What is ‘run on a bank’? And why is it important for us to know.

Does the world remember the mammoth 700 billion dollar bailout of banks in the United States during the 2009 crisis? Clearly not. Banks such as, Morgan Stanley, JP Morgan, Lehman Brothers, Bank of America and Citi group to name a few, all of them faced potential financial losses and even bankruptcy due to the infamous and imminent ‘run on banks’ during the 2009 financial crisis. The current public anger in India against the RBI for imposing restrictions on withdrawals from the troubled PMC Bank is justified, yet we must learn the lessons and understand the thought process of the central bank in India. Trade wars, diplomacy turning south, political instability, and geo-political issues have transformed the economy into a metaphorical Sine Wave, a constant battle between highs and lows. The fragile financial ecosystem has been in the making for a decade now, and yet, we remain ignorant of the role played by banks in this entire hullabaloo. However, RBI needs to educate customers and general public on various intrinsic processes and regulations without the condescending and complex financial jargons. And let me give them a head start by jotting down the most feared concept of ‘run on the banks’ to illustrate what happens when a bank is close to going under and the thought process of regulatory bodies in dealing with the situation.

A run on a bank is a phrase that defined the actions of depositors withdrawing all cash deposits from a bank because they predict that the bank may stop functioning or cease operations in the future. How does this relate to PMC Bank in India you ask. Let me elaborate. A couple of days ago, RBI imposed a limit of 1000 rupees per customer for withdrawals from PMC Bank. A bank ,that has on its books an instance of 2500 crore rupees loan to HDIL, a troubled realtor, currently languishing in the bankruptcy court. The current loan from PMC to HDIL going bad is not the surprising aspect of this situation, but the failure of the bank towards reporting of the loan in the financial statements and the classification of loan as Non-Performing Asset despite the relator defaulting on loans. To make the reporting aspect clear, here is an example. If you borrow money from a friend on the first day of the month, and promise to pay back at the end of the month, then your net income for the month would be the income minus the money you need to pay back to your friend. Simple mathematics. Same applies to banks and financial institutions, annual profits for the bank is calculated by the same concept of income minus the loans that have gone bad (bad loans are loans that are not going to be repaid to the banks). PMC Bank failed to subtract the bad loans on its books and that lead to inflation of profits. A gross accounting mistake and one that has serious regulatory impact. Further, the bank did not even attempt to maintain assets or cash balance to liquify when needed. With the current cash reserves and assets amounting to approximately half of the money owed to depositors, the bank is staring down the barrel of a gun. And if all depositors decide to withdraw all the money from the bank, there isn’t enough cash to fulfill that liability. Which would then cause mass panic and spread like a contagion across other banks and institutions. To put simply, if your friends bank is closing down, you would withdraw your cash from a different bank as well, wondering if your bank is at risk, and this chain continues, until finally, the entire country loses confidence in the banking and financial system. A classic case of run on the bank.

Why would the PMC Bank situation affect other banks and institutions? Well the simple answer is the interconnected financial system and interdependencies of banks. The elaborate answer would be risk mitigation and risk management. Banks, trade among themselves, and even have strong collaboration to ensure the banking ecosystem functions with consistency. In the process, banks even trade loans and assets for various reasons. The fear of a regulator such as the RBI in this case for example, is that, if a bank did not disclose the loans accurately, how do we trust the reporting on inter-dependencies communicated to shareholders in the form of annual statements. This fear is legitimate, and reminds me of the Lehman Brothers. Did the US government think that large banks named at earlier in this article would face bankruptcy? Of course not, but the reality did not take long to dawn upon Hank Paulson, the then Treasury Secretary of United States, and as some would call the de-facto President of the United States for a few months, given the problem he was solving and the decisions he needed to make. Banks in the US pre-2009 traded sub-prime loans amongst themselves and caused a network of culprits chained together unintentionally. A similar situation is impending every single time banks are put under scrutiny. The general public trust banks with their deposits and the least the banks could do is be honest in reporting losses and loans that have gone bad. Yet, somehow, despite audits, banks manage to find workarounds and when the workaround fails, a gloomy picture reveals itself, for the depositors and the public of course. With the current situation regarding the PMC Bank, it is hard to know at this point in time how bad the contagion is, and how far the malaise has spread. Exactly why the RBI imposed sanctions.

Central Banks across the globe, including our own RBI, need to follow stringent procedures to maintain the treasury reserve (money that is available in an economic calamity). Without reserves, the confidence in a country’s economy goes down. At a time when India is lobbying for Foreign Direct Investment across industries, the RBI will need to be vigilant and watch out for signs of stress and be proactive in stopping the spread of malaise. That being said, restrictions on banks are actions to taken after the fact, but what we to do about sending a message to other banks, who in all possibility might have similar situations in the making. A thorough probe is in effect and will be completed shortly by RBI, and we should expect that the responsible individuals be handed out the right reprimands and not be let off with slap on the wrists. An unfortunate situation, where, general public trusted the bank with hard earned savings and those savings are now under serious threat. However, this article was meant to help understand the role of RBI and the distinction between regular banks and the central banks. No, the government is not trying to fail the banks, or cause distress to the public, not in the least with Assembly polls scheduled in the state of Maharashtra. But facts can be distorted to portray a dismal image of the Modi regime. Let me make it clear that I am not absolving the government of all the responsibility, but making a case for misdirected anger. I hope RBI takes serious cognisance of this situation and clarify measures taken to avoid another instance of the situation we have on our hands, and failing to do so can be one of the mistakes that India will look back upon and repent.