Housing finance provided by scheduled commercial banks has risen at a scorching pace over the last decade, making housing loans an important component of total bank credit. This edition of Macroscan examines the factors underlying the sharp expansion of housing credit and the implications this has for risk profile of the banking system.

Globally, a significant component of the process of financial expansion and an important site for financial innovation has been the housing finance or mortgage market. The reasons for this are obvious. Every individual or family would like to own a house of their own if it can be afforded. Given the relative costs of housing within the desired asset basket of a household, it constitutes one among the larger investments or the single largest investment that many households can make. Given the life-span or durability of that investment and its liquidity characteristics, this is an asset which is most eligible for debt financing, since foreclosure due to default can in most circumstances be followed by easy liquidation to compensate the lender.

This makes housing finance one of the largest, feasible, mass markets for debt. That market can be made even larger if explicit or implicit government guarantees of housing loans are provided, as happened, for example, in the US with the creation of “Fannie Mae” in 1938 and “Freddie Mac” in 1970. More recently, financial innovation that has permitted the transfer and spread of risk has also helped expand the number of eligible borrowers.

Securitisation by transferring risk while allowing investors in securities to choose the bundle of risks considered appropriate facilitates the expansion of the housing finance market. It encourages the relaxation of lending norms, so that the threshold ratio of house prices to annual incomes at which a household becomes eligible for credit is lowered. Developments such as these expand the universe of borrowers to cover some borrowers considered “sub-prime” earlier.

Credit regime

Given the consequent increase in the number of less affluent borrowers in the housing finance market, the demand for housing credit tends to be sensitive to the interest rate. Hence, an easy credit regime with low interest rates and lax monetary control triggers a sharp increase in the demand for housing and the volume of debt. The consequent increase in housing investments and the demand it generates contributes in turn to the overall growth. In other words, the effectiveness of monetary policy as an instrument to drive demand and growth increases with the expansion in the relative size of the housing market. This encourages the government to find ways of expanding the market for housing as part of a strategy of promoting growth.

There is, however, one difficulty in all this. Since housing requires land, a scarce resource, as an input, and housing demand tends to be unevenly distributed geographically, with a concentration in urban areas as urbanisation proceeds, increases in demand often results in sharp increases in prices. This, on the one hand, increases the ratio of house prices to annual incomes and dampens housing demand. On the other, it encourages speculative investments in housing, especially since the pre-existing stock of housing, the value of which is rising, can to differing degrees be used as collateral. Most often the speculative impact dominates, resulting in spiralling prices, till a debt overhang, government action or a change in investor sentiment halts or reverses the rise.

Liberalisation feature

One fall-out of these features of the housing market is that financial liberalisation which permits securitisation and the creation of complex instruments that help transfer and distribute risk, and thereby, expands the universe of borrowers with access to the housing finance market, inevitably leads to a housing boom and a speculative spiral. If such liberalisation is accompanied by a loosening of monetary policy and an engineered reduction in interest rates this tendency is only strengthened. Often, therefore, these elements combine to transform the boom into a bubble that must finally burst, as happened in the run up to the sub-prime crisis in the US. When that happens, the value of the housing stock that constitutes the collateral for much of this lending collapses, with extremely adverse consequences for the financial system and the real economy.

Financial liberalisation, however, is not restricted to the developed countries. Over the last two to three decades most developing countries have liberalised their financial policies and transformed their financial structures in ways that make those structures approximate the Anglo-Saxon model created through liberalisation in the US and the UK since the 1980s. Thus, just as much as the mortgage market and its derivatives have come to play a role in the metropolitan countries, so have they in the developing countries. This has been true in India as well since the early 1990s.

Banks exposure to retail

This has led to a relatively rapid transformation of banking in India, with growing exposure of commercial banks to the retail credit market with no or poor collateral and a growing tendency to securitise personal loans. Total bank credit grew at a scorching pace from 2004-05 till 2007-08, 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.

Thus, one consequence of financial liberalisation was an increase in credit dependence in the Indian economy, a characteristic imported from developed countries such as the US. The growth in credit outperformed the growth in deposits, resulting in an increase in the overall credit-deposit ratio from 55.9 per cent at end March 2004 to 72.5 per cent at end March 2008.

Not surprisingly, these changes were not primarily driven by an increase in the commercial banking sector's lending to the productive sectors of the economy. Instead, retail loans became the prime drivers of credit growth. The result was a sharp increase in the retail exposure of the banking system, with personal loans increasing from slightly more than eight per cent of total bank credit in 1992-93 to more than 23 per cent by 2005-06 (Chart 1). Though there has been a decline in that ratio subsequently, it still stood at 19.4 per cent at the end of 2008-09. The decline appears to be the result of an overall correction in bank lending growth, which too declined in this period, with the adjustment being much sharper in the case of personal loans when the transition occurred in 2004-05.

Residex index

Of the components of retail credit, the growth in housing loans was the highest in most years. As Chart 2 indicates, the rate of growth of housing loans gathered momentum at the end of 1990s and remained at extremely high levels right up to 2006-07. As a result, the share of housing finance in total credit rose from five per cent in 2001-02 to 12 per cent in 2006-07 and was still at 10 per cent in 2009-10.

By all accounts, the credit-financed boom in the housing market has triggered a spiral in housing prices, which then feeds the boom even more. Unfortunately, till recently India had no reliable index of housing prices, with available figures being from stray private sector real estate consulting firms. But the Residex Index, now being collated by the National Housing Bank with 2007 as base (100), shows that even during the period when the boom was tapering off, prices in most metropolitan centres (Delhi, Mumbai, Kolkata and more recently Chennai) were rising quite significantly. Thus, the conclusion derived from experiences elsewhere in the world that easy credit accompanied by low interest rates leads to a sharp increase in housing finance and an increase in house prices fed by speculation seems to be true of India as well.

It is to be expected that the rapid increase in credit and retail exposure would have brought more tenuous borrowers into the bank credit universe. A significant (but as yet unknown) proportion of this could be “sub-prime” lending. To attract such borrowers, banks had offered attractive interest rates below the benchmark prime lending rate (BPLR). The share of BPLR 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 was especially marked for consumer credit and reflected a mispricing of risk that could affect banks adversely in the event of an economic downturn. More recently, banks, including public sector banks, have been opting for the scheme of initial teaser rates on housing loans, which tends to attract borrowers of doubtful repayment capacity into the housing market.

RBI warning

Further, rapid credit growth meant that banks were relying on short-term funds to lend long. From 2001, there was a steady rise in the proportion of short-term deposits with the banks, with the ratio of short-term deposits (maturing up to one year) increasing 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 increased from 9.3 per cent to 16.5 per cent. While this delivered increased profits, the rising asset-liability mismatch increased the liquidity risk faced by banks.

Faced with these risks the central bank has been periodically warning banks against excessive increases in exposure to the housing finance market. In its Annual Policy Statement for 2006-07, the Reserve Bank of India increased the general provisioning requirement for residential housing loans exceeding Rs 20 lakh from 0.40 per cent to 1.0 per cent.

More recently, the RBI has warned banks against resorting to teaser interest rates, given the experience with the consequences of such rates in the US and other contexts. However, the risk weight on bank exposure to housing loans has been kept low and a substantial segment of home loans falling below Rs 20 lakh has been kept within the ambit of favoured priority sector lending. This is partly because the Government has not been able to provide adequate volumes of affordable housing, especially in urban areas where the demand from a burgeoning middle class is substantial.

But it is also substantially because credit-financed housing demand is seen as an important driver of growth in the new context, creating a lobby in its favour within the Government. However, in the process India may be encouraging a trend that increases the fragility of the housing market, and therefore, of the financial and the real economy.

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(This article was published in the Business Line print edition dated August 24, 2010)
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