The Hindu Business Line : How banks can lend long-term at fixed rates

If banks are to be incentivised to offer long-term, fixed-rate loans, then mechanisms have to be found to manage the interest rate risk inherent in borrowing short and lending long. In the larger fight against inflation, the importance of better risk management and financial intermediation cannot be glossed over.

The real-estate sector has been the focus of much attention from all quarters — regulators, lenders, borrowers and investors — in recent times. Policy-makers have tightened credit flow to this sector, both in quantity and price, to bring down the level of demand and prices.

Policy has been generally confined to the broad objective of cooling demand with the focus being wholesale. Be it the level of risk weights or the tighter credit appraisal norms advocated for assessing proposals, the approach has been macro. A number of micro-level issues, critical to the overall efficiency of the system of real-estate and housing finance, have, however, not got the due attention.

There are, thus, extreme swings in policy at the level of the commercial banking system (which purveys credit). Banks which went head over heels till about a couple of years back to make 10- and 15-year fixed-rate housing loans have now made a complete about turn. Borrowing on fixed rate terms for 10/15-year tenor is now just not possible. The fixed-rate housing loan, as a product, is almost non-existent.

If the headlong rush into long-term fixed rate lending of about two/three years back was clearly not sustainable, the current focus on floating or variable rate loans is equally so and may even be inefficient and less than optimal for the financial system.

This article makes no pre-suppositions or assumptions about the superiority of one form of lending/borrowing over another. Indeed, there are pluses and minuses for both borrowers/lenders in both the methods. Borrowers' choice of whether to go in for fixed or floating rate loans depends on their understanding of the risk characteristics of each type, their assessment of the growth potential in their incomes, their inflation expectations and also on how these products are priced by the lenders. Their understanding of the risks, in turn, depends on the quality of the information and advice which they receive (from the banks or other financial advisors) during what is called the sales process.

But from the overall financial system development point of view, it cannot be that a particular set of conditions in the interest rate markets or a particular monetary policy banishes a certain type of product from the market. Ideally, one should have both fixed and floating rate products from banks through all phases of the interest rate cycle.

Why no long-term, fixed rate lending?

A study of the deposit profile (deposits still dominate commercial banks' liabilities profile at 80/85 per cent of overall liabilities) of commercial banks makes clear why banks cannot do long-term fixed rate lending. There is just too much interest rate risk which a lender imparts to his balance-sheet by lending long at fixed rates while he funds himself through the short-term market, exposing himself to the short-term market's pulls and pressures. If short-term rates rise, the lender would be squeezed as the cost of funds rise relative to the return on the fixed rate assets.

This is what has possibly happened the past couple of years consequent to the RBI tightening monetary policy from around late 2004/early 2005. All long-term fixed rate loans made during the initial years of the housing finance boom — from 2001 up to 2004 — are a drag on overall interest margins now. They are, therefore, being run down and banks are making sure they are not taking incremental fixed rate long-term exposures. (No official statistics are available as to the proportion of fixed rate loans in the total housing loan stock.)

As the Table shows, short-term deposits (deposits up to three years) account for a high 70 per cent of all deposits with public sector banks as at March 2006. It is even higher at 85 per cent and 90 per cent plus in the private sector and foreign bank groups respectively. These ratios have gradually increased over the past four years for the private and foreign banks whereas the March 2006 level for public sector banks is slightly lower than that seen earlier. As at March 2002, RBI statistics show that PSBs' deposits up to three years maturity formed around 80 per cent of all deposits.

These trends have been accentuated in recent times with a shortening of the deposit tenures. Recent RBI data show that deposits up to one year now account for close to 55 per cent of term deposits in PSBs and, of course, in the new private/foreign banks, it is as high as 80 per cent. With this kind of a deposit profile even in 2001/02 and the way it has shaped over the past five years, how did banks at all lent fixed long-term in the three-year period up to 2004?

Banks find easy way out

It was a gross mistake. And how have banks remedied that? Stop fixed rate long-term loans altogether and offer only floating rate lending. The interest rate risk is thereby passed entirely on to the borrower. So far, this has proved an easy way out for banks. Rising interest rates and their absorption by borrowers have still not worsened overall financial conditions or borrowers' repayment capacity so much that the quality of lending portfolios is strained. The biggest housing loan players not only continue to report low levels of impairment on the loan portfolio. They have also intensified their business development efforts in recent weeks and months.

But is the above state of affairs and trend optimal and efficient at all?

Leave alone lofty ideas about financial system development. It is obvious that even from lenders' point of view, such concentrated focus on a single product type is not optimal. Portfolio diversification benefits are available not only in the area of securities market investments.

The loan portfolio of a lender also has to be appropriately and sufficiently diversified by industry, maturity, product type and so on to handle diverse interest rate/credit risk profiles and environments. Diversification by way of industry is attained courtesy industry/group exposure norms specified by the RBI. But there is inertia in diversifying the asset side of the balance-sheet on other crucial parameters such as maturity and interest rate/product type.

Modify nature of liabilities/assets

It is clear that if banks have to be incentivised to offer long-term, fixed-rate loans, then mechanisms have to be found to manage the interest rate risk inherent in borrowing short and lending long.

Another element of risk in long-term fixed-rate lending is that of pre-payment — that is, the borrower paying back the loan fully during a downturn in the interest rates cycle. The bank will then face re-investment risk. The value of this pre-payment flexibility (which is actually a call option sold to the borrower by the lender) also has to be built into the risk mitigation mechanism.

Banks in India have normally charged a penalty for early payment when interest rates have fallen. This payment has traditionally been worked out as a certain percentage of the outstanding loan amount — kept at a sufficiently high level to deter pre-payments. More objective methods such as "mark-to-market" of the outstanding loan do not seem to have been tried out.

The major risk in long-term, fixed-rate lending, though, arises only on the interest rate side and it is here that the bulk of the work on risk management has to be done. Globally, the most common techniques applied in managing interest rate risk on the banking balance-sheet fall into two broad categories. Either modify the nature of the liabilities base or take the long-term asset off the books.

Interest rate swaps

The interest rate nature of the liabilities base is altered or modified by engaging in interest rate swaps. In this case where the bank has to mitigate the risk arising from its long-term, fixed-rate loan portfolio, it would pay a fixed cash flow and receive floating rate based cash flows in a swap. The floating rate the bank receives would offset the variable/floating rate the bank has to pay on its deposit base.

Ultimately, the bank would be left with fixed-rate cash outflows to match the fixed-rate inflows, leaving it immune to increases in funding costs. To the extent that the floating payments the bank receives and the rates it pays on deposits are not correlated, the bank would still run a residual risk. But the trend seen in the Indian market towards increasing reliance on up to one-year term deposits (even by the PSBs) means the level of residual risk may be quite manageable.

The popularity of this technique can be gauged from the fact that globally interest rate derivatives (mainly swaps) dominate both exchange traded and OTC derivatives markets, accounting for 75-80 per cent of all OTC and exchange traded derivatives outstanding. As of December 2006, the notional amount outstanding combined in the OTC/exchange derivatives markets was around $450 trillion of which interest rate derivatives accounted for $325 trillion, leaving other products such as currency, equity or commodities derivatives far behind.

In India, though, interest rate derivatives are yet to catch on. There is a fair amount of trading in rupee interest rate swaps — around Rs 5000 /6000 crore per day — but the trading is concentrated in a few foreign and private sector banks. This is predominantly proprietary trading based on differing interest rate views and not much of actual hedging of balance-sheet exposures (whatever little exposure may be there on account of fixed rate long term loans done in the past) takes place through the swap market.

PSBs, which may need to use this market the most as a hedging arena given their much larger share of the overall lending business, are not present in this market, save for a couple or so names. There are certainly issues in the current interest rate swaps market — be it liquidity, swap pricing, the benchmark floating rate used in the swaps which have held back wider participation from banks. But these do not appear insurmountable.

Another key tool employed globally in rate risk management is securitisation of the long-term asset and its removal from the books of the loan originator. Lenders here sell the underlying long-term asset in the capital markets as asset-backed/residential mortgage-backed securities. Investors in these securities have a claim on the cash flows of the underlying long-term loans/mortgages with the original lenders retaining a servicing role. The balance-sheet is thus freed of interest rate risk, is liquefied and can originate more long-term loans.

Securitisation and mortgage-backed securities form a multi-trillion dollar industry. In the US, for instance, more than half of all mortgages originated are securitised with the Federal agencies — Fannie Mae and Freddie Mac — being big players in this market. The size of the US residential mortgage market is around $6 trillion. And, not surprisingly, because of the depth and breadth of the market for interest rate swaps and securitisation, long-term fixed rate mortgages account for around 60 per cent of all mortgages outstanding in the US. In India, on the total outstanding housing loans of around Rs1,80,000 crore, as on date, less than 10 per cent has been securitised in the past decade of efforts towards this end by various agencies. A number of legal and taxation issues have been cited as the obstacles to the development of a market for securitisation. It is unfortunate that, like in many other areas, not much success has attended the efforts to sort out these issues.

The road ahead

Overall economic and financial sector policy and the way these shape the balance-sheet structure of financial institutions indicate that many of the risk-management products which are now common in the advanced markets will gradually be adopted by Indian financial institutions. A lot of effort probably has to go into creating awareness and appreciation for many of these products at the bank/individual institution level.

With a vast financial network covering the mainstream commercial banks, co-operative banks as well as the growing network of NBFCs, insurance companies and mutual funds, the importance of better risk management and financial intermediation in India cannot be overemphasised. The important thing is to ensure that these relatively minor aspects of the overall financial sector are not glossed over in the larger fight against inflation and ensuring a higher level of non-inflationary growth in the economy.

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