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The Story

The finance ministry on Saturday said the overall stress in the banking sector was declining, a day after the Reserve Bank of India (RBI) said in a report that the bad loan problem in India was likely to get worse.

Now before we dive into this story, a note on the RBI report. Every 6 months, the Reserve Bank releases what it calls a Financial Stability Report. It's supposed to give us an outline of the soundness and resilience of the banking ecosystem in this country. In their latest version, the RBI noted that India’s bad loan problem was likely to flare up considering the deteriorating economic conditions.

Intuitively this makes sense. If corporate India is in dire straits you can’t expect them to be prompt with their loan repayments. Naturally, defaults will pick up and bad loans will accumulate. But the government immediately countered this claim by stating that the RBI had only recently stated that bad loans were likely to decline (In the previous version of the FSR from June).

So it seems as if the government is now casting aspersions on RBI’s predictive powers here. And they are not entirely off the mark.

Take for instance a popular model RBI uses to predict the stability of the banking system. Now the way this model works is rather complicated. But in simple no-nonsense terms, it measures stability by triggering the failure of banks one at a time. Anyway, once a bank’s failure is imminent, you go and see how other banks are holding up.  If the banking system is robust, there won’t be widespread losses and the problem will be contained within a few banks. However in the event, it's fragile, you will see a multitude of banks failing, the moment one bank topples. Now bear in mind that the banks don’t actually fail here. It's just a mathematical equation that models the hypothetical failure of a bank. But it's still expected to yield valuable information and help us prepare for the future. Unfortunately, sometimes they don't work as well

For example, RBI had traditionally assumed a bank would fail in the event that the bank's capital reserves breach a certain threshold. The reserves are sort of proxy to determine whether a bank would have enough money in its coffers to honour all its obligations. So the moment a bank's reserves drop below a certain number, you’ll know for a fact that the bank will have problems serving its customers. And since banks borrow a lot of money from other banks, the fallout won’t be just limited to one entity. Other banks would also suffer in tandem and this is what the model kept predicting time and time again.

And then one day it actually happened for real. Multiple public sector banks started breaching this threshold due to the bad loan epidemic plaguing India and by September 2018, 5 Public Sector Banks had technically fulfilled the failure criterion and yet, there weren’t any widespread losses so to speak. Banks weren’t toppling like dominoes. There was no panic in the streets and things were pretty normal, all in all. So what went wrong?

Well, for one the failure criterion had a problem. Since Public Sector Banks are owned by the government, there’s always this belief that the state would rescue banks in the event a failure actually materialises. So despite the fact that banks were dangerously close to running out of essential reserves, the expectation of a government intervention held all that faith intact. And banks did not fail. The model failed instead.

So shouldn’t we just abandon these models altogether? What purpose does it serve if it can’t produce meaningful results? The government is right. RBI should stop peddling this nonsense and listen to the finance ministry’s version instead.

No!!! That’s not how this works.

When the RBI figured that their failure criterion had a problem. They promptly fixed it in the next draft. That’s how you do predictions. You go about refining your model so that the next iteration is better than the one you have right now. When the RBI released its report (FSR) in June, India’s economy was a very different beast than it is today. Since then India’s economic stability has progressively deteriorated. Every key indicator is on the decline. Foreign investors are tentative. Social unrest has further exacerbated our problems. And there’s a sense of doom and gloom pervading all corners. So it seems pretty far fetched to assume banks would somehow make a spectacular turnaround and improve their bad loan figures.

So instead of countering RBI’s analysis, it would perhaps be prudent for the government to err on the side of caution. If the RBI is wrong, great. Nothing happens. But what if it’s right. Can this country afford another wave of bad loans sweeping the banking ecosystem?

As Maynard Keynes once said, “When the facts change, I change my mind, What do you do, sir?”

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