The Hindu Business Line : Guarding against sub-prime in the Indian context

After the “junk bonds”, the latest dirty word in the financial market is “sub-prime”. What began as an attempt, by the American financial institutions, to design structured products leveraging the rise in the portfolio of housing loans, aimed at improving liquidity in the economy, blew up in the face leaving several financial institutions, hedge funds and pension funds in the red. All was well while the going was good, but the system came crashing like a pack of cards once the inadequacies in the market and failure of the systems were exposed. On hindsight, it is possible to attribute the causes of the crisis to a mix of factors.

1. Low interest rates aimed at feeding on the greed of people to aspire for things that they could not afford in normal course, thereby inducing them to borrow beyond their means;

2. Highly diluted standards of credit assessment that resulted in monies being lent to poorly rated borrowers, who would otherwise not be eligible to qualify under more stringent credit assessment norms;

3. Problems of additional lending on uncollaterised portion of the assets whose valuations were climbing at ridiculous rates following unrealistic market appreciation; such lending being based again on liberal assessment procedures;

4. Designing of fancy financial instruments such as mortgage-backed securities (MBS) and collaterised debt obligations (CDOs) in the name of securitisation of assets that enabled unscrupulous home loan companies to pass on the hazards of technically bad assets to unsuspecting investors;

5. The role played by investment bankers who took up bundling of assets in such a way that prime mortgages were bundled with many sub-prime ones so that the rating agencies would accord the desired ratings;

6. Rating agencies did not conform to accepted rating practices; instead they played into the hands of the promoters by giving them a rating on the CDOs that were not backed by proper study of the quality of the entire basket of assets;

7. Rise in the US Fed rates in quick succession that saw the controller increase rates as many as 17 times in a gap of two years that resulted in mortgagers defaulting on their repayments; and

8. Last but not the least, the gullible investors across the world, who had no means for any independent assessment of the quality of the assets bundled in the bonds, and yet were willing to channel funds by the millions into novel financial instruments.

Trend in India

In the Indian context, certain elements of the crisis are replicating themselves. Indian banks too are resorting to free disbursal of consumer loans, devoid of proper assessment or documentation. Market prices of real estate have shown a rising trend, thereby increasing the scale of borrowing. Interest rates have shown a rising trend in recent months, with commercial banks raising their rates on housing and consumption loans. This has also resulted in a rise in the number of bad loans made to these segments, on account of borrowers being unable to service the increased portion of EMIs.

But the regulator and the government have stepped in with advisories that have seen the rates subdue once again.

Yet, a sub-prime meltdown on the scale of the American crisis may not necessarily manifest itself in the Indian scenario. For one, the extent and scale of borrowals here are in no way comparable with that of the West. Secondly, sophisticated financial instruments such as the CDOs do not hit the market at random as they did in the US. Thirdly, the banks in India do have a reasonably good system of credit risk analysis in place, with the regulator also keeping a benign vigil on the movement of credit and the quality of assessment.

Stepping up vigil

The Reserve Bank of India is naturally concerned that this global development should not have any contagion effect on the Indian banking system. Securitisation of assets by the commercial banks is permitted by the RBI and Indian banks have been doing so for the past few years as per the guidelines prescribed by the RBI.

In order to avoid any contagion effect either from abroad or from within the banks in India, the RBI may initiate some steps. First and – probably, the easy option will be to put a blanket ban on investment in securitised bonds or against the class of assets bundled together. This will be too much of a harsh step amounting to throwing the baby along with the bath water.

The second course of action left for the RBI will be to impose certain restrictions. The RBI can impose prudential exposure norms. For restricting investment by banks or lending against such bundled assets, an exposure limit of 20 to 25 per cent of the net owned funds of each bank can be prescribed as a cap. Alternatively, 5 per cent of the total advances of the bank can be a cap. This would ensure that while the banks are permitted to invest in securitised bonds, the exposure is also contained. The risk weights for such bundled assets can be increased. Separate provisioning norms can be prescribed for such bundled assets.

The bankers will, of course, resent such measures. However, it will be good for everybody in the system in the long run.

(The author is the Chairman of Karur Vysya Bank)