Banking on home builders

A housing complex under construction in Tirupur.-M. BALAJI

While lending to homeowners may be a more secure form of credit, a rapid increase in such credit inevitably involves features that spell risk.

BANKING in India is changing face, looking to the mortgage market and personal debt as the route to profit. Having been permitted, in fact encouraged, to chase profits in markets that were restricted earlier and with instruments that were rare or non-existent, banks are choosing to change their portfolios rather sharply. This occurs at a time when the appetite and ability of banks to create credit have increased significantly.

Their ability to lend has expanded because the economy is awash with liquidity as a result of massive inflows of foreign capital. Excess liquidity has encouraged them to seek out potential borrowers and persuade them to increase their portfolio of debt. In the event, at a time when the gross domestic product (GDP) growth has been accelerating, credit has grown at an even faster rate. According to the Reserve Bank of India's (RBI) report on Currency and Finance 2006-07, the credit-GDP ratio in the country, which increased from 34.2 per cent in 1991 (when the reforms began) to 43.4 per cent in 2004, has risen to 54.1 per cent over the subsequent two years. Banks are at the centre of this credit splurge, accounting for close to 80 per cent of credit provided by the end of March 2006.

It could be argued that since GDP is growing rapidly, credit growth would be high as well. But the rise in the credit to GDP ratio indicates that there is more to the matter. Credit is growing even faster than warranted by higher growth. This appears to be true of all the major sectors agriculture, industry and services of the economy. In each of these, the rate of growth of credit has been in excess of the rate of growth of sectoral GDP. As a result, "credit intensity", defined as the ratio of credit offtake to sectoral GDP, has risen in all these sectors.

But focusing on the relative rate of growth of credit with respect to GDP in individual sectors can be misleading. The trend may be the result of the slow growth of production rather than a fast growth of credit, as appears true in an area like agriculture where GDP growth has been poor over a long period of time. A better index, therefore, would be the share of different sectors in outstanding credit, which would show whether one or more sectors are responsible for the spike in credit growth.

Thus, if we examine the share of outstanding credit of the scheduled commercial banks accruing to different categories of borrowers, we find that the share of agriculture fell sharply from 16 per cent at the end of March 1990 to 10 per cent at the end of March 2003, with the figure rising marginally to 10.8 per cent by end-March 2005. The trend seems to be the same in industry where the decline has been continuous, from 48.7 per cent to 38.8 per cent between 1990 and 2005. In trade, too, the decline has been sharp, from 17.1 per cent in 1995 to 11.2 per cent in 2005.

These trends point to a diversification of bank credit away from the commodity producing sectors and even trade. The loss in share of these sectors seems to be almost completely counterbalanced by loans to individuals and professionals (personal loans and professional services), whose share rose from 9.4 per cent to 16.8 per cent between end-March 1990 and end-March 2002, and then shot up to 27 per cent by end-March 2005. This is the direction in which credit is moving, and these are the sectors accounting for a substantial part of excess credit growth.

While a number of sub-categories such as loans for purchases of automobiles and consumer durables, especially the former, have gained in terms of growth in credit provision, there is one sector that has absorbed the bulk of the increase even here: that is, loans for housing. The share of housing loans in scheduled bank credit rose from 2.4 per cent in 1990 to 5 per cent in 2002 and then to 11 per cent by 2005.

From the point of view of the scheduled banks' lending portfolio, this has implied two outcomes. First, the exposure of the banking sector to the retail loan segment has increased substantially. The share of personal loans in total bank credit has almost doubled in recent years, rising from 12.2 per cent in 2001 to 22.2 per cent in 2005. Second, retail loan exposure has been concentrated in housing finance, with housing loans accounting for 53 per cent of retail loans in 2005.

One factor accounting for these outcomes, noted by the RBI's Report on Currency and Finance, is the decline in demand for bank credit from industry. With profits soaring in recent times, retained profits and reserves have proven to be major sources of finance for the corporate sector. Three among non-bank sources of finance for industry have registered significant or dramatic increases in recent years. To start with, resources raised through new capital issues increased from Rs.2,422 crore in 2003-04 to Rs.13,781 crore in 2005-06. Reports have it that sums raised through this route would exceed Rs.1,00,000 crore in 2007 (Business Standard, June 23). Second, the contribution of retained earnings rose from Rs.15,645 crore to an estimated Rs.48,402 crore over these three years. And, finally, borrowing from abroad rose from Rs.16,098 crore to Rs.45,708 crore.

In sum, own or cheaper sources of domestic finance have substituted for borrowing in aggregate corporate finance. But to the extent that firms' appetite for investment has increased, necessitating borrowing for investment, they prefer to borrow from cheaper sources abroad than from the domestic banking system.

Deprived of credit demand from their conventional blue chip clients, banks would have been forced to turn elsewhere. The retail market, with a preference for housing finance, seems to have been the chosen option. But, it would be wrong to presume that banks turned to the retail segment only because of the "push" out of the corporate credit market. Loans to the retail segment are lucrative. Since they are distributed across a large number of borrowers, the risks involved in such lending are hedged. Lending to the housing sector creates its own collateral in the form of the mortgaged property.

And, finally, banks in India, like their counterparts in the developed countries, are increasingly securitising retail debt. Mortgage loans to different segments are bundled together and securitised with the securities thus created being sold to financial institutions, insurance companies and mutual funds. Credit created by the banks disappears from their balance sheets and appears in the investment portfolios of investors and funds. This permits banks to transfer some of the risk associated with retail lending, reducing the risk they carry as a result of their high exposure to these markets.

The craving for housing finance created by these features is also resulting in a shift away from what are considered safe investments. For example, in the latter half of the 1990s, banks invested in government securities to an extent far in excess of that needed to meet the liquidity stipulations set by the RBI through its statutory liquidity ratio (SLR) guidelines. But more recently, banks have been unwinding their excess holdings of SLR securities to generate resources that can help finance incremental credit. Banks have also shown a tendency to resort to overseas borrowing to augment capital needed to finance the demand for credit from the retail market.

But with exposure growing rapidly in a single area, the risks are now clearly rising. While lending to homeowners may be a more secure form of credit, for the reasons noted above, a rapid increase in such credit inevitably involves features that spell risk. Finding a growing number of new borrowers to ensure credit offtake inevitably requires relaxing income criteria for those applying for loans or lending to those whose income stream is not guaranteed or secure. It may also involve lending without adequate scrutiny of income documents. The result would be an increase in the proportion of risky borrowers in a situation of rising credit provision and increased exposure to the housing market. Defaults and foreclosures could increase with adverse consequences for bank profitability and even viability.

This possible outcome can be worsened by the effects of speculation. An immediate consequence of a credit-financed spike in housing acquisitions is a rise in real estate prices. India has been experiencing such a rise in recent years, which in turn has encouraged real estate speculation. This implies that many borrowers are not financing homes they plan to live in, but those they plan to sell for profit at an appropriate time. If this leads to a glut in housing in certain brackets, or if changes, such as an increase in interest rates, affect speculators' expectations adversely, a collapse of the housing boom could ensue. Those who resorted to credit hoping to close their deals well before maturity might find it difficult to meet their credit obligations, and banks may find themselves saddled with foreclosed property worth much less in the market than the loan provided. What is more, with securitisation having gained ground in India, the ripple effects of this would be felt in other segments of the financial sector to which the risk has been transferred.

Recognising these risks, the central bank has been warning banks against increasing their exposure to the housing market any further and requiring them to be more stringent when scrutinising loan applications. It is unclear whether banks are heeding these warnings. There are signs of a dampening of the growth of housing credit in recent months; but that could be more the result of the recent hardening of interest rates rather than of increased bank caution. Banks need to lend when loaded with deposits; and that can be a problem if prime borrowers in the commodity-producing sectors, industrial firms, are reluctant to turn to the banks for credit. But the recent trends in Indian banking suggest that they have gone even further than warranted by this development. It is time to hold back. And it is also time to think of ways of diversifying portfolios, even if returns are not as attractive.