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Wednesday, June 3, 2015

Banking & Research - XIII : Efficient Intermediation

Intuitively, we are all well aware that the banking and financial system of a country plays a key role in mobilizing savings from the society and channelling them into productive investments. It is this intermediation that ultimately defines the pace of a country’s economic development and the quality of life of its citizens. Indeed, society often takes for granted this critical function of transforming society’s savings into investments by banks. But, financial intermediation is fraught with many risks. Hence, a well-functioning banking and financial system is a must for a country’s long-term economic prosperity.

To accomplish the task of efficient intermediation, there is a real need for a sound institutional framework duly supported by an equally effective legal system that can induce households to save a part of their current income and entrust it to financial institutions for safekeeping. In the whole process of entrusting their savings to the banking system, the households would be interested in an adequate compensation for the quantum of risk they are taking under the exchange. And, for banks to fulfil this requirement, they must enjoy a wide array of safe investment avenues. Thus, the assets side of a bank’s balance sheet becomes equally important for financial intermediation. Any non-prudent lending exposes a bank to losses. Such losses on the assets side are certain to result in banks’ defaulting, under their obligations to depositors. If a bank’s ability to honor its deposit obligations is doubtful, then its very ability to retain deposits comes under question. Once depositors lose confidence in a bank, it becomes difficult for banks not only to retain the existing depositors, but also to mobilize new deposits. No wonder, if such a predicament generates a “run” on bank. Such a run on a single bank is potential enough to generate a contagion effect that can ultimately cripple the very financial system of a country. An efficient banking system, besides impacting the costs of financial intermediation and the overall stability of the financial markets, facilitates efficient allocation of the scarce financial resources, particularly in developing countries, paving the way for an integrated economic development. Thus, to have a sustainable economic growth the banking system of a country must be sound. An extension of this analogy asserts that prudent risk management systems are a must for a sound banking system. In other words, it is the management of balance sheet risks by the intermediaries that ultimately ensures a sound financial system in a country.

It is in this context that it has become a challenging task for every bank to formulate its “expectations” about macroeconomic indicators that are known to impact a bank’s business, and accordingly draft its risk management policies and practices. It is all the more aggravated with the kind of wild fluctuations noticed under various macroeconomic indicators such as rate of inflation, rate of interest, price of primary commodities, price of crude oil, etc., during the last two decades. Despite such wild fluctuations, the role of  ‘expectations’  in business decisions is gaining more importance. Today, a bank must be able to formulate its expectations about the conditions likely to prevail in the future, their impact on business prospects, and the counter-measures that can safely steer its investment plans in consistence with the expectations. A need thus arises for these expectations to be rational for averting any untoward shocks. But, expectations about the future behavior of economic variables such as rate of inflation, rate of interest, exchange rate, rate of primary commodities, etc., remained an enigma despite the evolution of statistical techniques such as the time-series analysis, econometric models, and survey of intentions of the concerned agents and organizations. The empirical literature about the accuracy and rationality of ‘expectations’ made about economic variables is quite limited. It is in this context that the article, “Do Bankers make Rational Economic Forecasts?”, attempts to evaluate the accuracy of the economic forecasts made by Malaysian banks and the rationality of survey data. The findings revealed that Malaysian banks do make rational economic forecasts for gross revenue and employment but not for capital expenditure.

As seen earlier, it is the credit portfolio that enables a bank to discharge its obligations to depositors and thereby ensures its sustainability. It is in this context that the article, Post-merger Banks’ Efficiency and Risk in Emerging Market: Evidence from Malaysia”, evaluates the effectiveness of the banking system in Malaysia in general and the impact of the mega-mergers in the banking system on the overall efficiency of the domestically incorporated commercial banks. The authors have used the non-parametric method of Data Envelopment Analysis to measure the effectiveness of mergers. They have also attempted to identify factors that determine the efficiency of banks by employing the Tobit regression analysis in the second stage regression. The results indicate that there is a minimal mean input waste among Malaysian banks during the post-merged phase. The results also suggest that a bank’s size has a negative impact, while market power has a positive impact, on the overall and technical efficiency of Malaysian banks.

In line with the central objective of managing the risk embedded in the balance sheet of banks for ensuring efficient financial intermediation, the article, “Duration Approach to Measure Bank’s Risks”, proposes a model to measure the risk that a bank faces in the discharge of its intermediation using duration gap between assets and liabilities. The article considers duration gap as a better approach to measure banks’ risk exposure since it factors in the impact of interest rate changes, and other shocks like market risk and exchange rate risk. The article, using a sample data collected from 16 banks to work out a duration ratio by using two proxies—one based on assets and liabilities, and  the other on interest revenues and expenses—concludes that the duration is measured based on interest revenues and expenses as a more reliable measure of a bank’s risk. This study throws open a larger scope for further research on the reliability of duration ratio as a measure of banks’ risk using time-series data over longer periods.

Greater attention is being paid towards infrastructure development in the country today. Private participation is encouraged even in sectors such as roads, ports, airports, etc. Simultaneously, new avenues for financing infrastructure projects are being thrown open. Even commercial banks are encouraged to lend to infrastructure projects in spite of the long gestation periods of such projects. At the same time, banks are also being subjected to rigorous regulatory supervision in terms of risk-based capital, identification of bad debts and provisions thereof. These conflicting demands have placed banks in a quandary, and thus, risk management has emerged as the prime requirement for the success of banks. Against this backdrop, the article, “A Model for Risk-based Pricing of Infrastructure Financing by Banks”, attempts to prescribe a model risk-pricing mechanism under infrastructure financing, by considering various macroeconomic factors that are prone to influence cash flows of the financed infrastructure projects.

In order to perform the role of financial intermediation in a country’s economy successfully, the commercial banking system must strive to strike a balance between risk-taking and the need to maintain public confidence. It is in this context that a well functioning government securities market including a viable secondary market can provide a set of safe assets that can support, at least, a certain quantum of intermediation with no risk. Simply put, a safe government debt essentially functions as collateral for financial intermediation by banks. That is the prime reason why the balance sheets of banks, particularly in developing economies, show large amounts of government debt on the assets side. Government debt also plays an important role as a benchmark for private sector bond markets. However, there is also a flip side: Too much exposure to government debt constrains the flow of credit to enterprises. Ever since Indian banking system has been subjected to rigorous prudential norms, banks have been found to maintain high exposure to government debt vis-à-vis private lending, as the latter is perceived as more risky. In this context, the article, “Government Debt: A Key Role in Financial Intermediation”, attempts to get as many plausible answers as there could be for the question, “Does state-contingent inflation on government debt represent an optimal way to conduct fiscal policy in response to shocks?”

Courtesy: IJBM Vol 4 No.4


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