Credit Rationing and the Nature of Banking - Essay Example

The nature of banking is strongly related to the management and control of risks, dangers that certain unpredictable contingencies may occur, resulting in randomness in cashflow. To manage efficient functioning in such an environment, a bank has to meet capital adequacy requirements, and maintain a healthy positive ratio between its assets and liabilities.For a bank, a loan that it gives out is an 'asset', since it earns revenue, while a deposit is a 'liability' because it has to be repaid at some point in time, and with an additional interest. In order to maintain a balance between the two, it is compelled to limit its crediting activities within the values of those allowed by a positive ratio. According to a global capital adequacy standard introduced in 1988, this ratio of a bank's capital to its total assets is required by the regulating authorities to be above a minimum appropriate level to reduce the chances of the bank becoming insolvent. The extent of this level depends entirely on the perceived risks in the bank's lending or investment activities. This limitation sometimes leads to credit rationing, which is a situation where a bank refuses credit to a borrower at an interest rate set by the bank itself, because of unavailability of sufficient free capital. To understand the pressures on the capital free for lending available to the bank, we need to understand the limitations placed on it by the central bank in the particular country in order to control its activities. One of the limitations on the bank is the statutory requirement that it should submit a defined percentage of certain kinds of the deposits it receives, into the central bank as reserves at zero interest, in vault cash or deposits. These requirements represent a cost to the bank, as they earn no revenue,and are not in the bank's control.These reserves are used in the day-to-day implementation of monetary policy by the Central Bank. The percentage deduction from each deposit may go towards the maintenance of the entire banking system, but it reduces the amount of capital left to the bank for lending or investments. Another requirement is for the bank to maintain an amount of liquid assets for itself as reserve against specified deposit liabilities, for instance, to pay depositors in case they wish to make a withdrawal, or a certain amount that is due to them at the expiration of a designated saving activity. This further reduces the balance capital for investments, and these liquid assets languish in the bank without working to earn an interest. Higher the statutory reserve and liquid asset requirements, lower the amount of cash available to the bank to extend in terms of credit. In some countries, the statutory reserve ratio is high, resulting in less available amount of credit given out to the borrowers.Thus rationing the credit is the only option left to the bank, in order to maintain the capital adequacy requirements. In the periods where the demand for credit is high, because of a booming market or low interest rates, it may be suggested that the bank increase its interest rates, instead of rationing credits at previous rates. But this could result in bad credit, because the creditworthy individuals move off to cheaper options, following the conditions of adverse selection and the borrowers willing to pay the high rates are those who have very little to lose, or are willing to give up their collateral in exchange for the loan amount. In this case, the bank may be also stepping into a situation of moral hazard where the motives of these borrowers are suspect. To avoid these, banks try to give loans at affordable interests to those with a perceived low credit risk and ration it in the case of all others. But this does not always protect them from acquiring bad loans, or non-performing assets. An asset or loan becomes 'non-performing' or bad when it has not been serviced, or in other words, the interest and/or instalment of principal has remained 'past due' or unpaid for more than the stipulated period, 90 days in most cases. These loans have to be written off and eat away into the capital of the bank available for lending, and will lead to increased caution in extending future loans and credit rationing. Another important factor that contributes to credit rationing occurs during the process of credit analysis.A bank lends the money received from the depositors to the borrowers, but before extending this credit, it must ensure that the credit risk is worth taking , and determine the interest rate to be charged for it. The bank seeks relevant information from the borrower and passes it on to credit reference agencies or sharing arrangements, thus distancing itself from the borrower. In some cases, this activity may even be outsourced, which means that the entity doing the analysis is totally isolated from the borrower. This means that the analysis is based totally on the figures presented, and there is no room for soft analysis or consideration of a previous track record. Credit may be rationed in these cases, beacause of the institutionalisation of the credit investigation and approval process. The gathering of such information is increasingly expensive, and in some cases the banks consistently lend to borrowers whose creditworthinessas has been assured through previous transactions, without venturing to check out a range of other potential candidates.This usually results in regular lending to the bigger firms with high assets and low credit risk, and rationing out of deserving, but smaller firms who are yet to prove themselves, and are hence seen as high risk borrowers. Capital may thus lie unused with the bank, instead of supporting the deserving smaller businessess, which is a losing situation for both parties. Credit rationing may also be governed by competition and fluctuations of interest rates in the market, or because of incidents that act as a warning and tighten monetary control. The case of Enron, and the depression that followed the dot.com boom are instances in which the banking system lost money and introduced caution and control in its lending activities. In order to reduce credit risk, banks began to place new emphasis on diversification by extending a portfolio of loans with uncorelated prospects, which is very important in an increasingly globalised world. This means that it will refuse loans to too many borrowers from the same or similar fields, so that its interests are protected in case of a setback in any particualr area, because the loans extended in other areas will still be doing well. In this case it will refuse loans to a borrower or ration credit despite having adequate capital because of the similarity of the project with others. Thus credit rationing may arise out of banking imperfections, but they not the only factors, market situation may have an equal, if not a better say. Availability of credit is a major factor in the growth of an economy as it boosts industry and infrastructure. Credit rationing can thus have a major effect on an economy, and if allowed to go on uncontrolled may contribute to a credit crunch. Banking policies need to be attuned to the needs of the ever-changing equations in the market, in order to regulate or avoid credit rationing. Read More