Is India heading towards its own sub-prime crisis? There have been a number of developments that suggest such an eventuality is possible. Bank credit has been growing very rapidly in recent years, the retail exposure of banks in the form of personal loans has increased sharply, exposure to the "sensitive" sectors (especially by the new private banks) has exploded, and securitisation of loans (during which diligence can slacken) has also risen. If the economic environment takes a turn for the worse - as has already happened - then the danger of bank loans turning bad increases manifold.
HT PAREKH FINANCE COLUMNAUgust 9, 2008 EPW Economic & Political Weekly8India’s Sub-prime FearsC P ChandrasekharIs India heading towards its own sub-prime crisis? There have been a number of developments that suggest such an eventuality is possible. Bank credit has been growing very rapidly in recent years, the retail exposure of banks in the form of personal loans has increased sharply, exposure to the “sensitive” sectors (especially by the new private banks) has exploded, and securitisation of loans (during which diligence can slacken) has also risen. If the economic environment takes a turn for the worse – as has already happened – then the danger of bank loans turning bad increases manifold.Embedded in the Reserve Bank of India’s (RBI) first quarterly review of monetary policy for 2008-09 are a few words of caution regarding the ex-cessive expansion of credit provided by somebanks.Thecentral bank has, in the interest of “overall systemicstability”, called for a review of banks’ business strategies with an emphasis on credit quality. There are some who would argue that theRBI has not gone far enough.Some nine months ago, addressing a seminar on risk management, veteran central banker and former chair of two committees on capital account convertibil-ity, S S Tarapore, warned that India may be heading towards its own home-grown sub-prime crisis. The suggestion was dis-missed as alarmist by many, but there is reason to believe that the evidence war-ranted those words of caution at that time, and are of relevance even today. Besides the lessons to be drawn from develop-ments in the US mortgage market, there were three trends in the domestic credit market that seemed to have prompted Tarapore’s comment.Growth of Retail CreditThe first was the scorching pace of expan-sion of retail credit over the previous three to four years. Non-food gross bank credit had been growing at 38, 40 and 28 per cent, respectively, during the three financial years ending March 2007. This was high by the standards of the past, and pointed to a substantially increased exposure of the scheduled commercial banks to the credit market. In the view of the former deputy governor of the Reserve Bank of India, this increase was the result of excess liquidity (created by increases in foreign exchange assets accumulated by the RBI) and an easy money policy. He was, there-fore, in favour of an increase in the cash reserve ratio to curb credit creation.It must be noted that the easy liquidity situation and the expansion in credit were, in turn, the consequences of financial sec-tor reform. The sharp increase in the foreign exchange reserves of the central bank during these years was facilitated by the liberalisation of rules governing both equity investments by foreign investors and external commercial borrowing by Indian firms. The surge in capital inflows necessitated foreign exchange purchases by the central bank in order to prevent appreciation of the rupee, resulting in the accumulation of reserves. And there were limits to which the increase in the foreign exchange assets of the central bank could be sterilised. As a result liquidity expansion ensued, permitting credit creation whenever the demand for credit was buoyant. Liberalisation had not resulted in a similar situation during much of the 1990s, partly because the supply-side surge in international capital flows to developing countries, of which India wasamajor beneficiary, was a post-2002 phenomenon. Credit expansion in those years was also restrained by the industrial recession after 1996-97, which reduced the demand for credit.Retail ExposureThe second factor prompting Tarapore’s words of caution was the evidence of a sharp increase in the retail exposure of the banking system. Personal loans that were outstanding had risen from Rs 2,56,348 crore at the end of March 2005 to Rs 4,55,503 crore at the end of March 2007, having risen by 41 per cent in 2005-06 and 27 per cent the next year. On March 30, 2007, housing loans stood at Rs 2,24,481 crore, credit card outstandings at Rs 18,317 crore, auto loans at Rs 82,562 crore, loans against consumer durables at Rs 7,296 crore, and other personal loans at Rs 1,55,204 crore. Overall, personal loans amounted to more than one-quarter of non-food gross bank credit outstanding.The increase in retail exposure was also reform related. Financial liberalisation expanded the range of investment options open to savers and through liberalisation of controls on deposit rates increased the competition among banks to attract deposits by offering higher returns. The resulting C P Chandrasekhar (cpchand@gmail.com) is with the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.
HT PAREKH FINANCE COLUMNEconomic & Political Weekly EPW AUgust 9, 20089increase in the cost of resources meant that banks had to diversify in favourof more profitable lending options, especially given the emphasis on profits even in the case of public sector banks. The resulting search for volumes and returns encour-aged diversification in favour of higher risk retail credit. Since credit card out-standings tend to get rolled over and the collateral for housing, auto and consumer durable loans consists essentially oftheas-sets whose purchase was financed with the loan concerned, risks are indeed high. If defaults begin, the US mortgage crisis made clear, the value of the collateralwould decline, resulting in potential losses. Tarapore’s assessment clearly was and possibly remains that an increase in default was a possibility because a sub-stantial proportion of such credit was sub-prime in the sense of being provided to borrowers with lower than warranted creditworthiness. Even if the incomes of the borrowers do not warrant this conclu-sion, the expansion of the universe of borrowers brings in a large number with insecure jobs. A client with a reasonable income today may not earn the same income when circumstances change. SecuritisationA third feature of concern was that the Indian financial sector too had begun securitising personal loans of all kinds so as to transfer the risk associated with them to those who could be persuaded to buy into them. Though the government has chosen to hold back on its decision to permit the proliferation of credit derivates, the transfer of risk through securitisation is well underway. As the USexperience had shown, this tends to slacken diligence when offering credit, since risk does not stay with those origi-nating retail loans. According to estimates, in the year preceding Tarapore’s analysis, personal loan pools securitised by credit rating agencies amounted to close to Rs 5,000 crore, while other personal loan pools added up to an estimated Rs 2,000 crore.Put these together and the risk of excess sub-prime exposure was high. Tarapore himself had estimated that by November 2007 there was a little more than Rs 40,000 crore of credit that was of sub-prime quality, defaults on which could trigger a banking crisis.The problem that Tarapore was allud-ing to was part of a larger increase in exposure to risk that had accompanied imitations of financial innovation in the developed countries encouraged by liber-alisation. Another area in which the risk fallout of liberalisation was high was the exposure of the banking system to the so-called “sensitive” sectors, like the capital, real estate and commodity markets. At the end of financial year 2007, the exposure of the scheduled commercial banks to the sensitive sectors was around a fifth (20.4 per cent) of aggregate bank loans and advances, with the figure comprising an 18.7 per cent contribution of real estate, 1.5 per cent contribution of the capital market and a small 0.1 per cent from commodities. However, this aggregate figure concealed substantial variation across different cate-gories of scheduled commercial banks. The corresponding figures for real estate and capital market exposure were as high as 32.3 per cent and 2.2 per cent in the case of the new private sector banks and 26.3 per cent and 2.4 per cent in the case of the foreign banks. While the foreign banks may have the wherewithal to absorb sudden losses in these high risk sectors, the same is not true of the latter as illustrated by the ex-perience of Global Trust Bank, for exam-ple. However, it is these new private sector banks that are seen as dynamic and inno-vative, indicating that financial innova-tiveness is in many cases confused with a misplaced willingness to court risk in search of higher returns.Sub-prime LossesFurther, by late last year the evidence was growing that Indian financial institutions including banks were not averse to risk-taking even in the global market. As early as October last year, the then economic adviser to the union finance minister, Parthasarathi Shome, reported that Indian banks had been estimated to have lost around $ 2 billion on account of the sub-prime crisis in theUS. That was just a guesstimate, and the actual numbers are still not known, possibly even to theRBI. In March this year,ICICI Bank, a private bank leader, declared that, as on January 31, 2008, it had suffered marked to market losses of $ 264.3 million (about Rs 1,056 crore) on account of exposure to overseas credit de-rivatives and investments in fixed income assets. Even public sector banks like State Bank of India, Bank of Baroda and Bank of India too were known to have been hit by such exposure. If risks had been taken in the global market, they definitely must have been taken in large measure in the domestic market.These trends did not ring alarm bells earlier because of the acceleration of eco-nomic growth since 2002-03, which was based on a recovery in manufacturing growth besides continued service sector growth. The problem is that economic cir-cumstances are changing now with infla-tion ruling high, interest rates rising and growth expected to slow. Further, a global slowdown could adversely impact India’s export growth. One sector that is already showing signs of deceleration as a result of these developments is the manufacturing sector. This is bound to adversely affect the performance of banks’ loan portfolios. Most banks are beginning to report quar-terly results that show diminished profits or even losses. The slowdown could also result in adverse income effects that increase defaults on personal loans.In the circumstances it may be prudent to return to Tarapore’s words of caution and act before the situation deteriorates to a point were a US style meltdown visits India. That may require rethinking liber-alisation as well. But it may be better tostart now rather than wait for bank failures of the kind that are triggering calls for similar rethinking in the developed industrial economies.Just PublishedFrom SERIBAANBIG CAPITAL IN ORGANISED RETAILA Study on its Impact in West BengalShalti Research Group2008, ISBN: 81-87492-24-4, Hardcover, 143 pages, Rs. 200.00DistributorSREEJONITel.: +91-33-24115988, Fax: +91-33-24713250e-mail: bookshopping@sreejoni.com
HT PAREKH FINANCE COLUMNAUgust 9, 2008 EPW Economic & Political Weekly8India’s Sub-prime FearsC P ChandrasekharIs India heading towards its own sub-prime crisis? There have been a number of developments that suggest such an eventuality is possible. Bank credit has been growing very rapidly in recent years, the retail exposure of banks in the form of personal loans has increased sharply, exposure to the “sensitive” sectors (especially by the new private banks) has exploded, and securitisation of loans (during which diligence can slacken) has also risen. If the economic environment takes a turn for the worse – as has already happened – then the danger of bank loans turning bad increases manifold.Embedded in the Reserve Bank of India’s (RBI) first quarterly review of monetary policy for 2008-09 are a few words of caution regarding the ex-cessive expansion of credit provided by somebanks.Thecentral bank has, in the interest of “overall systemicstability”, called for a review of banks’ business strategies with an emphasis on credit quality. There are some who would argue that theRBI has not gone far enough.Some nine months ago, addressing a seminar on risk management, veteran central banker and former chair of two committees on capital account convertibil-ity, S S Tarapore, warned that India may be heading towards its own home-grown sub-prime crisis. The suggestion was dis-missed as alarmist by many, but there is reason to believe that the evidence war-ranted those words of caution at that time, and are of relevance even today. Besides the lessons to be drawn from develop-ments in the US mortgage market, there were three trends in the domestic credit market that seemed to have prompted Tarapore’s comment.Growth of Retail CreditThe first was the scorching pace of expan-sion of retail credit over the previous three to four years. Non-food gross bank credit had been growing at 38, 40 and 28 per cent, respectively, during the three financial years ending March 2007. This was high by the standards of the past, and pointed to a substantially increased exposure of the scheduled commercial banks to the credit market. In the view of the former deputy governor of the Reserve Bank of India, this increase was the result of excess liquidity (created by increases in foreign exchange assets accumulated by the RBI) and an easy money policy. He was, there-fore, in favour of an increase in the cash reserve ratio to curb credit creation.It must be noted that the easy liquidity situation and the expansion in credit were, in turn, the consequences of financial sec-tor reform. The sharp increase in the foreign exchange reserves of the central bank during these years was facilitated by the liberalisation of rules governing both equity investments by foreign investors and external commercial borrowing by Indian firms. The surge in capital inflows necessitated foreign exchange purchases by the central bank in order to prevent appreciation of the rupee, resulting in the accumulation of reserves. And there were limits to which the increase in the foreign exchange assets of the central bank could be sterilised. As a result liquidity expansion ensued, permitting credit creation whenever the demand for credit was buoyant. Liberalisation had not resulted in a similar situation during much of the 1990s, partly because the supply-side surge in international capital flows to developing countries, of which India wasamajor beneficiary, was a post-2002 phenomenon. Credit expansion in those years was also restrained by the industrial recession after 1996-97, which reduced the demand for credit.Retail ExposureThe second factor prompting Tarapore’s words of caution was the evidence of a sharp increase in the retail exposure of the banking system. Personal loans that were outstanding had risen from Rs 2,56,348 crore at the end of March 2005 to Rs 4,55,503 crore at the end of March 2007, having risen by 41 per cent in 2005-06 and 27 per cent the next year. On March 30, 2007, housing loans stood at Rs 2,24,481 crore, credit card outstandings at Rs 18,317 crore, auto loans at Rs 82,562 crore, loans against consumer durables at Rs 7,296 crore, and other personal loans at Rs 1,55,204 crore. Overall, personal loans amounted to more than one-quarter of non-food gross bank credit outstanding.The increase in retail exposure was also reform related. Financial liberalisation expanded the range of investment options open to savers and through liberalisation of controls on deposit rates increased the competition among banks to attract deposits by offering higher returns. The resulting C P Chandrasekhar (cpchand@gmail.com) is with the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.
HT PAREKH FINANCE COLUMNEconomic & Political Weekly EPW AUgust 9, 20089increase in the cost of resources meant that banks had to diversify in favourof more profitable lending options, especially given the emphasis on profits even in the case of public sector banks. The resulting search for volumes and returns encour-aged diversification in favour of higher risk retail credit. Since credit card out-standings tend to get rolled over and the collateral for housing, auto and consumer durable loans consists essentially oftheas-sets whose purchase was financed with the loan concerned, risks are indeed high. If defaults begin, the US mortgage crisis made clear, the value of the collateralwould decline, resulting in potential losses. Tarapore’s assessment clearly was and possibly remains that an increase in default was a possibility because a sub-stantial proportion of such credit was sub-prime in the sense of being provided to borrowers with lower than warranted creditworthiness. Even if the incomes of the borrowers do not warrant this conclu-sion, the expansion of the universe of borrowers brings in a large number with insecure jobs. A client with a reasonable income today may not earn the same income when circumstances change. SecuritisationA third feature of concern was that the Indian financial sector too had begun securitising personal loans of all kinds so as to transfer the risk associated with them to those who could be persuaded to buy into them. Though the government has chosen to hold back on its decision to permit the proliferation of credit derivates, the transfer of risk through securitisation is well underway. As the USexperience had shown, this tends to slacken diligence when offering credit, since risk does not stay with those origi-nating retail loans. According to estimates, in the year preceding Tarapore’s analysis, personal loan pools securitised by credit rating agencies amounted to close to Rs 5,000 crore, while other personal loan pools added up to an estimated Rs 2,000 crore.Put these together and the risk of excess sub-prime exposure was high. Tarapore himself had estimated that by November 2007 there was a little more than Rs 40,000 crore of credit that was of sub-prime quality, defaults on which could trigger a banking crisis.The problem that Tarapore was allud-ing to was part of a larger increase in exposure to risk that had accompanied imitations of financial innovation in the developed countries encouraged by liber-alisation. Another area in which the risk fallout of liberalisation was high was the exposure of the banking system to the so-called “sensitive” sectors, like the capital, real estate and commodity markets. At the end of financial year 2007, the exposure of the scheduled commercial banks to the sensitive sectors was around a fifth (20.4 per cent) of aggregate bank loans and advances, with the figure comprising an 18.7 per cent contribution of real estate, 1.5 per cent contribution of the capital market and a small 0.1 per cent from commodities. However, this aggregate figure concealed substantial variation across different cate-gories of scheduled commercial banks. The corresponding figures for real estate and capital market exposure were as high as 32.3 per cent and 2.2 per cent in the case of the new private sector banks and 26.3 per cent and 2.4 per cent in the case of the foreign banks. While the foreign banks may have the wherewithal to absorb sudden losses in these high risk sectors, the same is not true of the latter as illustrated by the ex-perience of Global Trust Bank, for exam-ple. However, it is these new private sector banks that are seen as dynamic and inno-vative, indicating that financial innova-tiveness is in many cases confused with a misplaced willingness to court risk in search of higher returns.Sub-prime LossesFurther, by late last year the evidence was growing that Indian financial institutions including banks were not averse to risk-taking even in the global market. As early as October last year, the then economic adviser to the union finance minister, Parthasarathi Shome, reported that Indian banks had been estimated to have lost around $ 2 billion on account of the sub-prime crisis in theUS. That was just a guesstimate, and the actual numbers are still not known, possibly even to theRBI. In March this year,ICICI Bank, a private bank leader, declared that, as on January 31, 2008, it had suffered marked to market losses of $ 264.3 million (about Rs 1,056 crore) on account of exposure to overseas credit de-rivatives and investments in fixed income assets. Even public sector banks like State Bank of India, Bank of Baroda and Bank of India too were known to have been hit by such exposure. If risks had been taken in the global market, they definitely must have been taken in large measure in the domestic market.These trends did not ring alarm bells earlier because of the acceleration of eco-nomic growth since 2002-03, which was based on a recovery in manufacturing growth besides continued service sector growth. The problem is that economic cir-cumstances are changing now with infla-tion ruling high, interest rates rising and growth expected to slow. Further, a global slowdown could adversely impact India’s export growth. One sector that is already showing signs of deceleration as a result of these developments is the manufacturing sector. This is bound to adversely affect the performance of banks’ loan portfolios. Most banks are beginning to report quar-terly results that show diminished profits or even losses. The slowdown could also result in adverse income effects that increase defaults on personal loans.In the circumstances it may be prudent to return to Tarapore’s words of caution and act before the situation deteriorates to a point were a US style meltdown visits India. That may require rethinking liber-alisation as well. But it may be better tostart now rather than wait for bank failures of the kind that are triggering calls for similar rethinking in the developed industrial economies.Just PublishedFrom SERIBAANBIG CAPITAL IN ORGANISED RETAILA Study on its Impact in West BengalShalti Research Group2008, ISBN: 81-87492-24-4, Hardcover, 143 pages, Rs. 200.00DistributorSREEJONITel.: +91-33-24115988, Fax: +91-33-24713250e-mail: bookshopping@sreejoni.com
