Monetary policy analysis: The undesired consequences of capital increment plan!!

December 10, 2018 | Investopaper

SOM THAPA

Chiranjivi Nepal, the governor of Nepal Rastra Bank, implemented a policy of increasing the paid-up capital of banks and financial institutions immediately after he joined the office on March 2015.

The directive

In the monetary policy of F.Y. 2015/16, the governor conveyed the directive as:

“BFIs will be required to increase the minimum paid-up capital in order to promote financial stability and mobilize the resources needed for long-term development. Commercial banks will be required to increase paid-up capital to Rs. 8 billion, national level development banks Rs. 2.5 billion, development banks operating in 4 to 10 districts Rs. 1.20 billion and the development banks operating in 1 to 3 districts Rs. 0.50 billion. Similarly, national-level finance companies and finance companies operating in 4 to 10 districts will require Rs. 0.80 billion paid-up capital and those operating in 1 to 3 districts Rs. 0.40 billion paid-up capital. BFIs are required to meet this provision by mid-July 2017. In addition, BFIs will be further encouraged for merger and acquisition.”

The idea behind this huge increase in capital requirement was to strengthen their financial condition. The hidden motive was to decrease the number of financial institutions by indirectly forcing the merger between similar financial institutions. The rationale behind this was that the financial institutions would not be able to raise 4 times the capital through additional new capital (right shares) or through the retention of their profits (bonus shares) in such a short span of time, so they would be forced indirectly to merge with one another. The plan worked as intended to some extent.

The paid-up capital ceiling has been reached by most of the institutions and the number of development banks and finance companies has dropped from 76 to 33 and from 48 to 25 respectively. However, commercial banks were more rigid to merge with each other.

In the monetary policy 2018/19, the governor has said: 

“The capital increment plan along with the merger and acquisition policy introduced by this bank has induced 162 BFIs to undergo a merger and acquisition process. In this process, the license of 121 institutions has been revoked thereby forming 41 institutions. There has been a marked decline in the number of BFIs since mid-July 2015 when the policy provision for significant paid-up capital hike was introduced. During the last three years, the number of commercial banks has come down to 28 from 30, development banks to 33 from 76 and finance companies to 25 from 48. Though the number of development banks and finance companies has significantly come down after the introduction of paid-up capital increment plan, the number of commercial banks has not come down as expected. “

The paid-up capital increment policy has been almost fully implemented and the policymakers might be congratulating each other for the successful implementation of their policy. However, there have been side effects of their policy which they were fully unaware of while formulating those policies. All doctors have knowledge about various medicines that can cure the patients’ disease. An average doctor prescribes any medicine which will cure the disease. A good doctor, however, only prescribes that medicine which will cure the disease with as little side effects as possible.

Likewise, a good policymaker should be able to envision not only the intended consequences of his actions but also unintended consequences which may overpower the positives that the action is intended to create. In this respect, our governor and his policymakers failed miserably. They were completely blind to all the other consequences that their action would bring with time.

The side effects of the policy

1. When the capital increment plan was implemented, a huge amount of capital was pulled out from other sectors of the economy and into the banking sector. So, the banking sector was surplus with excess capital which earned lower returns and other sectors of the economy which could have earned higher returns were deficient of capital.
2. The increment in capital pressured the management of banks to increase their profitability. So, the banks were unable to focus on long term business and competed with one another harshly. This increased the interest rate on deposits which proportionately increase the lending rate (interest on loans). This affected both the banks (increase in the cost of the fund) and borrowers (increase in interest on the loan).
3. The intense pressure to improve profitability in relation to increased capital pushed the banking institutions to increase their loan portfolio rapidly. This created the mismatch between deposits and loans thus inducing the credit crunch that is repeatedly occurring in the banking sector. The credit crunch is the unavailability of funds to provide credit to the borrowers.
4. The huge increase in the capital increased the supply of shares through bonus and right shares. Oversupply of shares, higher interest rate, and repeated credit crunch led the booming stock market in the opposite direction crashing more than 40% to 1131 from its all-time high of 1889. The investors lost more than one-third of their money in this period and are still continuously losing.
5. The higher interest rate on deposits and loans is harmful to the economy as a whole. It promotes savings and discourages investment. Who would risk their money on business when they can get 13% interest on their money? Also, who would take the risk of doing business by borrowing money at 16-17% interest?
6. The higher interest rate, the repeated credit crunch in the economy and the depressive stock market are the current side effects of the policies what our dear governor was so keen to implement. Although the banking sector is also responsible for the ongoing crisis in the economy, the major blame should be taken by the governor. “People respond to incentives” is one of the principles of economics. When tax rates are reduced, it provides the incentive to people to work harder since they can keep more of their income. On the other hand, if tax rates are increased, it demotivates people to work more as they have to give more portion of their hard-earned income to the government. In the same way, the huge capital incremental policies induced the banking sector to become aggressive in order to earn sufficient return on their capital. The major problem is not in the banking behavior. They merely acted as the policies induced them to act. The defect was on the policies that were implemented looking only one side of the coin, the policy maker’s side. They could not see the consequences of their policies on the companies, on the people working in those companies, on the economy and all other entities affected by those policies.
7. There was something wrong in the policy as well. The objective of capital increment was to strengthen the financial condition of banking institutions. However, the policymakers failed to see that the strength is not absolute but a relative concept. How much capital is optimal for banks? No one knows. It should probably depend on the size of deposits the banks possess (in order to protect the interest of deposit holders). NIC Asia has more than Rs. 160 billion in deposits with Rs. 8 billion in the capital. On the other hand, Civil bank has Rs. 40 billion in deposits with Rs. 8 billion in the capital. Civil bank has way more capital for its size of deposits than NIC Asia bank. Civil bank could have Rs. 2 billion in capital to utilize Rs. 40 billion and maintain the same level of capital strength as NIC Asia Bank. So, was it fair to the civil bank that it was forced to increase its capital to Rs. 8 billion which would earn way below average returns?

What policy would have been ideal?

The optimal capital increment policy would have been to increase the capital based on the size of their deposits or their assets. Suppose, the directive could have been to maintain the size of the deposit at 15 times the size of capital. A bank with Rs. 1 billion in the capital could collect Rs. 15 billion in deposits at most. The bank with deposits collection of Rs. 120 billion would have to increase its capital to Rs. 8 billion.

If some banks want to remain small, they should be allowed to do so. We need big banks for bigger projects. But we also need smaller banks for smaller projects. Sometimes small can be better. Small can be beautiful. In the economy, size does not matter, efficiency does.

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