Recently the PMC bank was in limelight due to RBI imposing some tough measures. Though this measure was to protect the depositors from the impending Crisis at PMC Bank, the very depositors were the people massively affected by it. The media was filled with its usual headlines. “I had my life savings in it”: Depositor XYZ was a common sight in media portals. The crisis also started political slugfest. Everyone was blaming the bank promoter instead of the bank and depositor. The regulator too got the heat of it by the financial intelligentsia. Intelligentsia blamed RBI for being late in arresting the rot. The general public blamed the promoter for conflict of interest. But nobody blamed the depositors and bank for not having adequate diversification.

PMC Bank Crisis

The RBI being the regulator of all the banks, it routinely inspects the financial health of all the banks. It has lots of powers given by the Banking Regulations Act and RBI Act to arrest the banking crisis situations. One day RBI came to know about a large loan asset of the PMC bank going kaput. To prevent “Bank Run” kind of situation, RBI issued directions to PMC Bank to suspend all its normal banking operations. This is a standard preventive measure.

The Banks by design are high leverage entities. Hence, Depositors are lenders to a bank. Similarly, the loans made by the bank is an asset. To know more about accounting classification read this article. If a loan goes bad and depositors beeline to withdraw, every such bank will go into crisis. The bank gives money received from depositors as a loan. When depositors approached on news of loan going bad, the bank doesn’t have money to pay back them.

The bank and regulator have lots of tools in its arsenal to deal with this kind of bank crisis (aka “Bank Run”). Stopping normal banking business is one such. Stopping business stops the regular cash drain by depositors. It also provides enough time to recover money from the company. The bank can sell itself too if the NPA threatened much. Then the acquiring company can go after the NPA. This option is sub-optimal than stopping banking. Normally, shutting down these Co-operative banks the standard option.

The actual fault

to prevent a single asset taking down a bank, RBI has put limits on group exposure. The bank was wrong in breaching this. In personal finances, this practice of setting up exposure limits to a particular item is called diversification. This PMC Bank Crisis happened because the loan to HDIL (around 33% – its 3 times stock exposure in my portfolio) went sour. To add fuel to fire, The Bank and HDIL both had common board member. More than this conflict of interest, the bank’s internal lending discipline that was at fault. The blame is on Chairman & CEO for lack of lending discipline.

It’s unwise to expect bank deposit and cash in hand to be safe.

Similarly, the depositors are at fault here too. They too didn’t diversify. Putting all your savings in 1 high-interest account is Sureshot way to doom. One needs only the PAN card (ID Proof) and the Aadhar Card (Address Proof) to open an account. So diversify your bank accounts too. But always remember that every bank (including SBI, HDFC, ICICI) runs the risk of a bank run, you cannot escape it. Even worse, the cash in hand runs the ever worse risk of inflation, demonetization & robbery. So it’s unwise to expect bank deposit and cash to be safe. Hence, Diversifying these bank and cash accounts is good.

Conclusion
  • There is nothing called “risk-free”. Everything carries its own risk. A large fiscal deficit can cause a national debt to collapse. Likewise, banks and your finances too can collapse if assets start getting impaired.
  • Do not keep all your eggs in the same basket. Diversifying reduces risk. But, remember that risk cannot be eliminated.
  • Always expect failure from your banks and other investments, governance system etc… As a result of this, your risk perception will also improve.
  • To manage risk, you also need to see and understand the risk. But, understanding of risk comes with experience, not by classroom learning.
  • Co-operatives banks are able to pay more deposit interest rates because of their higher risk. This higher risk comes from lending and the bank’s management.
  • Risk is nothing but a probability of losing money. One can lose money in n number of ways.
  • A risk is a probability event, hence exact calculations of it, fails miserably. First, be prepared for possibility of it. After that only prepare for actual probability of it.
  • Learn to write off when the risk you took backfires on you. Learn to do this without emotional pangs that you may encounter.
    Ex: Whining on social media, Dissuading others by overblowing it etc…