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How Sound Is Indian Banking?

The Committee on Financial Sector Assessment has found Indian banking to be in sound shape. However, while liberalisation and financial integration may not have resulted in excess exposure of Indian banks to the toxic assets that originated in the US and Europe, there is still cause for concern since the behaviour of domestic banks - with lending shifting in favour of more risky assets - has begun to resemble that of banks in the advanced countries.


and foreign exchange s egments..., the

How Sound Is Indian Banking?

banking sector has not been significantly impacted”, as evident from the “comfortable capital adequacy, asset quality and prof-C P Chandrasekhar itability indicators even for the half-year

The Committee on Financial Sector Assessment has found Indian banking to be in sound shape. However, while liberalisation and financial integration may not have resulted in excess exposure of Indian banks to the toxic assets that originated in the US and Europe, there is still cause for concern since the behaviour of domestic banks – with lending shifting in favour of more risky assets – has begun to resemble that of banks in the advanced countries.

C P Chandrasekhar ( is with the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.

t has been more than a year since the banking crisis broke in the countries of the Organisation for Economic C ooperation and Development. Over that period the International Monetary Fund’s estimates of losses incurred by the United States and European banks from bad assets that originated in the US have doubled to touch $2.7 trillion. When losses on loans that originated in Japan and Europe are included, the figure rises to a mammoth $4.1 trillion, which has put in question the viability of the world’s leading banks. If banks in the most developed financial markets of the world are under threat, the question naturally arises whether banks elsewhere in the world are safe.

Fortunately for India, precisely at a time when this question is being posed, its financial regulatory and policymaking e stablishment has put together a comprehensive assessment on the state of its financial sector. The recently released report of the official Committee on Financial Sector Assessment (CFSA) comprises six volumes: an executive summary, an overview report and reports of the advisory panels on Financial Stability Assessment and Stress Testing, Financial Regulation and Supervision, Institutions and Market Structure, and Transparency Standards. Not all of the evidence marshalled and arguments advanced by the committee can be discussed in this short column. But its assessment of the soundness of India’s banking system bears highlighting.

Main Finding of CFSA

The CFSA’s main conclusion is that:

The Indian commercial banking system has shown itself to be sound. This is important because commercial banks are the dominant institutions with linkages to other segments in the Indian financial system, accounting for around 60% of its total assets.

Moreover, while the “global financial turmoil has had repercussions on the I ndian financial markets, particularly in the e quity

may 9, 2009

ended September 2008 and the third quarter ended D ecember 2008”.

What is noteworthy is that the evidence of comfortable capital adequacy and improving asset quality with lower non- performing assets (NPAs) relates to a much longer period stretching from around the mid-1990s. The capital to risk weighted assets ratio at the system level rose from 10.4% in 1997 to 13.0% by 2008, suggesting that as a group Indian banks had enough regulatory capital at hand to deal with contingencies. On the other hand, the ratio of gross NPAs to total a ssets had declined from 15.7% to 2.4% between 1997 and 2008; and the net NPA ratio had declined from 8.2% to 1.1% d uring the same period.

This is indeed remarkable because this was a period when credit growth was substantial. Total bank credit in India has grown at a scorching pace in recent years, at a rate more than double the rate of i ncrease of nominal GDP. As a result, the ratio of outstanding bank credit to GDP which had declined in the initial postliberalisation years from 30.2% at the end of March 1991 to 27.3% at the end of March 1997 doubled over the next decade to reach about 60% by March 2008. Further, the growth in credit outperformed the growth in deposits between 2004-05 and 2005-06 resulting in an increase in creditdeposit ratio from 55.9% at the end of March 2004 to 72.5% at the end of March 2008. This increase was accompanied by a corresponding drop in the investmentdeposit ratio, from 51.7% to 36.2%, which indicates that banks were shifting away from their earlier conservative preference to invest in safe government securities in excess of what was required under the statutory liquidity ratio (SLR) norm.

Emergence of Retail Exposure

At one level enhanced lending is a positive phenomenon in any context, especially in that of a developing country such as India. But it is here that the scepticism lurking

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Economic & Political Weekly


b eneath the CFSA’s confident assessment begins to show. The nature of this increased lending does give cause for concern. Retail loans, which grew at around 41% in both 2004-05 and 2005-06, have been one of the prime drivers of credit growth in recent years, despite the moderation in growth rates to 30% in 2006-07 and 17% in 2007-08. The result was a sharp increase in the retail exposure of the banking system, with retail loans that were less than 10% of gross advances in the 1980s rising to 18.3% of the total by March 2004 and further to 25% by March 2007, where it has remained. Of the components of retail credit, the growth in housing loans has been the highest in most years, amounting to as much as 50% in 2005.

The danger here is that this rapid increase in retail exposure could have brought less creditworthy borrowers into the bank credit universe. Fortunately, restrictions on the activities of banks have helped limit exposure to other kinds of risky assets. Thus, according to the committee, the aggregate exposure of the banking system to “sensitive” sectors, like capital, real estate and commodity markets, stood at 20.6% of aggregate bank loans and advances at the end of financial year 2008. With exposure to real estate amounting to 18% of total advances, the role of capital (2.5%) and commodity markets (0.1%) was comparatively small.

Perils of Large Housing Exposure

But as the report suggests, large housing exposure is a cause for concern. Globally, it is now recognised that a sharp increase in retail exposure in general and real e state and housing exposure in particular occurs in a context of rising asset and housing prices. On the other hand, i ncreased credit provision to this sector tends to drive housing prices to even h igher levels. The boom-bust cycle this could result in can quickly turn safe assets into suspect ones, straining balance sheets.

The strain can be significant because rapid credit growth has meant that banks are relying on short-term funds to lend long. According to the CFSA:

The maturity profile of deposits, advances and investments of the banking system r eveals that since March 2001 there has been a steady rise in the proportion of short-term deposits maturing up to one year. Deposits maturing up to one year increased from 33.2% in March 2001 to 43.6% in March 2008. At the same time, the share of term loans maturing beyond five years increased from 9.3% to 16.5%. While this could imply increased profits, the increased asset liability mismatch has increased the liquidity risk faced by banks.

It also appears that to attract borrowers the banks have been cutting interest rates. The period of increased credit offtake has also seen an increase in loans provided at interest rates below the benchmark prime lending rate (BPLR). The share of such loans in the total rose from 27.7% in March 2002 to 76.0% at the end of March 2008. This increase has been marked in the case of retail credit. According to the CFsA, the rise in sub-BPLR loans can be attributed to “an increase in liquidity, stiff competition, buoyant corporate performance which lowered credit risk and growth in retail credit (housing)”. That increase, in its view, reflects a mispricing of risk that could affect banks adversely in the event of an economic downturn.

Off-Balance Sheet Exposure

Thus, lurking beneath the confidence in Indian banking exuded by the CFSA is an element of caution even if not excessive concern. Not the least because of other signs of an increase in risk-taking behaviour. Thus, while “capital adequacy ratios across bank groups have remained significantly above the regulatory minimum and, even better” and “NPA ratios have shown a significant decline”, the CFSA is concerned that “there has been an increase in the growth of off-balance sheet (OBS) exposure in recent years, particularly in the case of foreign banks and new private sector banks”. These OBS e xposures are in the nature of contingent liabilities (such as letters of credit, financial guarantees, acceptances, endorsements and underwriting and standby commitments) or derivatives (principally foreign exchange rate agreements and interest rate related contracts).

In recent years, the share of derivatives contracts has increased sharply and within them the share of interest rate contracts such as swaps has risen from less than 40 to 60%. The ratio of OBS exposure to total assets increased from 57% at the end of March 2002 to 363% at the end of March 2008. This increase is mainly on account of derivatives whose share averaged around 80%. Derivatives such as interest rate swaps are indeed risky. Moreover, as the CFsA recognises, currently prevailing accounting standards do not clearly specify how to account for losses and profits arising out of derivatives transactions. In its view, given the lack of prudential accounting and disclosure norms, the propensity of some players to use derivatives to a ssume excessive leverage is a source of concern, since it is difficult to gauge the quantum of market and credit risks that banks are exposed to.

These developments in Indian banking do have one important implication. Though liberalisation and financial integration may not have resulted in excess exposure of the Indian banking system to the toxic assets that originated in the US and Europe, it has altered banking behaviour so that it has begun to resemble that of banks in those countries. One consequence is an increased exposure to risk, which is a matter of concern in itself and not just because the Indian regulatory s ystem is not yet geared to deal with such risk, if it can at all.

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Economic & Political Weekly

may 9, 2009 vol xliv no 19

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