Fatal attraction

At a "property fair" in Chennai on February 13. Since growth in the housing, automobiles and consumer durables sectors had been driven by credit-financed purchases encouraged by easy liquidity and low interest rates, a fall in credit offtake could intensify the effects of the ongoing crisis.-R. SHIVAJI RAO

The official Committee on Financial Sector Assessment, chaired by Reserve Bank of India Deputy Governor Rakesh Mohan, released its report at the end of March. However, its output, which consists of six volumes (an executive summary, an overview report, and reports of the advisory panels on Financial Stability Assessment and Stress Testing, Financial Regulation and Supervision, Institutions and Market Structure, and Transparency Standards) running into more than 2,500 pages, has not received the attention that the effort seems to warrant. Possibly, its sheer bulk has deterred many an analyst.

There could, however, be another reason. The assessment is a part of the Financial Sector Assessment Programme (FSAP) which, as the preamble to the Executive Summary notes, is a joint initiative of the International Monetary Fund (IMF) and the World Bank that began in 1999. That programme ostensibly attempts to assess the stability and resilience of financial systems in member countries, though there are a number of instances such as in the case of Argentina where a positive and upbeat assessment made under the programme came not long before the onset of a financial crisis. In the event, the credibility of the FSAP has been in question.

And that is even truer today. This is because the programme is anchored in the belief that the integration of financial markets in developing countries with their global counterparts is necessarily positive so long as the structure, procedures and regulatory framework prevailing in mature markets is adopted in these countries. Hence, the programme attempts to assess the status and implementation of various international financial standards and codes in the regulation and supervision of institutions and markets, as well as the adequacy of the financial infrastructure in terms of legal provisions, liquidity management, payments systems, corporate governance, accounting and auditing. For all these, the benchmark is the system in the developed countries, especially the United States. The assumption seems to be that the greater the degree to which financial structures in emerging markets are reshaped in the image of those prevailing in the developed countries, the more resilient they will be.

It hardly bears stating that the financial crisis that engulfed the developed industrial countries and led up to the current recession in the real economy has proved this assumption to be wrong. This in itself is reason for ignoring the report. However, since the assessment is a country exercise owned by national regulatory authorities even if inspired by the IMF and the World Bank, there could be nuances that can contribute to a better understanding of the effects of financial liberalisation and globalisation.

In the case of this mammoth exercise undertaken by India, the report exudes confidence that the Indian financial system is stable and resilient. But lurking beneath this confidence is evidence of growing fragility in the financial sector as a result of its transformation to approximate the Anglo-Saxon model. It is now well accepted that countries seeking to attract capital chose to liberalise their financial policies in two ways. They eased entry provisions with respect to foreign institutions that are the carriers of that capital, as it were. They relaxed regulations relating to the markets, institutions and instruments that constitute the financial structure to provide a favourable environment for global firms. Even though liberalisation of regulations with respect to foreign institutions and foreign capital inflows is not a sufficient condition for attracting such inflows, it obviously is a necessary condition.

This is illustrated by the Indian experience, where capital inflows rose significantly long after it liberalised its financial sector. Liberalisation began in the early 1990s and was substantial by the middle of that decade. But it was only after 2003 that India witnessed any surge in capital inflows. Until 2002-03, the maximum level that net inflows had touched was $8.2 billion, in 2001-02. The surge occurred thereafter. Capital flows rose to $15.7 billion in 2003-04, $21.4 billion in 2005-06, $29.8 billion in 2006-07 and $63.8 billion in 2007-08.

It now appears that the problems for monetary and exchange rate management that this surge created and the liquidity overhang it resulted in led to a sharp increase in credit provision in India as the Financial Sector Assessment Report (FSAR) indicates. Total bank credit grew at a scorching pace from 2005 onwards, at more than double the rate of increase of nominal gross domestic product (GDP). As a result, the ratio of outstanding bank credit to GDP, which had declined in the initial post-liberalisation years from 30.2 per cent at the end of March 1991 to 27.3 per cent at the end of March 1997, doubled over the next decade to reach about 60 per cent by the end of March 2008. An aspect of financial liberalisation and economic reform was an increase in credit dependence in the Indian economy, which is a characteristic that seems to have been imported from developed countries such as the U.S.

At first sight, this increase in credit appears positive inasmuch as it reflected a greater willingness on the part of banks to lend. Thus, the growth in credit outperformed the growth in deposits between 2004-05 and 2005-06, resulting in the increase in credit-deposit ratio from 55.9 per cent at end March 2004 to 72.5 per cent at end March 2008. This increase was accompanied by a corresponding drop in the investment-deposit ratio, from 51.7 per cent to 36.2 per cent, which indicates that banks were shifting away from their earlier conservative preference to invest in safe government securities in excess of what was required under the statutory liquidity ratio (SLR) norm.

Rapid credit growth has meant that banks are relying on short-term funds to lend long. Since March 2001, there has been a steady rise in the proportion of short-term deposits with the banks. Deposits maturing up to one year increased from 33.2 per cent in March 2001 to 43.6 per cent in March 2008. On the other hand, the proportion of term loans maturing after five years has increased from 9.3 per cent to 16.5 per cent. As the FSAR recognises, while this could imply increased profits, the rising asset-liability mismatch has increased the liquidity risk faced by banks.

However, these changes do not appear to have been driven by the desire to provide more credit to the productive sectors of the economy. Retail loans, which grew at around 41 per cent 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 per cent in 2006-07 and 17 per cent in 2007-08. The result was a sharp increase in the retail exposure of the banking system, with overall personal loans increasing from slightly more than 8 per cent of total non-food credit in 2004 to close to 25 per cent by 2008. Of the components of retail credit, the growth in housing loans has been the highest in most years.

The danger here is that this rapid increase in credit and retail exposure, with inadequate or poor collateral, could have brought more tenuous borrowers into the bank credit universe. A significant but as yet unknown proportion of this could be sub-prime lending. According to one estimate, by November 2007, there was a little more than Rs.400 billion of credit that was of sub-prime quality, defaults on which could erode the capital base of the banks.

It also appears that to attract such borrowers the banks have been offering attractive interest rates. The period of increased credit off-take 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 per cent in March 2002 to 76 per cent at the end of March 2008. This increase has been marked in the case of consumer credit. According to the FSAR, 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.

But this is not the only evidence of the mispricing of risk. According to the committee, the exposure of the banking system to the so-called sensitive sectors, such as the capital, real estate and commodity markets, was also on the rise. Thus, at the end of financial year 2007, it stood at 20.4 per cent of aggregate bank loans and advances, with real estate contributing 18.7 of that figure, the capital market 1.5 per cent and commodities 0.1 per cent.

The FSAR also notes that the off-balance sheet (OBS) exposure of banks has increased significantly in recent years, particularly in the case of foreign banks and new private sector banks. The ratio of OBS exposure to total assets increased from 57 per cent at the end of March 2002 to 363 per cent at the end of March 2008. This increase is mainly on account of derivatives whose share averaged around 80 per cent. Public sector banks have followed, with their exposure rising subsequent to the amendment of regulations to permit over-the-counter (OTC) transactions in interest rate derivatives.

However, as the FSAR recognises, currently prevailing accounting standards do not clearly specify how to account for losses and profits arising out of derivatives transactions. Given the lack of prudential accounting and disclosure norms, the propensity of some players to use derivatives to assume 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.

To deal with its increased exposure to risk, the Indian banking sector too had begun securitising loans of all kinds so as to transfer the risk associated with them to those who could be persuaded to buy into them. As the U.S. experience has shown, this tends to slacken diligence when offering credit, since risk does not stay with those originating retail loans.

The effect of securitisation is partly seen in the income structure of the banks. Although net interest income has remained the mainstay of banks in India, fee income has been contributing a significant portion to the total income of the new private and the foreign banks in recent years. Treasury income, which was the second most important source of income until 2003-04, has declined to negligible levels.

These changes in the financial sector point to two ways in which the current crisis can affect India. First, the credit stringency generated by the exodus of capital from the country and the uncertainties generated by the threat of default of retail loans that now constitute a high proportion of total advances could freeze up retail credit and curtail demand, as is happening in the developed industrial countries.

Second, individuals and households burdened with past debt and/or uncertain about their employment would prefer to postpone purchases and not take on additional interest and amortisation payment commitments. Thus, the offtake of credit can shrink even if credit were available, resulting in a fall in credit-financed consumption and investment demand.

Since growth in a number of areas such as the housing sector, automobiles and consumer durables had been driven by credit-financed purchases encouraged by easy liquidity and low interest rates, this could intensify the effects of the ongoing crisis.