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Understanding yet another Dent on Bank's Trustability.

In this week's FinMail we bring you the simplified version of what happened at Laxmi Vilas Bank and what led to its downfall. We take a look at the basic functionality of banks' operations and how NPAs are created and how they facilitate a Bank's Failure. Sit back and relax because this is going to be a long ride.

The Failure

The RBI on Tuesday, 17th November 2020, placed Laxmi Vilas Bank under moratorium to protect the depositors' money and to maintain stability in the banking and finance industry. With RBI placing a moratorium, it means that no depositor could withdraw more than ₹25000 for the next 30 days. While the depositors' money has been frozen above ₹25000, it doesn't mean that they will not get the remaining money back. It is done only so that everyone doesn't panic withdraw and unstabilize the bank and the industry.

What next?

LVB will be merged with Singapore-based DBS Bank's Indian Arm DBS India. The merger deal is all ready to be executed and is waiting for the approval of the government which will be approved most likely.

The RBI for the first time in the history of Indian Banking and Finance will merge an Indian Bank with a Foreign Bank. With this deal happening, the Singapore-based bank will provide ₹2500 Crores to its Indian Arm to provide liquidity and support to the merged entity. DBS Bank will get the advantage of the wide branch network of LVB and will help DBS strengthen its expansion in India. So it is like a win-win for both the banks.

What led to the downfall of a 94-year-old bank?

LVB is a bank with 94 years of history and even if it has been in India functioning for the past 94 years, it hasn't grown that much. The downfall is being assumed because of the rising NPAs, Losses, and declining Net Worth and Liquidity. Plus an interesting thing to note here is the director's panel has been constantly changing. There were multiple resignations of directors after RBI laid down a Prompt Corrective Action in September 2019. RBI took this step over concerns of rising NPAs. Interestingly, LVB continued its normal operations till 2017, but since 2017, it started out lending huge loans to corporates and since then the loan book of LVB expanded in all sectors and so were the NPAs. With NPAs and losses rising, the bank was in dire need to raise some money to help the bank out of the hole, but it failed to raise money too. With a major fundraising deal failing there was no other credible plan to lift up the failing bank. And thus, the central bank decided to place a moratorium and go on to merge LVB with DBS.

The Troubled Banking and Finance Industry

The downfall of LVB marks the failure of 5 Banking or Financial Institutions within 30 months in India which includes IL&FS, DHFL, Yes Bank & PMC Bank. The troubles at the respective institutions while being different at the first look, has the same bad root which is Bad Loans.

And this is just the picture that has come out. There may be many dead bodies left to be dug or there maybe graves that are being created. And if we try to find out the reason on

"What is wrong with the Banking and Finance Industry?"

We just don't want to open that door.

A few months back, Finance Minister - Nirmala Sitharaman while presenting the Banking Regulation Amendment Bill that enabled to bring all the co-operative banks under the supervision of RBI, she noted,

"About 277 urban cooperative banks have reported losses. As many as 105 urban cooperative banks are unable to meet the minimum regulatory capital requirements and 47 are having negative net worth. Besides, 328 urban cooperative banks have more than 15% gross NPA ratio, as of March 2019."

RBI report in January 2020 revealed that Indian banks have the highest number of NPAs as compared to 10 emerging economies including China, Turkey, Philippines, Brazil, and Indonesia. It confirmed that 9.1% of the total advances (₹9.36 lakh crores) turned into NPAs in 2018-19. It further pointed to the low percentages of NPA, 1.8% in China and 4% in Turkey, to draw a comparison with India’s increasing number of NPAs.

Before we understand how rising NPAs hurt the Banking and Finance Industry and how did it led to the downfall of a 94-year-old bank, let us understand in simpler terms what a bank is and how it works and how it earns?

What Is A Bank?

Google defines a bank as, "A financial establishment that uses money deposited by customers for investment, pays it out when required, makes loans at interest, and exchanges currency."

Investopedia defines a bank as, "A bank is a financial institution licensed to receive deposits and make loans."

How Banks Work and earn?

ft. Taarak Mehta ka Ooltah Chashmah

The answer is given in the definition which is by accepting deposits and providing loans. The difference between the received interest from borrowers and provided interest to depositors is the income of the bank. Wait a minute, we have to provide what are you here for - An Analogy.

Meet Bank of Sundarlal (BOS) a newly opened bank in Kalupur Ahmedabad with another branch in Goregaon East in Mumbai. Now, as the BOS (Bank of Sundarlal) is new, there will be no depositors who will be ready to park their funds in BOS. But Mr. Jethalal knows the chairman of BOS - Mr. Sundarlal well and also trusts him (please assume it here) so he under the trust of Mr. Sundarlal opens an account in BOS and deposits his funds there. Now, BOS has promised its depositors 4% p.a. interest on Savings A/C and 8% p.a. interest yearly on Fixed Deposits. BOS provides slightly higher interest rates on deposits concerning the fact that it is a new bank and to attract more customers. But remember, BOS is a bank and not a charity, and thus to provide interest rates to the depositors, the bank has to earn income and profit. So, BOS will also provide loans at attractive rates to attract borrowers. The rate of Personal Loan is fixed at 10% p.a. So, let's say Mr. Jethalal deposited ₹1,00,000 in BOS's Fixed Deposit and ₹50,000 in savings a/c. So, the bank of Sundarlal has now ₹1,50,000 as deposits which it can use to lend to someone who wants to borrow. But, BOS to avoid any contingency it keeps aside ₹10,000 and decides to lend ₹1,40,000 to a borrower in Ahmedabad. Now, after one year the borrower decides to pay back all of his loans so he gives back ₹1,54,000 (₹1,40,000 + ₹14,000 Simple Interest). Here the fixed deposit of Mr. Jethalal has also matured. So the BOS will payback ₹1,10,000 to Mr. Jethalal (₹1,00,000 + 10,000 SI). Also, the saving account of his has earned yearly interest which amounts to 2,000.

So to put things in perspective, BOS has earned an interest of 14,000 whereas paid interest of 12,000 in total. The difference of 2,000 will be the income of BOS. Now, with Mr. Jethalal being very satisfied with the services of BOS, refers this bank to his friends and relatives. Now the bank slowly and steadily starts picking up new customers and gaining more amounts of deposits. With more amounts of deposits, the bank will need to lend out more money to different borrowers and thus spreading through various cities and states.

This is how a bank functions on the base level. Sure there are more activities that are involved and more complex calculations of interest rates. This is an example of how a single bank functions and if we consider multiple banks that are operating in a city, state, or nation, things will get a little more complicated. Because with the number of banks increasing, competition between banks will also tighten and there will be more and more banks fighting for a customer to deposit or to lend a loan. And because of that, there will be mis-sellings, loans to the ineligible, which can be a threat to the client of the banks as well as the bank itself. And the most common way a bank can fail is rising NPAs and declining liquidity. So let us understand what NPA is?

NPA - Non Performing Assets

Bank earns money out of lending business, from the loans which they provide. Interest charged by them on various types of loans is a form of income for banks. So the money lent by banks is the bank's assets. Now, what if some person is not paying the loans back to the bank? In that case, such loan is no longer generating income for a bank, these types of loans i.e assets are dead assets to a bank, hence they are called Non-Performing assets or NPAs.

You might think that going by this, deposits accepted by banks are their Liabilities. Well, in that case, you're right but banks generally don't pay up those liabilities instead they convert them into assets by lending them to different borrowers.

Why Rising NPAs are trouble for banks and the banking industry?

Rising NPAs mean more defaults on the loans which means the bank will lose more money while also paying back the depositors till it can't one day out of the blue. But where does this problem start first of all? As we had a look at the example of how banks work, we saw that smaller and new banks that want to establish themselves in the industry, need depositors that trust the bank with their money. And how do they attract them to deposit money with them?

Higher Interest Rates on Deposits

You will generally see small or co-operative banks will offer higher deposit rates than nationalized banks because they want to attract more customers. But with promising good interest rates, they would also need to earn higher interest rates on the loans that they offer to the borrowers to make a profit or just to be able to pay their depositors.

Now one way is to offer loans at higher interest rates but banks usually don't do that because no one would prefer a costly loan. So, the other way is to provide loans to people who are not eligible or to provide more amount than the eligibility of the borrower. They offer loans to those who aren't able to get loans from a nationalized bank or who are getting fewer amounts at a higher rate of interest. So you always know that with higher returns there is also a higher risk of loans getting defaulted and which is the reason NPAs rise and also the reason for a bank's failure.

And this is precisely what happened at LVB, they kept expanding their loan books and giving out loans to corporates too. Since 2017, they shifted their focus from small and medium enterprise loans to big corporate loans and since then their NPAs were seen rising. In fact between FY2010 and FY2017 their loan book grew 4 times across sectors like Infra, Textile, Metals, etc. And things haven't been good at LVB for the past few years. And finally on Tuesday RBI placed a moratorium on the bank and then announcing a merger with DBS.

So don't panic about what you will do if your bank fails. We have got a point that you should keep in mind when you face a situation similar to this.

What will happen to your money if your bank fails?

Deposit Insurance And Credit Guarantee Corporation (DICGC), insures each depositor in a bank up to a maximum total amount of ₹5,00,000 including both principal and interest amount held in savings or current a/c, fixed deposits, or recurring deposits.

However, that doesn't allow you to withdraw your deposits when the bank is placed under moratorium by RBI. But still, your money is safe up to ₹5 Lakhs. Do note this insured is per bank and not per bank branch or per bank account. You can refer to the whole insurance guide here. Things that you should take care of while choosing a bank.

The first piece of advice we would give you that is to avoid opening a bank account in a Co-Operative Bank. You should not choose a bank just because it provides you a higher rate of interest on your deposits.

Bank accounts are meant to provide you liquidity while ensuring some returns. So, don't think of your bank deposits as your Investments. Bank Deposits are your umbrella for a rainy day and it should be the case. Always think of the safety of your liquid funds over Returns.

Always prefer to have your bank account with a Nationalised and Reputed bank.

If you do choose to open an account in a co-operative bank, don't deposit more than 5,00,000 per bank.

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