6 Jan 2024

How safe are “too big to fail” banks?

When conservative investors ask for “safest banks” to keep their money in, a popular answer they get is to stick to the D-SIBs—the list of banks that the RBI has declared as domestic systemically important banks. These banks are considered “too big to fail”. People assume that if such a bank were to fail, the government will intervene and save them. But is that really true?

What are “too big to fail” banks?

To understand this better, we need to start from the origins of the idea of systemically important banks. During the 2008 financial crisis, many governments had to bail out big banks in their respective countries. The governments were pretty much forced into this bailout since these banks were “too big to fail”. If such a bank was allowed to sink, the ripple effects would have been so severe that a significant chunk of the economy would have fallen with the bank! So the governments didn’t have much of a choice but to distribute cash to bail these banks out.

This is a moral hazard. A moral hazard is defined as a situation where one party takes excessive risk because they know that another party will rescue them if the risk were to realise. Big banks now know that they can lend recklessly in a pursuit to maximise their profits. If the low quality loans they give out are repaid, the banks get to keep the profit. If the lenders fail to pay, well, the government will bail the banks out anyway. So the big banks have no reason to be prudent about their lending. This is a problem.

To mitigate this moral hazard, a framework was brought up, called the G-SIB Framework. Essentially, banks that are too big to fail are identified and they are held to a higher bar than other banks. If a big loan they give out goes bad, the onus of recovering from that loss is placed on the bank itself.

The D-SIBs list, or the “domestic” systemically important banks is the same framework applied to Indian banks. The Reserve Bank of India (RBI) determines which Indian banks need to be held to a higher bar and sets them that bar.

What does it mean to be a D-SIB?

To understand D-SIBs, we need to first understand how the RBI prevents Indian banks from sinking. The RBI does this by prescribing a Capital Adequacy Ratio (CAR). Read this tweet thread by Kirtan A Shah to learn how CAR works, but in short, banks are required to have “risk capital” of at least 11.5% of their loan book. Risk capital is capital the bank can use to make up for any loss arising from bad loans.

An oversimplified example may help. A bank that has lent ₹10,000 crores needs to have risk capital of at least ₹1,150 crores. If the bank loses ₹200 crores to bad loans, the bank will dip into the risk capital to make up for the loss. Now the available risk capital is only ₹950 crores while the bank has active loans of ₹9,800 crores. The bank will need to raise additional ₹177 crores to bring the risk capital back to the required 11.5% level.

That 11.5% captial adequacy ratio is for “ordinary” banks. Since the nation cannot afford to have a D-SIB fail, the D-SIB banks have a higher CAR requirement. HDFC Bank and ICICI Bank need to maintain a CAR of 11.7% while SBI needs to maintain a CAR of 12.1%. That’s pretty much it.

In essence, neither the government nor the RBI is committing to bail out the big banks. These banks are classified as D-SIBs only to reduce the likelihood of them needing a bailout tomorrow. Assuming sovereign guarantee for these banks is a mistake.

Should we stick only to D-SIBs?

While any additional CAR doesn’t hurt, it is up to each investor to decide for themselves what protection an additional of 0.2% or 0.6% CAR is going to give them.

The RBI has been very proactive in regulating banks and preventing bank failures. Depositors have lost capital from the failures of PMC Bank and some small cooperative banks. But there has been no loss due to other bank failures. Yes Bank and Lakshmi Vilas Bank customers suffered some temporary liquidity issues, but no one lost their deposit.

I personally don’t consider a CAR of 12.1% to be significantly better than 11.5%, so I consider all domestic banks to have similar amount of risk. Choose any bank that you are comfortable with, but know that “too big to fail” is not a guarantee of bailouts.

What if I want more safety?

Some of us may find the banks’ capital protection measures unconvincing. The additional protection from the D-SIBs is not significantly better, either. If you seek even more safety for your capital, you have a few other options.

  • If you are okay with volatility, you can buy gilt mutual funds. The bonds are isssued by the government; the government can pay its loans off much more easily than any bank can.
    • What’s the downside? There will be volatility and the returns will be unpredictable.
  • Park your money in post office savings schemes. This money is essentially lent to the government, so it’s very safe.
    • What’s the downside? Working with the post office is not as convenient as working with a bank.
  • If you are savvy enough, find mutual funds that have less duration risk and invest predominantly in gilts. Quantum Liquid is one such fund, but there likely are other options too.
    • What’s the downside? You need to keep an eye on the mutual fund’s portfolio to make sure that the fund management team is not exposing your money to excessive risk.

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