Mayhem in the streets. Customers clamor for deposits and RBI sets withdrawal limits on the Punjab and Maharashtra Co-operative Bank. Today's newsletter on the story that created headlines all over the country.


The Story

On Tuesday, the Reserve Bank of India imposed restrictions on the Punjab & Maharashtra Co-operative (PMC) bank for not doing a good job in reporting the actual state of affairs in the company. And as punishment, it restricted the bank from creating new loans.

But that's not all. The RBI also put a cap on the daily withdrawal amount for the bank's customers at Rs. 1000 from here on, for the next 6 months.

So if you want to withdraw Rs. 40,000 for your child's school fee. Yeah, you are in a spot of bother.

But why would the RBI resort to such a draconian measure? After all, the provisions of the RBI act that allows it to impose these harsh corrective measures were put in place to protect the interests of the depositors.

Isn’t it a bit counterintuitive for the RBI to do the exact opposite, by way of introducing a withdrawal limit? Or is the RBI simply a twisted entity that revels in the misfortune of others?

Or even better, as one Twitter economist pointed out “ Why not simply inform the depositors about the matter and ask them to withdraw the funds either way. Let the bank die. Who cares?”



The story is much more complicated than it seems.

A Bank Run

If there was any way the bank could die without affecting the people, that would be the best recourse. However, that can’t happen, EVER.

See, banks don’t actually carry these deposits in their lockers. They mostly use the money to create new loans.

So, the amount of cash it holds to service withdrawals from customers is not equal to the total deposit in the bank. It’s only a small fraction of this amount.

And the logic here is rather simple. It’s highly unlikely for everyone to go and withdraw funds at the same time. So you only keep what you need and the rest, you loan out. The RBI decides on the minimum amount a bank is expected to hold at any given point in time. But it's most definitely not equal to the entire amount of the deposit.

And so, if people were to believe that a bank might go down in the near future, they will be out in the street trying to withdraw their deposits immediately. And that’s when the scheme breaks down. The small backup will be woefully inadequate to service every withdrawal request and all the calculations go for a toss.

They call this a bank run.

And this might offer some clue as to why the RBI might have resorted to this brazen move.

As far as we understand the bank in question is a co-operative bank. It’s not a full-fledged commercial bank like, say, State Bank of India.

It’s smaller in size, it takes fewer deposits and is usually restricted to a single geographical area. Which means it’s not as tightly regulated as the other commercial banks.

So sometimes, problems might fester without the RBI actually taking notice.

News reports seem to suggest that the bank was under-reporting bad loans. These loans that the bank offered to prospective customers only to find out much later that some of them might not be paid back in full.

  1. A few unpaid loans in the mix, investors might exercise caution.
  2. A few more unpaid loans in the mix, the bank might have to fix the problem before it can create more loans.
  3. Add a few more unpaid loans on top and the bank might not survive.

You get the drift.

So it’s imperative to report bad loans accurately considering the bank’s future might be at stake. Unfortunately, when you don’t abide by the rules, RBI will walk in and take you to task.

And that’s what likely transpired here. The bank was barred from creating new loans for under-reporting its problem loans and the RBI forced the bank to cease most of its operation. For 6 months, they’ll be doling out zero loans to be precise and they’ll just have to focus on getting their finances right.

But why the withdrawal limit on those poor depositors?

Well, it’s because people will get wind of this development eventually. Imagine a bank that’s on RBI’s bad books, not doing regular banking things. You expect nobody to take notice?

People will freak out guys. And when they do, they’ll want their money back and this will trigger a run on the bank, panic in the streets and pandemonium everywhere.

Or maybe we are just stupid and there’s some grand design behind RBIs decision.

But no matter what happens here, the cooperative bank and the RBI have a lot to answer for. It shouldn’t have come to this. People shouldn’t have to see their savings tied up because there weren’t enough checks and balances put in place.

This is a travesty and I hope that they recognize this as much.

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That's it from us today. We will see you tomorrow. Until then :)