Evidence of Negative Relationship Between Banks’ Holdings of G-Secs and Loan Growth: RBI Study

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Banks rebalance their portfolio of assets towards government securities safety (G-Secs) when economic growth slows or borrowers’ asset quality deteriorates, consistent with the portfolio rebalancing channel, according to empirical analysis by senior officials of the Reserve Bank of India (RBI).

At the same time, increased investment by banks in G-Secs in the face of higher government borrowing is crowding out private credit, although this may be mitigated to some extent by central bank market operations and that crowding out is lower for banks with better asset quality and greater capital adequacy.

“An increase in the share of public securities in banks’ asset portfolio has a favorable impact on their profitability, indicating a better risk-adjusted return on investment, although this result seems to be driven by public sector banks.

“Policies aimed at strengthening the asset quality and capital position of banks can lead to increased flow of bank credit to productive sectors,” said Sanjay Singh (Director, Department of Statistics and Information Management ); Garima Wahi (Assistant Adviser, Monetary Policy Department/MPD) and Muneesh Kapur (Adviser, MPD), in a working paper.

While holdings of G-Secs provide liquidity and stability to the banking system, they can also crowd out private sector investment by reducing the pool of loanable funds available from banks, the authors said, adding that this can hurt investments and to domestic production.

There is also evidence of a negative relationship between gross government borrowing/bank holdings of G-Secs on the one hand and loan growth on the other, indicating the presence of crowding out in addition to the phenomenon. portfolio rebalancing.

The paper finds a favorable impact of investments in G-Secs on the profitability of public sector banks, indicating better risk-adjusted returns on G-Secs’ investments compared to lending operations in an environment of increasing their non-performing assets.

On the other hand, for private sector banks, G-sec investments do not translate into higher profitability, in line with the conventional wisdom that higher loan returns relative to G-sec investments.

Referring to the observations of the eminent economist Luis Serven, the authors stated that if the increase in holdings of G-Secs by banks is associated with higher and efficient public investment spending, which stimulates potential output of the economy, then higher holdings of G-Secs can crowd into the private sector. sector investment.

Moreover, if government spending is counter-cyclical and minimizes the impact of a negative exogenous shock, such as the COVID-19 pandemic on the economy when private spending is anemic, then increased government borrowing may not result in eviction.

Finally, liquidity management operations by the central bank through various instruments such as open market operations in line with the current monetary policy stance to ensure adequate liquidity for productive purposes and the real economy can help offset the negative impact of government borrowing on bank lending.

Given the above, banks’ actual holdings of G-Secs at all times reflect a combination of their risk appetite, regulatory requirements, government funding needs, the state of the economy and central bank market operations, RBI officials said.

The portfolio rebalancing hypothesis posits that commercial banks prefer to move to safer and more liquid assets like G-Secs in times of stress – for example, when growth is weak, banks have non-performing loans ( NPL) higher and are insufficiently capitalized.

Banks may prefer to lend to the private sector rather than invest in G-Secs, given the higher risk-adjusted returns of such an approach.

However, banks struggling with consistently high NPLs may prefer to invest relatively more in risk-free G-Secs. In such a scenario, the increase in banks’ claims on G-Secs can be expected to have a positive impact on net interest margin (NIM) and return on assets (RoA).

Published on

July 08, 2022

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