How RBI fenced Indian banks from the turmoil

How RBI fenced Indian banks from the turmoil
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First Published: Sun, Oct 05 2008. 10 18 PM IST

Updated: Sun, Oct 05 2008. 10 18 PM IST
Immediately after Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection last month, at a meeting with the executives of Lehman Brother’s India arm and local banks, the Reserve Bank of India (RBI) told the US investment bank to close all transactions with Indian banks within 24 hours. Lehman Brothers took 48 hours to do so. The central bank followed this up last week by asking Indian banks to furnish data on their exposure to other troubled financial entities including Wachovia Corp., Fortis NV, American International Group Inc. (AIG) and Washington Mutual Inc.
India’s largest private sector lender ICICI Bank Ltd’s exposure to Lehman Bothers is $83 million(Rs390.7 crore), less than 0.1% of its consolidated balance sheet. State Bank of India, Bank of India, Bank of Baroda, Punjab National Bank, Axis Bank Ltd and a few other Indian banks have small exposure to the Wall Street bank in various forms, and part of this has already been closed.
Lehman Brothers runs a non-banking financial company, or NBFC, in India but its entire capital, some Rs800 crore, is invested in government securities and bank deposits and hence there is no cause for alarm. Similarly, there is no immediate problem for the local insurance ventures that have Fortis and AIG as partners. In future, Fortis and AIG may not be able to bring in fresh capital but their stakes can always be sold to others. Finally, Wachovia holds a banking licence in India but that will be cancelled as such licences are non-transferable.
Overall, there is very little impact of the battered and bruised global investment banks and mortgage firms on the Indian financial system. The local banks are healthy, with adequate capital and very little net non-performing loans.
So, how did RBI ring-fence the Indian banks from the turmoil?
Before answering this question, let’s first look at the root of the global problem. It started with the US housing market, where a lot of imprudent loans were given to borrowers who couldn’t afford to repay them. These faulty loans were sliced, mixed with good loans and sold to other banks across the globe. This is loosely called securitization. Banks, insurance firms, pension funds, and even state governments bought those rated assets without batting an eyelid, as there was plenty of liquidity and interest rates were low. The bubble burst when interest rates started climbing and house prices started falling. The problem was magnified with the proliferation of derivatives on these loans that were affected by the meltdown in the values of the underlying assets.
How did India escape this? A cautious and conservative RBI has not allowed banks to take excessive risk. The work started in 2000 when RBI first conducted a stress test of the banks’ investment portfolios in an increasing interest rate scenario. The yield on the benchmark 10-year bond dropped to its historic low of 4.97% in October 2003 but well before that, in January 2002, RBI advised banks to meet the adverse impact of interest rate risk by building up an investment fluctuation reserve, or IFR. When a reversal of rate movement started in late 2004, this helped banks absorb the impact of rising interest rates and mark to market, or MTM, losses.
RBI sensed the real estate bubble ahead of other regulators and in June 2005, it directed banks to have a board-mandated policy in respect of their real estate exposure limits, collaterals and margins. It also increased the risk weight on banks’ exposure to commercial real estate from 100% to 125% in July 2005 and 150% in April 2006, to discourage them from aggressively disbursing real estate loans, as higher risk weight called for more capital and made money more expensive. The risk weight on housing loans to individuals against mortgage of properties was also increased from 50% to 75 % in December 2004 (this was subsequently reduced for housing loans up to Rs30 lakh). RBI also increased the risk weight for consumer credit and capital market exposures from 100% to 125%.
Unable to rein in the scorching loan growth in the real estate sector, personal loans, credit card receivables, and loans against shares, and apprehending a higher default rate in such loans, RBI also progressively raised the provisions for standard assets in November 2005, May 2006 and January 2007. These loans now attract 2% provisions for standard assets, while loans to agriculture and small and medium enterprises continue to attract 0.25% provisions and all other loans 0.40%. RBI has also clamped down on inter-bank liabilities and banks are not allowed to borrow more than 200% of their net worth or capital and reserves from other banks. The limit for exceptionally well-capitalized banks is 300% of their net worth.
At the same time, NBFCs as well as banks and financial institutions are not encouraged to securitize their exposure and create more liquidity. A February 2006 RBI norm on securitization, in fact, virtually killed the market as securitization does not bring down capital requirement any more.
Finally, RBI has also resorted to strong moral suasion to dampen banks’ appetite for risk. They now closely monitor unhedged foreign currency exposures of their corporate clients and do not dare to venture into selling exotic derivatives to help firms tide over currency fluctuations. As a result of all these, sophisticated credit derivatives market and financial innovation in India are still at an embryonic stage, but very few are complaining as it seems better to feel safe than sorry.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to bankerstrust@livemint.com
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First Published: Sun, Oct 05 2008. 10 18 PM IST