Who Is Responsible for the Bad Loans (Non-Performing Assets) Problem?

A mud-slinging exercise is going on between the former Congress and present BJP government about who is responsible for the mounting non-performing assets (bad loans) problem. Political parties, as usual, are blaming each other for this mess.

Former RBI governor Dr. Raghuram Rajan implicated bankers themselves for this problem. In a note on bank non-performing assets (NPAs) prepared at the request of Murli Manohar Joshi, Chairman of the Parliament Estimates Committee, Dr. Rajan said The truth is bankers, promoters, and circumstances create the bad loan problem…The RBI is primarily a referee, not a player in the process of commercial lending. He also said, the government should refrain from setting ambitious credit targets or from waiving loans.

He also warned that the next crisis in India’s banking sector could come from loans given to the unorganised micro and small businesses, called MUDRA loans, and credit extended through the Kisan credit card.

How much truth is there in Rajan’s allegations that bankers, promoters and governments are responsible for this crisis and that RBI is just a referee and not a player and so not at all responsible for this mess? Let’s see.

To understand the NPA crisis, we have to understand how the modern banking system, especially the practice of fractional reserve, works. Historically banks evolved as a ware house where people used to keep their property for safe-keeping for which they had to pay bankers a safe-keeping fee. Bankers never paid any interest to depositors initially. When their depositors returned and demanded their property, which used to be money (gold and silver coins) mostly, they gave them back to them. Their profit in this business was in the form of the safe-keeping fees that they used to charge.

As time went by bankers slowly realized that they can actually utilize the idle money that is sitting in their ware house and earn extra interest above and over their safe-keeping fees. Doing this will be a breach of the deposit contract, because it amounted to a crime of embezzlement, but bankers took the risk to make that extra interest earning. When their depositors were out and not demanding their money back for a period of time, they loaned that money to third parties at interest. As long as they could time the gap, between depositors coming back demanding their money and the loan period, well they earned that extra interest. Whenever they misjudged this gap, they failed to fulfill their deposit obligations and went bankrupt and were either hanged till death or went to jail. Slowly they started giving interest payment to depositors themselves for using their money as loans to third parties instead of charging safe-keeping fees from them to hide their illegal tactics. Depositors’ still didn’t know that their money is being loaned out to third parties at a big risk. This was the birth of the system of fractional reserve banking i.e., keeping in ware house only a fraction of the original depositors’ reserve. And this is the system on basis of which the modern banking system works today.

As one can see, there are significant risks of bankers going bankrupt and depositors losing their money in this system.

As if this was not enough, with the advent of government installed central banking and fiat paper currency standard the risk increased exponentially because now the central banks themselves started printing, or digitally creating, fiat currencies to give them to banks as base money on which banks will pyramid their money via the process of money creation. Here is Prof. Rothbard discussing this great risk to the whole system:

We have seen that, by setting up a Central Bank, governments have greatly widened, if not removed, two of the three main checks on bank credit inflation. What of the third check—the problem of the narrowness of each bank’s clientele? Removal of this check is one of the main reasons for the Central Bank’s existence. In a free-banking system, inflation by any one bank would soon lead to demands for redemption by the other banks, since the clientele of any one bank is severely limited. But the Central Bank, by pumping reserves into all the banks, can make sure that they can all expand together, and at a uniform rate. If all banks are expanding, then there is no redemption problem of one bank upon another, and each bank finds that its clientele is really the whole country. In short, the limits on bank expansion are immeasurably widened, from the clientele of each bank to that of the whole banking system. Of course, this means that no bank can expand further than the Central Bank desires. Thus, the government has finally achieved the power to control and direct the inflation of the banking system. (What Has Government Done to Our Money, P. 77)

With the presence of central banks now the immediate risk of banks going bankrupt lowered because central banks are here to bailout the commercial banks when they get into trouble. But remember, central banks can’t bailout banks all the time. As the amount of bad loans increases, the risk increases dramatically even for the central banks. This process can only end in a crack-up boom i.e., a hyperinflationary depression.

Thus, as we saw above, the RBI is 100% responsible for creating rupees out of thin air and giving them to commercial banks to loan them out to everyone and their mother. RBI is also responsible for monetizing government’s fiscal deficit i.e., creating rupees out of thin air and giving them to governments to spend on their fiscal boondoggles. Without RBI enabling bankers, promoters and governments, these entities can’t create bad loans. The source of bad loans thus is RBI. RBI is neither a referee nor a player in this game of bad loans, but is the captain. Mr. Rajan can’t absolve himself by pointing fingers at others when all other fingers are pointing in his direction. The root cause of all our monetary, fiscal and other economic problems is our central bank RBI. Forgetting this 800 pound gorilla in the room will be a grave mistake for all of us. As long as RBI is not dismantled and sound monetary and economic system is not put in place in India, our woes will continue unabated.