Banking Distress: Causes and Remedies

The past three years or so have witnessed rapidly increasing stress in the Indian banking sector, with non-performing assets (NPAs) steadily climbing from under 3% to over 11% of total assets. Loan-loss provisioning for these NPAs has seriously eroded the capital base of a number of banks, thereby limiting their ability to make further loans.1  There is now general consensus that the state of Indian banking is one of the biggest challenges facing the country in accelerating investments and growth.2  Expectedly, given the magnitude and gravity of the problem, much has been written and debated about ways of tackling current NPAs and of preventing recurrence of such a problem in the future.3

There is certainly urgency in finding a solution to the current NPA problem, but diagnosing the cause(s) and putting correctives in place is perhaps even more important.  Unfortunately, the entire discourse around this issue appears to have boiled down to the governance practices in public sector banks (PSBs), particularly political interference and crony capitalism.  The solutions, therefore, have more or less polarised around two ideologically coloured views – (a) privatisation of PSBs; or (b) strengthening independence and capacity of PSBs. While this is a perfectly legitimate debate and may well lead to a part of the solution, it should not forestall the search for other causes, which may be just as important, and perhaps more tractable.

The Causes

The purpose of this article is to argue that much of the problems currently being faced by the banking sector arise from a fundamental change that occurred in the Indian banking sector after 2002. Prior to that, Indian banks mainly had two types of loans: (a) working capital loans to production entities, firms and farmers, which accounted for 76% of the banking portfolio; and (b) retail term loans to households for housing and durable goods, which was somewhat less than 20%.4  Since then the banks have been aggressively making term loans to companies for fixed capital investments, such as land, building and machinery. This now accounts for 38% of the banking portfolio, with working capital at 42% and retail at about 20%.  It so happens that the bulk of the NPAs by value are long-term loans to corporates.

This shift from short term working capital loans to long term loans has not gone entirely unnoticed.  Concern has been expressed in many quarters about the serious asset-liability mismatch in the banking sector, whereby the average tenor of assets (read loan portfolio) has been rapidly going up relative to that of the liabilities (deposits).  While this is certainly a matter of concern, it should be made clear that this is not the cause of the NPA problem. 

What is missed by the commentators is that there is a significant difference between the de jure (contractual)and the de facto (behavioural)tenors of bank deposits.  The average de jure tenor is usually computed by taking the weighted average of the contractual tenors of demand and term deposits, which works out to around 2 years.5  However, most deposits, both demand and term, usually remain with banks for much longer periods, which can be as high as 14 or 15 years.  Thus, the de facto average tenor is probably above 10 years, which may well be higher than the average maturity of the loan portfolio.  This difference between the de jure and the de facto means that the asset-liability mismatch becomes a problem only when there is a loss of depositor confidence and withdrawal of deposits.6 This is not the situation as yet.

In my opinion, the NPA problem has arisen from four features that characterised bank loans for fixed capital formation:

  • Banks did not, and even today do not, have the capacity to assess the long-term credit-worthiness of borrowers.  They rely almost exclusively on assessments made by credit-rating agencies.  Unfortunately, the credit-rating agencies provide ratings only when the company concerned intends to raise debt capital directly from the market.  Therefore, in cases where the company has not issued long-term bonds, there is no real basis to judge the viability of the company.7
  • Banks have no capacity to monitor the use of the long-term loans by the borrower.  This is particularly egregious for project loans, especially when it is without recourse.8  The consequence of this inability is that the parent company can use the funds for purposes other than for which they were borrowed without the banks being any the wiser.  As a result, whatever little appraisal was done initially becomes seriously vitiated.
  • Most importantly, such loans create an existential problem for the borrower since attaching such assets essentially means “winding up” the companies.    It is only natural that company promoters would fight such an eventuality tooth and nail.  Since winding up petitions, especially with multiple lenders, was a complex legal process, which frequently took 7 to 10 years in the courts, with promoters using every possible trick to stall proceedings, banks faced the alarming prospect of making large loan loss provisions which would stay on the books for many years with very little recovery at the end. It is no wonder that bank managements have allowed these potential NPAs to simply accumulate over the years through myriad forms of “ever-greening”.9 Reserve Bank of India’s (RBI) forced recognition of these NPAs since 2015 has now brought the problem to light.10
  • Finally, there was gross mispricing of loans by the banks.  In practically all banks, the yield-curve is almost parallel to, and sometimes even flatter than, the yield-curve on government securities. Even if the banks were unable to assess the appropriate risk premium at different tenors due to (a) above, there is no reason why a premium was not attached to the illiquid nature of the underlying collateral, which is also related to (c) above.

The Origins

This high exposure of banks to companies in fixed assets, especially in project finance, did not happen by itself, but at the behest of successive governments.  It really begins with a decision taken by the government in 1997 to stop issuance of tax-free bonds by the Development Finance Institutions (DFIs), which were the main source of term finance for corporates.11 This closed the only source of relatively low cost funds for these institutions, and was instrumental in some of them converting to commercial banks and others shutting down.  Consequently, Indian commercial banks were forced to fill the vacuum and, in effect, convert themselves to ‘universal banks’.12

The problem escalated due to the government’s focus on infrastructure during the 2002 to 2009 period, especially with the efforts made in promoting ‘public-private partnerships’ (PPPs).13  This led to a rapid increase in project financing to private infrastructure firms.  The global financial crisis in 2008-09 again required the banks to take substantial further exposures in long-term loans as external loans taken by Indian corporates simply dried up.14  If the Indian banks had not stepped in at that time, many large and important projects would have simply collapsed with enormous collateral damage to the economy.  No government could tolerate such a possibility.

The question then arises that whether compelling banks to enter project finance in the absence of any alternate source of finance or back-stopping the cessation of external loans amounts to ‘crony capitalism’?  A bit of rational thinking should convince one that such is not the case.  This of course does not necessarily mean that crony capitalism was not present, but putting it all down to that one factor requires a lot more evidence than exists.  Therefore, to pin all the blame on poor governance in PSBs, especially by government interlocutors, appears gratuitous.  There needs to be far more thought given to fixing the structural limitations within which the Indian banking sector exists.

The Current Solutions

The first and, by far, the most important solution to the NPA problem is to provide for rapid resolution of defaults. It should be remembered that something similar used to happen earlier with working capital loans as well.  This was taken care of by the promulgation of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act in 2002, which resulted in Gross NPAs being reduced from 19% in 2002 to 6% by 2006 and even lower thereafter.  However, the SARFAESI Act is of consequence only in cases where the collaterals are moveable assets, and especially where there is a single claim-holder.  It is simply not appropriate for fixed capital loans with multiple lenders.

The need for a Bankruptcy Act was anticipated and recommended in the Tenth Five Year Plan as far back as 2002.  After much delay, the Insolvency and Bankruptcy Code (IBC) was eventually passed in 2016, which has now made it much easier for banks to effect recovery through liquidation of fixed assets.  As the IBC institutions and processes are strengthened, it should take care of the existing NPAs and, up to a point, the need for banks to do ever-greening.  However, it does not in itself address the other issues associated with long-term loans, especially that of mispricing.

Other than the promulgation of IBC, the government’s response to the banking crisis has rested on two pillars: (a) recapitalisation of the public sector banks (PSBs); and (b) merger of PSBs.  Unfortunately, both these measures only serve to improve the capacity of the banking sector to extend new loans, but does nothing to address the underlying the structural problem faced by it.  The recapitalisation is an essential measure to restore the CRAR to levels at which the banks’ can lend again. Fair enough; this is a price that has to be paid for imprudent loans in the past and the ever-greening that had taken place.  The bank mergers have been presented as a way of creating fewer, larger and stronger banks which can take on international competition.  This is really eye-wash.  The Indian banking sector faces absolutely no challenge from foreign banks, and it is really difficult to argue that we have too many banks in the country in view of the fact that we are still a severely under-banked country by global standards.  In reality what this measure does is to take a number of banks which were under RBI’s Prompt Corrective Action (PCA), and therefore unable to expand their loan portfolio, out of this constraint.  Does this improve matters? Sadly, the answer is: no.

The Needed Remedy

The real solution lies in tackling the structural problem being faced by all Indian banks, whether they are presently in trouble or not.  There is, in particular, one measure that is essential to address the fundamental change that has taken place in Indian banking, and which is not even under discussion.  Indian banking laws follow the “Anglo-Saxon” model in which there is a fire-wall between commercial and investment banks.  The shift to ‘universal’ banking should have been accompanied by amendments to these laws, but we chose to follow a ‘reform by stealth’ approach.15  The key change is that countries which have a “universal” banking model, such as Europe and Japan, permit banks to issue bonds for financing term loans. Our Banking (Regulation) Act 1949 does not do so. Banks can issue bonds only for raising their own capital. 

The only way to correct this problem would be to amend the Banking Act to permit issuance of bonds by banks for on-lending.16  Ideally, banks should be required to ensure that a minimum percentage of their term loans are financed by long-term market borrowings. Such a measure would have a number of positive effects.  First, if the banks are required to issue bonds to finance a part of their term loans, it would lead to a much more rational (read steeper) yield curve on bank loans since the interest rate on bank bonds would be significantly higher than those on deposits.

Second, a more rational yield curve would also probably drive some corporates to borrow directly in the bond market, thereby reducing the pressure on banks.  The Security and Exchanges Board of India (SEBI) is considering making it mandatory for listed companies to raise a part of their long-term debt from the market, but this can potentially be very distortionary in terms of credit allocation in the economy.17  A more rational bank yield curve would obviate some of this distortion since there would be a self-selection element in companies’ decision to issue long-term bonds.18

Third, this would automatically correct the growing asset-liability mismatch problem, and thereby improve the credibility of the banking sector as a whole.

Finally and perhaps most importantly, since banks would have to get themselves periodically rated, the yield curve of individual banks would reflect the strength of their loan portfolios.  As a result, banks with weaker balance sheets will have to offer higher interest rates on their bonds, which will get reflected in higher interest rates that they will have to charge to the same potential client.  This should have the effect of introducing a self-correcting mechanism in the lending behaviour of banks well before they run into serious problems.

Thus, the choice facing the government is clear: either revert to the status quo ante where banks eschew lending for fixed capital formation; or amend the banking laws to reflect the new reality.19 The patchwork tinkering that is going on at the moment simply postpones judgement day; but that day will certainly come, sooner or later.


REFERENCES :-

1. Banking laws require banks to limit their loan portfolios to a particular multiple of their capital base, referred to as the Capital Adequacy Ratio (CAR).

2. The other two major challenges being: (a) the precarious state of the world economy; and (b) rural distress.

3. A simple web search reveals that there are more than 100,000 articles on how to tackle the NPA problem in Indian banks and more than 200,000 on its causes.

4. The remainder was term-loans to enterprises, mostly as ‘bridge finance’.

5. Demand deposits (termed CASA in banking parlance) can be withdrawn immediately, i.e. a contractual tenor of zero, and term deposits have contractual tenor that vary between one and five years.  Since CASA usually is between 40 to 50% of total deposits, the average comes to around 2 years.

6. A ‘bank run’ is an extreme case of this.

7. Most corporates do have ratings for shorter durations, and banks tend to use these as proxies for long-run risk.

8. ‘Without recourse’ means that the lender has no claim on the assets of the parent company, but only on those of the project (which are usually developed through special purpose vehicles (SPVs).  Most infrastructure loans fall into this category.

9. Since balance sheets and profit and loss accounts are the basis on which management is evaluated, ‘kicking the can down the road’ is a time-honoured practice of top management in non-promoter driven companies, which almost all banks are.

10. The ‘poor governance in PSBs’ narrative, which hinges around higher NPAs in PSBs relative to private banks is driven by two, not necessarily independent,  factors: (a) private banks tend to have lower proportion of project loans than PSBs; and (b) some private banks are in fact promoter-driven.

11. The main DFIs were Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI) and Industrial Investment Bank of India (IIBI).

12. ‘Universal’ banks perform the roles of both commercial banks and investment banks.

13. At this time, infrastructure was included in the ‘priority sector’ list.

14. There had been a sharp increase in external commercial borrowings by Indian corporates, which rose from about $3 billion in 2002 to $28 billion in 2008.

15. The U.S.A., which also followed the same model, adopted a legislative approach to move to universal banking by diluting the Glass-Steagal Act.  The U.K. too acted similarly.  In both cases, there has been a reversal after the global financial crisis, which we would do well to bear in mind.

16. It surprises me that RBI has not demanded this change.  I can only ascribe it to ‘lazy’ regulating – to use RBI’s own expression.

17. The logic of the proposal, at one level, is sound in that it will force all listed companies to obtain long-term ratings, which will be useful not only for banks but also for equity investors.  However, it can work against younger companies, especially those which are recently listed.

18. This could of course lead to an adverse selection problem, which implies that banks need to improve their appraisal capabilities in any case.

19. In all fairness, over the years the government has tried to create new institutions for infrastructure lending, but with a singular lack of success.

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Despite a brutal second wave with cases peaking in April-May 2021, India’s Gross Domestic Product (GDP) grew at a record pace of 20.1 percent in the April-June 2021 quarter compared to the corresponding period last year. The GDP, in absolute terms, stood at Rs 32.38 lakh crore (constant prices). This was actually lower by 9.2 percent than the numbers seen in the April-June quarter of 2019-20. In fact, as the figure below shows, the April-June 2021 GDP numbers are closer to the levels seen during the January-March 2017 quarter.

Source: MOSPI (Annual and Quarterly Estimates of GDP at constant prices, 2011-12 series)

While growth in the April-June 2021 quarter is promising and reflects recovery from the deep plunge seen in April-June 2020, comparisons are being drawn with the pre-Covid levels. 

But what are these pre-covid levels? Should numbers of a single quarter, say April-June 2019-20 be used as the benchmark, or an average growth seen in the previous few quarters be considered as a benchmark for comparison? 

An alternate strategy

We propose an alternative way through which, we compare the present Gross Value Added (GVA) numbers (in level terms) with the numbers obtained using simple univariate time-series forecasts. These forecasts are obtained by exploring the time-series properties of the variable of interest. In particular, these forecasts are arrived at using the Autoregressive Integrated Moving Average models (ARIMA models). ARIMA is a statistical analysis model that uses time-series data to better understand the facts and to predict future trends. 

This comparison helps in assessing how distant are the current GVA numbers from the levels which would have been achieved had there been no shock in the form of the COVID-19 pandemic.   

Since GDP includes taxes, we look at the activity-based variable after excluding the impact of taxes. The variable of interest, therefore, is the Gross Value Added (GVA). We use the GVA data available from June 2011 till December 2019 and extend it using the projections obtained from a univariate ARIMA model. As mentioned before, in this model previous observations are used to predict future values. Therefore, we have excluded the period post-December 2019 to ensure that the trend is not influenced by the COVID-19 shock. 

The figure below shows the raw data along with the projections for the subsequent six quarters (from March 2020 onwards) based on the ARIMA model. These projections present a picture of the GVA trends under normal circumstances, i.e. if the economy would not have been subjected to the COVID-19 shock.

Adjustment for seasonality 

An economy, over the long term, experiences a concept known as seasonality. These are seasonal fluctuations, movements, that recur with similar intensity in a given period (such as months) each year, thus showing a clear pattern of peaks or troughs over a sufficiently long time period. Broadly, seasonality arises from several calendar related events such as – weather-based factors: monsoon, winter or summer months, agricultural seasons: harvest or sowing season, administrative procedures: tax filings, financial year closure, working days, festivals: Diwali, Christmas, etc., institutional: Annual budgets or Fiscal year ending, social and cultural factors: Statutory holidays, etc.

Such seasonality needs to be adjusted to comprehend the underlying trend, cyclicality, and other movements for a better understanding (Pandey et. al, 2020). 

The quarterly GVA series shown above exhibits seasonality and therefore we seasonally adjust the extended GVA series (GVA values till December 2019 along with the forecasted values) and compare with the seasonally adjusted actual data post-December 2019.  

The difference between the series till December 2019 extended with time-series forecasts and actual series post-2019 (both adjusted for seasonality) would give an assessment of the shortfall in economic activity arising due to the COVID-19 shock. 

Shortfall due to COVID-19

The table below shows the differences between the estimates based on the time-series forecasting and the actual values. We present this exercise for the overall GVA as well as its components. The key highlights of the comparison exercise are as follows:

Table 1: Difference between the Actual values and Estimated values (Rs. Lakh Cr)

*Both Actual and Estimated Values are seasonally adjusted

1. In the January-March 2020 quarter, the difference between the forecasted (estimated) values and the actual values is small. This is due to the limited impact of the pandemic during this quarter. 

2. However, the difference widened to Rs 8.7 lakh crore in the April-June 2020 quarter. This was the period of the nationwide lockdown. As a result, the economic activity was adversely impacted. The major difference was seen in the contact-intensive trade, hotels, and transport sectors. Since agriculture was not impacted by the pandemic, the projected and the actual agricultural GVA is the same. 

3. With the gradual opening up from the July-September quarter, we see that the gap between our estimates and actual values is reduced. However, the financial sector continued to reel under the impact of the pandemic. While some improvement was seen in the GVA of the trade, hotels, and transport sectors in the July-September quarter, there still was a significant shortfall of Rs. 1.4 lakh crore.4. In the October-December 2020 and the January-March 2021 quarter, a distinct improvement is seen in the actual overall GVA numbers. The gap between the estimated and the actual values for the overall aggregate GVA narrowed to Rs 0.8 lakh crore and Rs. 0.3 lakh crore for Oct-Dec 2020 and Jan-Mar

2021 quarter respectively. Except for the trade, hotels, and transport sector, the gap was less than Rs 1 lakh crore for all the sub-sectors. 

5. But, the April-June 2021 quarter revealed that the gap has widened to the tune of Rs. 5.3 lakh crore. This shows that while the recovery was underway, the onset of the second wave and the consequent partial lockdowns pulled back the growth momentum to some extent. The sectoral variations are also worth noting. While agriculture, mining, and manufacturing showed stellar performance despite the second wave, the contact-based services sector (trade, hotels and transport) pulled down the growth. The construction sector also bore the brunt of the second wave.

The above exercise presents an alternative approach to assess the shortfall in GVA numbers due to the COVID-19 shock. There are sectoral variations: while agriculture posted a robust growth and the manufacturing sector was relatively less impacted, it is the contact-intensive sector that primarily got affected due to the shock. Our exercise shows that after the April-June 2020 quarter, the economic recovery was gaining momentum. However, the second wave led to a pause in the recovery process. 

Going forward, with a sustained pick-up in the pace of vaccinations, we should see economic recovery getting back on track. The high-frequency variables such as exports, PMI manufacturing and services, petroleum products consumption, electricity consumption, and GST collection, etc., also suggest a pick-up in economic activity since the beginning of the second quarter. 

The authors are Senior Fellow and Fellow respectively at the National Institute of Public Finance and Policy (NIPFP), New Delhi. Views are personal.

The Union Budget for FY 2021-22 presented on February 1, 2021 has the distinction of being the first budget after Covid-19 devastated much of the world, including India. India registered a historic contraction of nearly 24% in its Gross Domestic Product (GDP) in the first quarter of the current financial year, unemployment surged, small enterprises suffered acutely and vulnerable households slipped into poverty. During the course of the year, the government announced a series of measures to alleviate the Covid-19 induced stress. Since then, there have been signs of a nascent recovery in the economy. In this context, there has been tremendous anticipation around this budget to put India firmly back on the growth path. 

Towards this end, the budget has made many noteworthy announcements. Two key announcements stand out viz., a push to the privatisation agenda by announcing the privatisation of two public sector banks and an insurance company, and the establishment of an asset reconstruction company to take over the Non-Performing Assets (NPAs) of banks. 

Privatisation of public sector banks

Signalling a clear and key policy shift, the government has announced an ambitious and strategic privatisation policy by proposing to disinvest/strategically sell public sector entities (PSEs). Towards this end, the government has approved four sectors as strategic, where it will retain a minimum number of entities. It will pare down its presence above this minimum in strategic sectors, and completely in non-strategic sectors. Notably, banking, insurance and financial services have been identified as  strategic sectors.  

A number of central PSEs (including Air India, Shipping Corporation of India and the Container Corporation of India) have also been identified by the budget for divestment this fiscal year. Further, the NITI Aayog has been tasked with identifying the next pipeline of central PSEs for disinvestment.  Within this overall context, the current budget has also proposed to privatise two public sector banks (PSBs) in addition to Industrial Development Bank of India (IDBI), and a general insurance company.  

Privatisation of PSBs is not a new idea. It was attempted earlier as well.  The former Finance Minister, Yashwant Sinha, proposed to bring government stake below 51% in PSBs in early 2000s. However, this did not garner enough support. Given the burgeoning requirement of capital by PSBs and the limited fiscal space with the government, it has now become imperative to find other avenues to bridge the gap.  The proceeds of the disinvestment could help release government resources to more productive uses, particularly as government finances too have come under tremendous pressure in the wake of the pandemic.  

Moreover, with the approval of banking as a strategic sector, and the maintenance of public sector presence, the government should be able to avoid any compromise on its social agenda – a key concern that has been flagged earlier on privatisation of banks. 

Resolution of bad assets

Flow of credit is an imperative to meet the needs of a growing economy. A surge in bad or non-performing assets impedes the flow of credit. This is because banks must make higher provisioning to cover their bad assets, reducing the overall credit available to firms and households. It also makes banks risk averse. 

Measures to provide relief to borrowers such as the moratorium on loans – could exacerbate the problem of bad loans. An improvement in the NPA ratio of the banks was visible before the pandemic but the policy support extended to borrowers could impact the asset quality of banks through postponement in recognition of bad assets. 

The Financial Stability Report released by the Reserve Bank of India (RBI) in January this year estimates a sharp rise in the stressed assets on the banks’ books, particularly in the case of public sector banks. A number of measures were taken by RBI to improve the flow of credit by banks; however, the offtake of credit is still slow. The need of the hour therefore is to resolve these bad assets and clean up banks’ balance sheets so they can begin to lend more freely. 

The budget tries to address the problem of bad loans by announcing an asset reconstruction company (ARC) and an asset management company (AMC). This mechanism is expected to take over the stressed assets from banks, manage and eventually dispose them for value. The assets may be disposed of to potential buyers which include alternative investment funds (AIFs).  

The idea of a “bad bank” has apparently been inspired by the experience of countries such as the US and Malaysia. The Malaysian government, for instance, set up “Pengurusan Danaharta Nasional Burhad” – a government-backed AMC – that successfully bought and resolved bad assets in the Malaysian financial system in the aftermath of the Asian Financial Crisis in late 90s. 

While details on the Indian initiative are sparse at this point, the proposed mechanism is understood to not be a government owned entity. Instead, this mechanism would be primarily led by banks, with the government offering some support – perhaps in the form of a guarantee. The success of this proposal would depend on how well the proposed entity is managed. It will also depend on the capital allocation strategy by banks and how much money the government sets aside for this entity.

The reference to Alternate Investment Funds (AIFs) and other entities as potential buyers perhaps hints at measures for improving the efficiency of the stressed assets market – an important step that must go hand in hand with the creation of a “bad bank”.  However, a pitfall that the proposed mechanism must guard against is the potential “moral hazard”. It must disincentivise, rather than incentivise, poor decision making by the banks that led to the bad assets in the first place. 

Both the above announcements mark important interventions in the banking sector. Their success will however depend on the actual details – of the institutional structures and enabling frameworks put in place. Implementation will also be key, given the competing interests when it comes to privatisation and the government’s own poor track record on divestment.  This will, therefore, be a keenly watched space in the coming year.  

The views expressed in the post are those of the author and in no way reflect those of the ISPP Policy Review or the Indian School of Public Policy. Images via open source.

On February 01, 2021, Finance Minister Nirmala Sitharaman introduced the Budget for FY 2021-22 in the Parliament. Budget announcements are always a highly anticipated event in India; this time the expectations were even higher for the government to provide a credible roadmap for recovery. However, ahead of the Budget, another bill rumored to be proposed during the session was making news. The to-be-proposed Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 has taken the nascent crypto-industry in India by surprise. The Bill has dual objectives of (i) banning ‘private’ cryptocurrencies in India and (ii) creating a framework for the Reserve Bank of India to issue official digital currency. While further details on the Bill are awaited, now is an opportune time to look at the current status of digital currencies in India and around the world.

The Reserve Bank of India (RBI) has viewed cryptocurrencies with a jaundiced eye. In April 2018, the RBI issued a circular, “prohibiting banks and entities regulated by it from providing services in relation to virtual currencies.” The circular was subsequently overturned by the Supreme Court on grounds of being a “disproportionate” response by the RBI. It further asserted that there was no evidence that any regulated entities had indeed incurred losses or instability on account of virtual currencies. 

Understanding Digital Currency

For a preliminary understanding of digital currency, one can look towards its most popular example – BitCoin. It was launched against the backdrop of the 2008 global financial crisis (GFC) as a bulwark against excessive printing of currency by central banks. The mystery surrounding the inventor, the legendary Mr. Satoshi Nakamoto, only added to the allure of the new digital currency. Here was a currency that was decentralized and maintained user anonymity while ensuring complete transparency for all transactions. BitCoin is limited to 21 million units, which are mined by solving complex mathematical problems (a.k.a. proof of work) and can then be traded on BitCoin exchanges. Blockchain technology, upon which BitCoin is built, has a certain democratic appeal; blockchain ledgers are immutable and can be changed only when such a change is validated by a given number of participants. Despite these advantages, there has been criticism against BitCoin or any of the non-fiat digital currencies to be used as a reserve currency, especially on account of limitations to being used as a medium of exchange

Opportunity for a Central Bank Digital Currency

In recent years, and perhaps consequentially, central banks around the world have begun to evaluate the possibility of a sovereign-backed digital currency also known as a central bank digital currency or a CBDC. This begets an obvious question – what indeed is a CBDC? Traditionally, money comprises cash, deposits maintained by commercial banks with the central bank and deposits with commercial banks. A CBDC introduces a new form of digital money which is a liability of the central bank. In theory, even retail participants could hold a CBDC in the future. Secondly, one might wonder, what are the motivations for issuing such a form of money? A report published by the Bank for International Settlements (BIS) in 2020 broadly categorizes the merits and risks of a CBDC as follows:

a. Payment systems – motivations and challenges

This category includes a multitude of motivations such as ensuring continued access to risk-free money in societies where cash is going out of fashion, improving financial inclusion, enhancing efficiency of cross-border payments, etc. Key risks in this category include ensuring cyber resilience and balancing public privacy needs with anti-money laundering requirements.

b. Monetary policy – motivations and challenges

If CBDCs are designed as interest-bearing instruments, then monetary policy transmission would, in theory, be immediate. This could incentivize commercial banks to accelerate passing on the effects of changes in policy rates. Whether CBDCs should indeed be interest-bearing instruments is a design challenge requiring further study.

c. Financial stability – motivations and challenges

A key motivation for central banks to evaluate issuance of CDBCs is to pre-empt the risk of loss of monetary sovereignty on account of displacement by privately issued digital currencies such as Diem (previously called Libra) by Facebook. However, introducing a CBDC introduces the possibility of a bank run in times of crisis from commercial deposits to central bank money.

Way Ahead

Money is an economic, social, and political phenomenon. Introduction of CBDCs requires careful planning, analysis, and balancing risks with efficiency motivations. Design choices abound in terms of technological architecture as well as features embedded in the instrument. In the Indian context, a well-designed pilot project aligned with social and economic realities is paramount. Internationally too, interest in CBDCs has increased, partially on account of the COVID-19 pandemic. A survey conducted by the BIS in 2020 revealed that 86% of central banks (out of a total of 65 respondents) were actively engaged with CBDC research, evaluation, and/or development (see figures below). China famously leads the pack in digital currency development adding a currency dimension to its competition with the United States.

Figure 1 Source: BIS Central bank survey on CBDCs. 1 Share of respondents conducting work on CBDCs.

Adoption of new technology is often scary, and rightly so, especially in cases where it has the power to improve or destroy entire systems. India’s financial system has been revolutionized by fintech, especially in the digital payments space. It is indeed time we re-visited the idea of money in light of the technology now available at our disposal. The to-be-proposed Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 signals India’s willingness in this regard.

The views expressed in the post are those of the author and in no way reflect those of the ISPP Policy Review or the Indian School of Public Policy. Images via open source.