The financial sector, affected by the collapse of Global Trust Bank, has raised concerns over banks' exposure to equities.

Last week, Mint Street became the venue of a shotgun wedding of GTB with Oriental Bank of Commerce. The cause for the proposed amalgamation "was the deterioration in the financial position of GTB, as the bank had reached negative net worth and could not provide capital essential to permit it to continue accepting public deposits", said a Reserve Bank of India spokesperson.

What should GTB clients do?
The Global Trust Bank Crisis: Complete Coverage

The inconvenience caused to the public and more importantly to corporates has inspired discussions that banks should refrain from taking equity as a security for lending. "Stock market values are inflated on account of this financing, and as such, it can be said that banks actual fund the boom in the market," said Ashvin Parekh, executive director, Deloitte.

The real seeds of GTB's failure were sown back in 2000-01 when the private sector bank financed Ketan Parekh and, thereby, took significant exposure to the capital market.

Two recent failures in the banking sector -- Nedungadi Bank was run by conspiring sharebrokers, and Madhavpura Cooperative Bank had a huge exposure to Ketan Parekh to the extent of 40 per cent of its advances -- also stemmed from individual banks' exposure to equity. Likewise, Harshad Mehta was able to inflate stock prices on the back of funding from banks.

In May 2001, in the wake of the stock market scam, the central bank capped banks' total equity investments, by way of direct investments in shares, equity-oriented mutual funds, convertible bonds and debentures, IPO financing, advances to individuals/brokers for investment in equity shares, at 5 per cent of the total outstanding advances of the previous fiscal.

A joint standing technical committee of the RBI and the Securities Exchange Board of India on bank financing of equities had recently suggested the higher cap. However, this depended on prudent accounting standards and good risk management standards.

"Banking is a business of taking risks. But banks need to be well capitalised and manage risks prudently," said a RBI spokesperson with reference to the recent GTB crisis.

GTB's latest balance sheet shows that it had almost 50 per cent exposure to the equity market against its advances. Against total advances of Rs 3,276 crore (Rs 32.76 billion) in fiscal 2004, its capital market exposure stood at Rs 1,560 crore (Rs 15.6 billion). Consultants feel that banks taking a higher exposure to shares, convertible debentures and units of equity mutual funds pose a risk to the system.

ASK-Raymond James & Associates Ltd in a research paper had pointed this out back in 2000, prior to the Ketan Parekh scandal. It stated that a higher cap would have long-term repercussions with earnings of banks falling, potential equity investment losses adding to non-performing assets and margins coming under pressure. Four years later, GTB's gapping hole of Rs 1,500 crore (Rs 15 billion) in NPAs was proof enough of the need for greater caution.