Does a business entity need interest-bearing savings accounts? The answer can be positive or negative depending on the situation. Business entities need working capital to carry out their day-to-day business activities. They can rarely place funds in interest-bearing deposit accounts; rather, they maintain current accounts with banks for regular business transactions. But interest-bearing accounts are maintained by individuals for passive income and for a future safety net. Therefore, banks depend on individuals for their input content.
In the banking sector, we often talk about the mismatch of maturities between deposits and loans. This means that banks provide term loans based on short-term deposits. Short-term deposits support term loans through a fractional banking system. If all banks are considered to form a unit with the support of the central bank, depositors or borrowers are automatically equated with loans. In this context, the settlement system for net payments through mutual clearing network facilities has shortcomings in terms of maturity mismatch. It’s a short-term solution. In the long term, the mismatch due to maturity or default must be taken care of by the lender of last resort through bailout or refinancing.
Banking is a regulated industry. In accordance with the country’s industrial policy, banking is a controlled sector and the establishment of a bank is subject to a specific license from the central bank. The sector is governed by regulations framed by national laws in force and international principles. Laws and regulations are available to oversee the system on behalf of prudential regulatory framework such as statutory regulatory buffer, capital adequacy ratios, prepayment ratios, asset and liability management, testing of resistance, the internal credit rating system, the Basel 3 framework, the Basel fundamentals, and much more. We observe that regulations are born on a daily basis, the respect of which in itself is a paying effort. Despite prudential regulations, non-performing assets in the banking sector are a common phenomenon at home and abroad.
If the financial market is classified, two submarkets appear – the money market and the capital market. Both deal with investment aid, under separate regulations. The money market facilitates short-term working capital needs. On the other hand, the capital market treats stocks and debts as different types of bonds.
Banks should deal with money market products: short-term loans against short-term deposits. But in practice, it is observed that banks provide term loans to commercial enterprises. There are differences between short-term and long-term loans. The first is used to meet day-to-day needs, which are eliminated from revenue from regular sales and debt collections. Inventory and finished goods are supported by short-term loans. The sale of goods or the realization of the proceeds from the sale facilitates the satisfaction of short-term borrowings.
Capital is injected by owners or entrepreneurs into non-repaying business ventures; rather give benefits to the owners in the form of profit or dividend. Owners’ capital does not sustain a business, a long-term fund is needed. The fund can be raised either by equity or by capital borrowed from the capital market. But the capital market is rarely favorable to raising debt capital. Businesses must depend on the banking system for term loans.
The term loan is used for the development of the infrastructures of the companies concerned. Repayment of loans and interest depends on cash flow. Interest charges are eligible expenses. After deducting expenses, the profit is determined. These interest charges are payable by operating receipts. But the repayment of the principal amount is payable out of the taxed profits. In this case, the capital charges like the depreciation charges support a lot. The smooth refund depends on the size of the refund. It should be equivalent to depreciation charges so that the profit can be used either for distribution or for reinvestment in businesses.
Maturity mismatch is frequently cited by the banking industry, although it deals with capital market products by lending term loans. Capital market products need a longer repayment term. But the banks in practice grant average loans. The repayment schedule is set on the basis of unrealistic cash flows, the failure of which results in default.
In line with the concept framed by Hyman P Minsky, financing is classified into three categories: (a) hedge financing, whose interest and principal are settled by income streams; (b) speculative finance, whose interests are covered by income flows; and (c) ponzi finance, where inflows are insufficient to cover interest and principal, requiring new loans to support repayments. Medium-term capital expenditure loans cannot be classified as hedge financing. Therefore, cash flow mismatch due to unexpected variations definitely leads to defaults. Repayment of a loan for capital expenditure requires more time with a reasonable payment size.
Otherwise, trading companies can only settle interest payments from current sales proceeds. Maturity mismatch is a fundamental problem for banks trading capital market products. Authorization of such products may lead to equity investments that require central bank support as a last resort at some point during the life of the loan. Imposing different prudential regulations known as international best practices becomes a mere mathematical exercise and a waste of talent.
It is certain that prudential regulations are well-honed tools for dealing with crises. But whether the tools are applicable to capital market products remains a question. Perhaps regulation is helpful for money market products. If so, why are capital market products allowed in banking?
It is often said that the capital market in the country is ongoing, but the products are rarely noticed. The banking sector can be said to facilitate capital market products despite the risk of default. It is also a window to cross with the earnings of voluntary defaulters.
The right operators must be placed for the right jobs. Banks were born as money market operators. They should be by regulation limited to assigned work. If banks do not opt for capital expenditure loans, capital market products will develop. This is a simple equation for which only regulatory instructions are needed.
Banking is a regulated industry, but regulation of its operations is massive. Compliance is reported as unmanageable. Are all regulatory instructions necessary? Central banks themselves lend to their employees and dealers. Do they have to follow many regulations? This is a question for the sector. Either way, they should impose workable but effective regulations on banks so they don’t have to play hide-and-seek to achieve paper-based compliance.
Banks should favor money market operations through short-term loans to meet the working capital needs of commercial enterprises based on short-term deposits. Banking services in the form of unfunded facilities like letters of credit, standby letters of credit, bank guarantees, etc. should also be short-lived. Short-term funded facilities can also be authorized at the individual level for different purposes such as consumer loans, credit card loans, etc. Conditionally, term financing can be considered for individuals for large purchases and purchases of durable goods like home loans.
The banking system must get out of the circle of non-performing assets. To achieve this, banks should only be allowed to perform money market operations and various transactional services without dealing in capital market products. The regulatory framework needs to be reviewed to define the scope of operations of banks within the framework of money market activities.
Tashzid Reza works in a trade finance company operating as a liaison office in Bangladesh.