Ironically, on the day US investment bank Lehman Brothers Holdings Inc. filed for bankruptcy, the chief executive officers of six large commercial banks assembled at a south Mumbai hotel to debate a topic close to every foreign banker’s heart—“Should India open up the financial sector?” The occasion was Mint’s annual banking conclave.
Y.V. Reddy, former Reserve Bank of India (RBI) governor, widely known for his views against opening up the sector, had retired just 10 days before the collapse. His successor D. Subbarao, former finance secretary, was to be the chief guest at the conference but he excused himself because he could not have expressed his views on the subject in his new role as RBI governor. The mood at the conference was sombre and even the traditionally aggressive foreign bankers, who always blame the Indian banking regulator for keeping the doors closed, were restrained in their arguments. The beer tasted flat that evening, the food stale, and a few panellists, including ICICI Bank Ltd’s then managing director and CEO, K.V. Kamath, did not wait for the dinner and left immediately after the discussion was over.
The exposure of ICICI Bank, India’s largest private sector lender, to Lehman Bothers was $83 million (around Rs403 crore today), less than 0.1% of its consolidated balance sheet, but investors rushed to sell the bank’s stock and pulled it down by 15% in the next few days as panic gripped the market.
A few other banks, including State Bank of India and Punjab National Bank, two large public sector banks, had a small exposure to Lehman Brothers in various forms. At a meeting with the executives of Lehman Brothers’ India arm and local banks, V. Leeladhar, the then deputy governor of RBI, told the US investment bank to close all transactions with Indian banks within 24 hours. Lehman Brothers did so in 48 hours.
Lehman Brothers was running a non-banking financial company in India, but its entire capital was invested in government bonds and bank deposits and hence the money was safe. Its broking arm, Lehman Brothers Securities Pvt. Ltd, housed in Ceejay House— hemmed in between the Arabian Sea and the glass-walled Atria shopping mall on Annie Besant Road in mid-town Mumbai, the most expensive office space in the city—was taken over by Japan’s Nomura Holdings Inc. in October. Nomura also took over Lehman Brothers’ backoffice operations, which employed 2,200 people, in Powai, a western suburb of Mumbai.
RBI was prompt in protecting Indian financial intermediaries from the direct impact of the Lehman collapse, but it took time to appreciate the gravity of the unprecedented liquidity crunch that the global financial system had plunged into after the collapse.
The first rate cut was announced on 20 October, more than a month later, and by that time overnight call money rates soared and commercial banks ran dry. By the time RBI realized the magnitude of the crisis and swung into action by cutting interest rates and the cash reserve ratio, or CRR—the portion of deposits that banks need to keep with RBI—the confidence of the financial system had been shattered. Banks stopped lending to individuals as well as firms because they were not confident that liquidity would remain in the system and they were hoarding money by paying very high rates to depositors.
It took nearly six months to restore the confidence of the financial system and convince banks that liquidity would be maintained. RBI did that by bringing down its policy rate from 9% to 3.25%, CRR from 9% to 5% and the floor for banks’ government bond holding from 25% to 24%. Collectively, the cut in the reserve requirement and the opening of new refinance windows pumped Rs5.6 trillion into the Indian financial system.
While RBI was slightly late in waking up to the new reality after the Lehman collapse, one must give the regulator credit for sensing trouble ahead of others and ringfencing banks from the global turmoil. For instance, it increased the risk weight on banks’ exposure to commercial real estate from 100% to 125% in July 2005 and 150% in April 2006. The idea was to discourage banks from aggressively disbursing real estate loans. Higher risk weight calls for more capital and makes money more expensive. The risk weight on housing loans to individuals against mortgage of properties was raised from 50% to 75 % and for consumer credit and capital market exposures, increased from 100% to 125%.
Despite all these measures, loan growth in the real estate sector, personal loans, credit card receivables, and loans against shares rose at a scorching pace, raising fears of a higher default rate on such loans. While loans to agriculture and small and medium enterprises continued to attract 0.25% provisions and all other loans 0.4%, RBI had jacked up the provisions for standard assets for these loans to 2% in stages in November 2005, May 2006 and January 2007. It also clamped down on inter-bank liabilities and did not allow banks to borrow more than 200% of their net worth, or capital and reserves, from other banks.
The collapse of Lehman Brothers was the symptom of an ailment first seen in 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. Banks, insurance firms, pension funds, and even state governments bought those rated assets as there was plenty of liquidity and interest rates were low. While most central banks looked the other way and waited for the bubble to burst, RBI went ahead and pricked the bubble.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Please email your comments to firstname.lastname@example.org