. This difference has narrowed since 2013 and this is where the fundamental problem for the Indian bank lies. Banks have been happy to lend to individuals, but seem reluctant to lend to industry.

Before getting to the heart of the matter, it’s important to understand how banks actually work. Banks take money from savers and lend to borrowers. While this sounds logical, it is incorrect. As the Bank of England points out in a paper titled “The Creation of Money in the Modern Economy,” “When a bank gives a loan… to someone who takes out a mortgage to buy a house, they don’t. usually not done by granting him thousands of pounds of banknotes. Instead, he credits their bank account with a bank deposit of the mortgage amount. At that point, new money is created. “

Therefore, the conventional wisdom on banking is wrong. In fact, as Josh Ryan-Collins, Tony Greenham, Richard Werner and Andrew Jackson write in Where Does the Money Come From ?, “Banks don’t have to wait for a customer to deposit money. before being able to grant a new loan to someone else… It is exactly the opposite: the realization of a loan creates a new deposit in the borrower’s account… thus creating the illusion that the borrowers have made deposits.

So what really happens is that when banks make loans, the borrower who takes out the loan spends this newly created money, which through a series of other transactions ends up in a bank. as a deposit. Saving is therefore an accounting consequence.

Given this, commercial banks are a much bigger part of an economy than most people realize. As Collins and others point out, “The main determinant of how much [banks] lending is not about interest rates, but the confidence that the loan will be repaid. Apart from that, potential borrowers need to be confident in their own ability to repay their loans.

How does it all fit together with regard to the Indian bank? The Reserve Bank of India has cut interest rates over the past two years in the hope that businesses will borrow and grow. But that didn’t happen because commercial banks are not in the mood to create new money by lending to businesses. Additionally, many businesses are also not confident about borrowing money, given the state of the economy and / or their past borrowing frenzy.

In this scenario, banks continued to create new money through retail loans. As Collins and others write: “The incentives they face often lead them to favor loans against collateral or existing assets, rather than loans to invest in production. “

Most retail loans, such as home or auto loans or loans against stocks, term deposits, etc., are against collateral or existing assets.

This has led to a situation where banks are reluctant to lend to small businesses across the country. Bank loans to micro and small industries were ??3.8 trillion in March 2015, and it barely reached ??3.84 trillion, in March 2021. Loans to the entire industry during the same period increased by 1.6% per year to reach ??29.2 trillion. Meanwhile, retail bank lending grew 15.8% per annum to reach ??28 100 billion.

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

As Mark Carney, former Governor of the Bank of England, put it in the context of the borrowing frenzy that occurred before 2008: “This borrowing was primarily for consumption and for real estate investment rather. only to companies and projects that would generate the necessary income obligations. “

Something similar is happening in India right now. There is no reason to suspect that personal loans will not be repaid. But the real question is whether banks will continue to be able to grant new loans to individuals at the same rate as they have been doing in recent years? Ultimately, it is economic activity that creates the capacity to take new loans and repay them. And economic activity occurs when industry borrows to grow, thereby creating jobs and income.

Vivek Kaul is the author of “Bad Money”.