HT PAREKH FINANCE COLUMN

b eneath the CFSA’s confident assessment begins to show. The nature of this increased lending does give cause for concern. Retail loans, which grew at around 41% in both 2004-05 and 2005-06, have been one of the prime drivers of credit growth in recent years, despite the moderation in growth rates to 30% in 2006-07 and 17% in 2007-08. The result was a sharp increase in the retail exposure of the banking system, with retail loans that were less than 10% of gross advances in the 1980s rising to 18.3% of the total by March 2004 and further to 25% by March 2007, where it has remained. Of the components of retail credit, the growth in housing loans has been the highest in most years, amounting to as much as 50% in 2005.

The danger here is that this rapid increase in retail exposure could have brought less creditworthy borrowers into the bank credit universe. Fortunately, restrictions on the activities of banks have helped limit exposure to other kinds of risky assets. Thus, according to the committee, the aggregate exposure of the banking system to “sensitive” sectors, like capital, real estate and commodity markets, stood at 20.6% of aggregate bank loans and advances at the end of financial year 2008. With exposure to real estate amounting to 18% of total advances, the role of capital (2.5%) and commodity markets (0.1%) was comparatively small.

Perils of Large Housing Exposure

But as the report suggests, large housing exposure is a cause for concern. Globally, it is now recognised that a sharp increase in retail exposure in general and real e state and housing exposure in particular occurs in a context of rising asset and housing prices. On the other hand, i ncreased credit provision to this sector tends to drive housing prices to even h igher levels. The boom-bust cycle this could result in can quickly turn safe assets into suspect ones, straining balance sheets.

The strain can be significant because rapid credit growth has meant that banks are relying on short-term funds to lend long. According to the CFSA:

The maturity profile of deposits, advances and investments of the banking system r eveals that since March 2001 there has been a steady rise in the proportion of short-term deposits maturing up to one year. Deposits maturing up to one year increased from 33.2% in March 2001 to 43.6% in March 2008. At the same time, the share of term loans maturing beyond five years increased from 9.3% to 16.5%. While this could imply increased profits, the increased asset liability mismatch has increased the liquidity risk faced by banks.

It also appears that to attract borrowers the banks have been cutting interest rates. The period of increased credit offtake has also seen an increase in loans provided at interest rates below the benchmark prime lending rate (BPLR). The share of such loans in the total rose from 27.7% in March 2002 to 76.0% at the end of March 2008. This increase has been marked in the case of retail credit. According to the CFsA, the rise in sub-BPLR loans can be attributed to “an increase in liquidity, stiff competition, buoyant corporate performance which lowered credit risk and growth in retail credit (housing)”. That increase, in its view, reflects a mispricing of risk that could affect banks adversely in the event of an economic downturn.

Off-Balance Sheet Exposure

Thus, lurking beneath the confidence in Indian banking exuded by the CFSA is an element of caution even if not excessive concern. Not the least because of other signs of an increase in risk-taking behaviour. Thus, while “capital adequacy ratios across bank groups have remained significantly above the regulatory minimum and, even better” and “NPA ratios have shown a significant decline”, the CFSA is concerned that “there has been an increase in the growth of off-balance sheet (OBS) exposure in recent years, particularly in the case of foreign banks and new private sector banks”. These OBS e xposures are in the nature of contingent liabilities (such as letters of credit, financial guarantees, acceptances, endorsements and underwriting and standby commitments) or derivatives (principally foreign exchange rate agreements and interest rate related contracts).

In recent years, the share of derivatives contracts has increased sharply and within them the share of interest rate contracts such as swaps has risen from less than 40 to 60%. The ratio of OBS exposure to total assets increased from 57% at the end of March 2002 to 363% at the end of March 2008. This increase is mainly on account of derivatives whose share averaged around 80%. Derivatives such as interest rate swaps are indeed risky. Moreover, as the CFsA recognises, currently prevailing accounting standards do not clearly specify how to account for losses and profits arising out of derivatives transactions. In its view, given the lack of prudential accounting and disclosure norms, the propensity of some players to use derivatives to a ssume excessive leverage is a source of concern, since it is difficult to gauge the quantum of market and credit risks that banks are exposed to.

These developments in Indian banking do have one important implication. Though liberalisation and financial integration may not have resulted in excess exposure of the Indian banking system to the toxic assets that originated in the US and Europe, it has altered banking behaviour so that it has begun to resemble that of banks in those countries. One consequence is an increased exposure to risk, which is a matter of concern in itself and not just because the Indian regulatory s ystem is not yet geared to deal with such risk, if it can at all.

Economic & Political Weekly