Do Indian banks really run the risk of maturity mismatch?

Addressing the audience, Sen pointed out that most of the Indian banks had gradually shifted towards universal banking (offering all financial services) under one roof. However, according to Sen, such a shift to universal banking should have typically been preceded by a change in the borrowing mix of the banks which was not done. But first, let us get down to what exactly is this concept of maturity mismatch that Pronab Sen has spoken about.

What maturity mismatch in banks is all about?

In any financial fund-based business, the spread of the bank / NBFC is the gap between the yield on funds and the cost of funds. That is called the net interest margin (NIM) in the case of banks. Banks typically raise funds through equity, short term debt, long term debt and through deposits; which includes current, savings and FD accounts. That is the liability side of the bank balance sheet. On the assets side, the banks make investments in government securities, gives loans to retail consumers and also give loans to industrial users.

Maturity matching is important because it determines the cost of funds and also the risk. For instance you can raise 5 year funds and deploy these funds in giving 7 year loans. That is perfectly understandable. The problem arises when the bank raises 1 year funds and deploys it in 10 year loans. That creates a mismatch in maturity and this gap is called the maturity mismatch or the asset liability mismatch. Most banks have an asset liability committee (ALCO), which continuously monitors the asset liability match of the bank.

Why maturity mismatch matters to banks?

Having understood what is maturity mismatch, let us look at why it is important for banks not to have a maturity mismatch. There are broadly two risks in having a maturity mismatch i.e. borrowing at the short end and lending at the long end.

·         The first risk is that your short term funding has to be renewed multiple times to meet the long term deployment of funds and that has a cost. Hence when there is a maturity mismatch, such renewal costs have to be built into spread calculations.

·         The second risk is that when the bank has to renew its borrowings, either the cost of funds at the short end may have gone up or the short term market may have dried up due to RBI sucking out too much liquidity. Both situations can be risky.

IL&FS actually went bust in 2018 due to a huge maturity mismatch. For a long time, IL&FS was borrowing in the money market and deploying the funds in long term infrastructure projects. At one point that was extremely profitable as the gap between the cost of funds and the yields gave IL&FS huge spreads and allowed them to report bumper profits. In 2018, when rates were hiked by the RBI, the money markets became very tight and IL&FS found it could not fund its long term assets with short term liabilities. That was the time IL&FS folded up amidst a liquidity crunch as outstanding loans to banks of Rs1 trillion could not be refinanced while assets were locked away in long term infrastructure projects.

But, does the IL&FS story apply to Indian banks?

Pronab Sen believes the answer is “yes and no”. On the one hand, most of the PSU banks enjoy an implicit guarantee from the government since it is about the credibility of public deposits. Sen feels, that is the only reason we have not seen the outcome of a major maturity mismatch in the Indian context. However, it is important to understand why Sen believes that there is the risk of maturity mismatch in bank balance sheets in India.

Sen believes there are several reasons. Indian banks have followed the British model wherein the funds were raised predominantly through deposits. However, with universal banking, the profile of bank lending had changed substantially. For instance, retail loans, consumer loans and mortgage loans became a big part of the bank assets. However, universal banking was reflected only in the assets side of the balance sheet and not on the liability side. Fund raising by banks continued to be on deposits alone.

Sen has also shared some interesting statistics. The average tenure of bank lending is about 9 years today. However, the average tenure of deposits is just around 2.5 years. That means; the banks run a huge maturity mismatch risk, which has not exploded only because there is the implicit government by the government. According to Sen, back in the early 2000s, working capital loans accounted for 70% of the bank assets. However, that has now fallen to 35%, with longer term loans rising from 10% to 45% of bank assets.

Warning on privatization of banks

Just a few weeks back, the RBI bulletin had carried an interesting article about why it was essential to be more calibrated in bank privatization. The article had highlighted that many of the government projects like Jan Dhan and financial inclusion had been successful only due to the full support of PSU banks. Also, private banks had done little to boost infrastructure lending or for national priority projects. Hence the article had suggested that rampant privatization of banks may not be the answer. That article had created a furore in the media and eventually the RBI had to issue a clarification that it did not reflect the view of the RBI. But this point is very relevant in the context of what Sen has said about banks.

In fact, Sen has also sounded a word of caution on privatisation of state-run banks. His contention is that such rampant privatization could lead to heightened risks. Privatisation would mean the entire deposit and loan portfolio of lenders going to a private entity without government support. Like we have seen in the case of IL&FS, the government may not be either willing or able to rescue private banks beyond a point. In his speech, Sen has underlined that the maturity mismatch problem in banks may not have exploded purely because the government is picking up the risk (implicitly) in the case of PSU banks. Privatization could lead to systemic risks for the banking system as a whole.

The gist of Sen’s piece is that before Indian government embarks on a massive privatization program, it is essential to ensure three things. Firstly, the banks must be allowed to borrow long term so that the liabilities side also reflect universal banking. Secondly, asset liability mismatch must be disclosed and reviewed more closely on a periodic basis. Lastly, solutions for MSME lending and infrastructure lending has to be in place before taking up large scale privatization of banks. You really cannot argue with that!