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, the
Committee's output, which consists of 6 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 2500 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,
which, as the preamble to the Executive Summary notes,
is a joint initiative of the International Monetary
Fund 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 number of instances such as 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 under
question.
And that is even truer today. This is because the programme
is anchored on 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 of which the benchmark is the system in the
developed countries, especially the US. The assumption
seems to be that the greater is 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 would 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 warrants
ignoring the report. However, since the assessment is
a country exercise owned by national regulatory authorities
even if inspired by the IMF and the 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,
lurking beneath the confidence the report exudes that
the Indian financial system is stable and resilient
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 liberalize 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. Till 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 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 which seems to have been imported
from developed countries such as the USA.
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 out-performed
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 76.0
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,
like 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 securitizing 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 US 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 to 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.
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