Sometime in 2011 when the first signs of an economic slowdown appeared, my boss asked the entire team of analysts to figure out how badly their respective sectors could be hit. The standard way of doing that was to check how bad things were in the last crisis, and use that as a benchmark. So he asked me “How low did bank credit growth go around end-2008, immediately after the crisis?” I said, “It shot up to 33% from 26% prevailing before the crisis.”
Strange are the ways of banking. During the post-Lehman financial crisis, when, as a colleague put it “the economy had disappeared for some time”, bank credit demand skyrocketed and in 2010, when the economy substantially recovered, even roared, credit declined steadily, touching single digits on several fortnights.
Blame the Scots for this. Apparently, as one senior banker explained at that time, we have borrowed our cash credit system from the Scots ages ago. Banks set credit limits for corporations based on the company’s financials and on an assumption based on past statistics that an average borrower will use up to 60% (say) of the total sanctioned limit. This can lead to a problem when almost every borrower wants to use 100% of the limit or more.
My boss then asked “Ok, but how bad did the margins get?” By now, there should be no prizes for guessing my answer – “The margins shot up by 15-20 basis points during that quarter.”
So this is the chain of events in 2008, which may partly be repeated this time around: During the post-Lehman phase, developed country banks de-leveraged, cutting off credit to Indian companies. These companies ran to overseas branches of Indian banks but by then these branches were also short of resources. Costs of foreign borrowing in India went up. Private equity and structured funding routes (especially for real estate developers) froze. Companies were left with no choice but to crowd into the domestic branches of Indian banks.
I fervently hope we are not heading for a post-Lehman scenario this time. But banks must prepare for that. The current public discourse seems to be oblivious to such a possibility.
There is fundamentally nothing wrong with a panic-induced 35% loan growth (rather than excessive leveraging driven by exuberance) and bankers should love it. But it can be a miserable time for bankers because the additional credit has to be matched by resources, preferably deposits. That comes at a cost. Add to that the pressure from the government not to raise lending rates.
The excess demand in 2008, a result of diversion rather than new demand, led to even AAA-rated oil companies borrowing short-term money from banks at 14-15%. A corporate and a banker were celebrating the official closure of a Rs800cr loan, when in the middle of the celebration the banker’s senior called up to inform that they could afford to lend only half of that amount. Throats dried up even as the alcohol flowed.
If the Eurozone gets into a deeper crisis and their banks reduce credit to Indian corporations, it can trigger a start of the 2008 credit crunch cycle. It could be more stressful due to three additional reasons – the $5bn worth whammy of foreign currency convertible bonds which are up for redemption, a sizeably larger government borrowing program, and the fact that RBI has lesser leeway to inject primary liquidity. Prior to the 2008 logjam, the cash reserve ratio (CRR, or the proportion of deposits that banks need to keep with RBI) was 9%, now it is 4.75%. Moreover, 2008 saw a general risk aversion; in 2012, India is a special category nation inspiring not aversion but revulsion.
The combined impact of these factors will be to raise demand for credit and push up interest rates - banks have to pay more on deposits and increase lending rates. This will conflict with RBI’s relatively relaxed (though not easy) interest rate environment. More importantly, the government will go berserk with banks increasing rates, as they are of the firm belief that rates should always be going down. Banks in turn will be reluctant to lend at higher rates, fearing more defaults.
It does not appear as though the system is anywhere close to being prepared for this eventuality. There is still too much talk about weak credit demand arising from a weak economy. Nothing radical can be done, but being prepared can help withstand the blows. It is also an opportunity for the government to show some resolve and take firm steps to preclude a ‘crisis’, particularly since its credibility is in tatters. A substantial cut-back in their borrowing program will help. Banks have to plan accordingly; perhaps moderately lower retail lending growth to conserve resources for corporations. And RBI on its part may have to temporarily jettison its inflation argument and cut CRR sharply.
Dipankar Choudhury was Director of Indian Financial Services Research at Deutsche Bank, and is currently an independent consultant focusing on banks and financial services.