Modern Banking: Some Differing Perspectives & the Issue of NPA.

AuthorPadhi, Satya Prasad
PositionNon-performing assets


The present paper holds that the issue of non-performing assets (NPA) plaguing the banking sector in India is one that pertains mainly to how banks adjust to growth prospects. A hypothesis can be: the degree of freedom that monetary policy gives to the banking sector; greater the freedom, which permits banks to be more sensitive to growth prospects related issues, the lower would be the incidence of NPAs. Here, it would be argued that the issue is one of low versus high interest rate policy adopted by the central bank; the former, for instance, would give more freedom to banks, permitting it to be more sensitive to growth prospects. Still it is not monetary policy issue per se; though it plays an important role in actualizing growth, the prospects depend primarily on generation of better supply responses (Padhi, 2018; 2018a), which can have autonomous characteristics. It is all about how banks align to growth prospects per e. The freedom to banks, or any viewing of low versus high interest rate debate, depends on different views on modern banking, which can broadly be interpreted in two ways. This follows, in economics discourse, different views on money supply thesis. There is the traditional exogenous money thesis, which gives banks less freedom, as opposed to the endogenous thesis.

Given the above picture, the paper is organized as follows. It begins with an overview of both exogenous and endogenous money thesis, with an emphasis on how the role of banks fundamentally differs. Next it starts with how the different views on banking relate to the low versus high interest rate policy, and how this policy debate defines the banks' sensitiveness to growth prospects; it then relates how this debate sheds light on the NPA issue. Finally it provides the concluding note.

Exogenous Money

This particular focus should start with the mainstream neo classical perspective, in which an economic system starts with some output flow. Policy makers would be choosing the money supply corresponding to the requirements of output. This induces the exogenous view of money supply (Dasgupta, 1997): monetary authorities (say, as the basic source) define issuing of government borrowing through bonds that takes place when the central bank creates a new reserve fund, which is when spent by the government. This partly circulates among the public in terms of coins and currency. Rest of the reserves (with the central banks), the deposits with the commercial banks, can be lent out. That is, banks expected that not all deposits would be withdrawn by borrowers, and a fraction of deposits can be kept reserved for the cash requirements. Rest can be lent; if lending also creates new deposits, the process of lending can further resume after the reserve requirement. This process then adds to the magnified increase in demand deposits--the credit multiplier process. The credit multiplier would equal 1/reserve ratio (RR) and through this the banks, if credit multiplier and money multiplier equals, can add to the supply of money (for the exact processes, see, Gupta, 2000).

Then, taking circulating currency and reserves of banks with the central bank as the base money, the money supply would be higher. It is true that not all lending and money generated so translates into demand deposits; for instance, there can be savings and other long term deposits, which call for a broader definition of money supply created by the credit multiplier.

This view of money also is specific to an institutional view of a central bank. The banks are supposed to keep a percentage of reserves with the central bank, or the central bank can also stipulate an overall RR (and credit multiplier). If so, given some base money, there is the regulation of the aggregate money supply.

What should be the required stock of money, and how it is to be generated in each stage? The equation MV = PT says that if money supply (M) times the velocity (V) equals the transactions related demand for money (T), and if so, the policy focus should be price (P) stability (i.e. zero inflation). More or less money supply would imply inflation or deflation and policy would manipulate aggregate money supply to avoid these events.

It should be stressed that banks in the process also do another important economic job. If money supply enabled output flow is partly saved, and is kept in the banks, banks should translate them into investments i.e. lending for investment purposes should just equal the willingness to save (or the savings that the output flow generates). Here, Friedman (1957) would also add that the output flow (or, T) is also inclusive of some demand and supply of financial assets, through which savings and investment are mediated. If bank rate of interest equals the (marginal productivity-based) real rate of interest, the financial market would clear with a given "currency/demand deposits" to financial assets ratio. Then, corresponding to MY = PT, the savings investment equality can be attained. The central bank can manipulate the base money, the reserve requirements, and the rate of interest, to regulate the money supply that ensures price stability.

Higher money supply, given the income flow, would result in inflation. Why this is a problem? It should be noted that the additional income flow is actualized by the savings that anticipates the income flow. If the income flow has a real rate of interest (i.e. marginal productivity theory), this, after bank intermediation costs, determines the deposit rate of interest i.e. the income flow to savers. However, this income flow, like the lending rate of banks, is contractual. Inflation, though keeps the real returns of the businesses, reduces these contractual rates denominated in terms of money. Inflation reduces the incentives to save and bank intermediation. It redistributes income that transfers part of real income of savers and bankers to the businesses that constitute their pecuniary income (and does not contribute towards further income generation processes).

Additional Developments

It should be noted that Friedmanian understanding broadly (or implicitly) encompasses an ISLM framework (always clearing the potential output though) in which rate of interest determines the simultaneous money and real market equilibrium (i.e. financial assets are in sync with real assets' performances, or corresponding to the real marginal productivity-based rate of interest, the demand and supply of financial assets equals, without any monetary disturbances; bank lending should confirm to it). This comes with the proviso that potential disturbances, say, output level and growth not confirming to their potentials, arise from monetary mismanagement; Friedman (1960) suggests that this source of disturbances can be eliminated if money stock and its growth follows the potential growth--the k- percent rule, to achieve price stability (or a definite inflation targeting) that in turn permits the real market (and rate of interest) stability. Then, ISLM comes with a somewhat vertical Phillips curve. Any sign of inflation is bad.

However, it has been noted (Orphanides, 2007) that broad money aggregates (especially M2) highlight fair degree of instability in response to bank deregulation (and MI to technological changes). In the language of ISLM, there is instability of LM curve that shows that monetary disturbances arise from the side of rate of interest (Poole, 1970). In particular, Wicksell (1898) had noted that if rate of interest is low in relation to the normal one (given normal output), bank credit-led money supply, reflecting aggregate demand outpacing normal output, results in higher inflation. But he remains silent on output configurations. Real world experience suggests that monetary disturbances have real consequences. This aspect has been attended to by New Keynesians' Taylor rule (see, Lavoie, 2006 for a critical review of the rule). There are rigidities, say price rigidity. If money supply and aggregate demand increases, say in a low interest rate regime, firms lag behind, and the increases in monetary aggregate demand translates into short run output increases i.e. short run non-neutrality of money (Sims, 2004). Taylor rule is so formulated that this can permit transition of output towards potential output, which comes with some inflation i.e. targeted inflation. That defines the upward sloping Phillips curve. Beyond a limit, say targeted inflation that corresponds to normal output, policy makers should not permit more credit-led money expansion i.e. policy rate should be raised. It should be stressed that this rule also acknowledges that if rate of interest achieves stability, there is the stability with respect to money supply growth that would be sync with potential output growth. So, there is the Taylor's rule that aims at interest rate management, to confer stability to monetary aggregates.


This perspective explicitly assumes that there is a rate of interest adjustment that makes savings equal to investment; more specifically, it is sensitive towards inflation because it is sensitive towards savings; higher savings lead to higher investment. Banks also favour this view, to safeguard their monetary contracts. However, the criticism is that investment acquires autonomous characteristics. Investment is guided mainly by profitability, and if sensitiveness towards inflation is very high, and induces a high rate of interest, banks, in this context of monetary constraints, may have to forgo investment opportunities. Do banks forgo such opportunities? The neo classical theory that hypothesizes that higher savings permits higher investment would...

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