Inoperative Accounts

Bank’s have historically understood Inoperative Accounts as those where there have been no operations for some time. Some banks have an additional category called a Dormant Account.

RBI issued instructions to be followed by all banks to the effect that an account where there are no customer induced operations for 2 years is deemed an inoperative account. Money deposited by the customer in the account, a withdrawal by cheque or at an ATM are examples of customer induced operations. RBI had earlier clarified that credit of interest from a fixed deposit of the customer in to a Savings Bank account constituted a customer induced operation in the Savings Account. Credit of interest from the Savings Account itself does not constitute a customer induced operation.

Recently RBI has further clarified that credit of dividends on shares as per the mandate of the customer also constitutes a customer induced transaction. An account will become Inoperative only after 2 years from the date of the last customer induced operation.

The purpose of classifying an account as Inoperative is to alert the staff and guard against risk of fraud. Any attempt at a transaction in an Inoperative account will need to be approved at a supervisory level.

It is not very clear why the Bank should be much concerned about whether there are operations in the account or not. The objective is to prevent fraud. The solution for that is to ensure that the customer is aware of the account and is regularly monitoring it. Bankers are aware that there are certain types of errors that may not come to light unless pointed out by the customers. If a credit intended for A comes accompanied by all particulars of B’s account, a credit to B will show no error in the Bank’s books, unless A claims non credit or B complains of unrelated credit. Checking cannot prevent such mistakes. Customer’s verification of her account is essential. In electronic transfers RBI has warned customers that banks cannot be expected to verify the customer’s name against the account number and will credit the remittance based on the account number. Only the customer can point out a credit to an unintended account.

Therefore, the key question is whether an account is monitored by the customer or not. Not whether there are operations in it or not. If a devout Muslim intends to save money for 5 years and does not want to accept interest, the only option available to him is to open a current account. Should the Bank compel him to make operations in the account? He has no need to. In any case, banks have now realised that all operations, deposits and withdrawals, have a cost and there is no need to encourage customers to transact unless they have to. I suggest that an account in which there has been an Internet Login during the past one year need not be deemed inoperative. If the account has no internet banking arrangement, a balance confirmation certificate taken from the customer say, 3 months before an account is to become inoperative should be adequate. A SMS of the balance in the account which is acknowledged with an mPIN by the customer should also be adequate. It is not clear to me why in these days of high transaction costs we should insist on operations by a customer who does not want to operate. In fact, credit of interest from FDs or dividends from shares can continue for long after a customer is incapacitated or dead, leaving the account vulnerable to fraud.

Prepayment penalty on floating rate term loans

RBI has now instructed banks not to charge foreclosure charges/ prepayment penalties on all floating rate term loans to individual borrowers. This was a long-standing customer demand. As in most other industries, in banking too new customers often benefited at the expense of existing customers. When interest rates went down, existing borrowers did not get the benefit. If they tried to become new borrowers of another bank and close the loan with the present bank, they were charged a stiff prepayment penalty that made switching not viable. So, borrowers in effect became hostages. The circular frees the hostages. However, it does not extend to other entities such as partnerships and limited companies in trade and industry. Presumably, it will apply to a proprietorship business, say, a doctor or a farmer. Nor  does it apply to fixed rate loans where the borrower has taken a calculated risk for a lower rate.

Accounts in the name of minors

Banks had always allowed minors to operate accounts but the age at which this was allowed had differed from bank to bank. Some banks wanted minors to be able to sign ‘uniformally’. Since signature verification was the key in identification until the advent of the PIN/Password or Bio-metrics, the ability to sign more or less the same way at all times was critical to operate an account. But most of the fears were unfounded and as is often the case, a push from RBI gets things moving. RBI has now advised that minors above the age 10 years may be allowed to open and operate savings bank accounts independently. Banks, may, however, fix limits up to which the accounts may be operated, taking age into account. Readers will note that current accounts are not allowed for minors because of the possibility of an inadvertent overdraft. Minors cannot contract and a debt from a minor cannot be collected in courts of law. 

Risk Weighting or Simple Leverage

For about a decade now, bank regulation had hinged on two basic concepts. One is risk weighting. The other is capital adequacy. Risk weighting implies that assets on a bank’s balance sheet should first be converted by a factor depending on the riskiness of the asset and only the resulting ‘risk weighted assets’ should be added up. This aggregate will then be multiplied by what is known as the ‘capital adequacy ratio’ to determine how much capital the bank should maintain. Seems logical but in practice, banks and regulators underestimated the risks on banks’ balance sheets and capital was found inadequate when crisis struck. American regulators now propose to impose a minimum ratio of capital to (all) assets (called the ‘leverage ratio’) of 5% on the country’s biggest banks. (6% if the bank qualifies for deposit insurance). Is it good-bye to risk weighting then? Not so fast, perhaps. A leverage ratio of 3% already exists, in addition to the capital to risk weighted assets ratio of 8%. Expect the leverage ratio to go up all over the world, including in India.

Post Bank of India?

RBI issued only two banking licenses recently. The application of India Post is being considered separately. The Post Office has two important advantages. An impressive physical presence already in existence and the strength of the Sovereign behind it. The Japan Post Bank has long been among the largest deposit holders in the world. Even in  US, financial services by the Post Office has been proposed (see link) The Indian Post Office already offers a basic savings account and time deposits but offering full service banking is another game altogether. Nevertheless, a Post Office Bank will be accessible and will be trusted, forming the basis of banking. Expect an India Post Bank in 2015?

Central Repository of Information on Large Credits (CRILC)

Communication gaps between different banks financing the same borrower have always existed. A common approach by all institutions in a multi-creditor situation is certainly desirable when the exposure is stressed. But the first step towards any such ideal is that all participants should have the same information at their disposal. Hence, RBI’s Central Repository of Information on Large Credits. All banks are required to report basic information in respect of all exposures in excess of Rs 5 crores to a central database. Knowledge of experience of other lenders is sure to improve the quality of all lending

Bye, Windows XP

Unless you have been away in Mars for a few years now, you know that Microsoft has discontinued support for the Windows XP operating system. It has been some years now since Windows 7 came on the scene, followed by Windows 8. But Windows XP was a popular OS and and is still used by many banks. In particular, it is widely used in ATMs. To change to a new OS in all ATMs is a large exercise, so banks have been postponing the day of reckoning. RBI has now advised banks to get on with it so that systems are secured even after the help from Microsoft for XP ceases. Banks are said to be working out a separate deal with Microsoft for continued support for XP for some time. Users may not notice this but the developments show one feature of technology, that is you have to spend money on upgrading it every so often.

Overnight Repo Under LAF

In the last Monetary Policy Statement, RBI did not revise the interest rates that it charges to banks for borrowing from it. Instead, it reduced the amount of borrowing available under overnight facility (where the rates are lower) and increased the amount of borrowing available under medium term  – 7 days and 14 days – facilities (where the rates are higher). It is as though, a commercial bank told a borrower that we are not increasing your cash credit rate of interest, just that you have to take more of your borrowing as term loans at a higher rate. In effect, interest rates have been raised.


Stress Testing in banks

RBI has come out with guidelines on stress testing for banks.

It is a technical document. The actual process of stress testing is likely to be confined to a small team at the corporate offices of  banks. The underlying principle, however, is straight forward. What if things go wrong? This can be compared to a fire drill. Call it a virtual fire drill. The emphasis, however, is not so much on the individual’s response to a fire but more on the construction, fixtures and the firefighting equipment.  What if the fire is big, very big and lasts long? Are the building and contents fire-retardant or inflammable? Is the fire fighting equipment in place? Similarly for a bank, stress may come from a sudden increase in interest rates, a sudden rise in NPAs or a sudden demand for cash.

Stress testing is linked with another process known as the ICAAP, which asks banks to measure for themselves the adequacy of the capital they hold. Of all the measures regulators use to keep risks in banks under control, the most important is the one requiring them to hold capital, or owners’ money, in proportion to the risk that the banks take. Stress testing will give you an idea whether the capital that you hold will be enough under conditions of stress.

The common stress factors are interest rates, exchange rates, equity prices and likely NPAs. Loans that may be viable when the interest rate is 12% p.a. may no longer be viable when the interest rate is 14% p.a. Borrowers might not be able to afford the higher rates and more NPAs are likely. How much more? Will it push the bank in to the red? Sensitivity tests are carried out to find out the impact on income at different levels of severity of the stress factors. The stress testers have to keep correlations in mind. Interest rate changes will impact exchange rates and share prices. To go back to our physical analogy, earth quakes may cause fires and flooding causes short circuits. Power and drinking water supply is disrupted in a disaster.

Banks face credit risk on their loans, market risk on their investments and operational risk on just about every thing else.  Changes in interest rates create interest rate risk. But the risk critical to banks is liquidity risk.

As much as capital, banks also need to keep liquidity. You may have the best assets but your ATMs have to be loaded all the time and every demand for withdrawal of deposits has to be met. Accepting deposits repayable on demand is the unique selling point of banks, and if that does not work, what is called a feedback loop starts. When people who ask for their money do not get it, others panic and ask for their money back, too and if sufficient numbers join the run, the best bank will go under. In the wholesale markets, if investments lose value, investors will be compelled to sell to keep their safety ratios in tact. This will depress prices further, creating second order effects.

In addition to sensitivity tests, the bigger banks need to carry out scenario tests – where many things go wrong at the same time. The Harshad Mehta scandal in India and thee 2007/2008 sub-prime crisis in USA are examples. Banks are inter connected in various ways. They lend to each other, participate in the same loans, and customer payments keep passing from one bank to another.  With such linkage, there may be a general loss of confidence all around. Stress testing also extends to a situation where there are such system-wide problems. 

There is a concept of reverse stress testing too. This measures how far things have to go wrong to cause serious damage to earnings. Instead of assessing the impact of stress, the exercise assesses the stress that will cause a particular impact.

The quality of collateral and its realisability will also be part of a stress test. Instead of a sudden stress, a period of prolonged low level stress should also be visualised.