Keep watch on credit risk of new private banks: Economic Times, 16th January 2008

The lesson imparted by the subprime crisis is that there is a need to re-focus on ‘credit risk’ along with ‘market risk’ and ‘operational risk’. These risks have become progressively more important as we have traversed the road to Basle II. The story is similar to what has happened in almost all financial crises in the past two decades or so. There is inadequate assessment of risk as financial institutions lend large sums to a certain sector. They borrow funds at high costs and disburse them to the growth sectors and compromise on credit quality assuming that the run will continue. The exotic world of derivatives may provide an escape route, but someone will be left holding the baby when things fail. Are there any such signs in India today? The new private banks (NPBs) have a story to tell as their performance has been remarkable in the past seven years. They are aggressive in their operations be it in raising deposits or lending for housing, credit cards, SME, agri etc. compared to the public sector banks (PSBs). Their share in total advances has increased from 6% to 16% between 2001 and 2007, while the share of PSBs has come down from 80% to 73%. Their growing market share has been applauded by all and their models have become benchmarks. However, their level of aggression could raise some eyebrows as their business models are open to question as the risk carried on their books could tend to be non-conventional. They have been more aggressive in the past five years compared with the public sector banks (PSBs) in terms of innovation, and probably efficiency. There is, however, a prior reason to believe that the credit risk being carried may be on the higher side based on certain indicators when juxtaposed with those of the public sector banks. Firstly, advances of NPBs rose by 39.9% as against 29.1% for PSBs in FY07, and correspondingly their gross NPAs rose by 55.2% as against a fall of -5.8% for PSBs. The elasticity of NPAs to growth in advances is 1.38 as against -0.19 for PSBs. Within different sectors their NPAs to priority sector rose by 125% (2.6% for PSBs) and that to non-priority sector by 38.6% (-18.8%). These banks have been targeting the agri and SME sectors quite aggressively and have not fared too well on the quality issue. Secondly, the quality of their respective portfolios is disparate in terms of risk that is being carried. Sub-standard assets of NPBs rose by 110.1% as against 24.6% for the PSBs. The loss and doubtful debts assets increased by 15% as against a fall of 19.4% for the PSBs. Quite clearly, an aggressive foray into lending in the last few years to claim market share has had an impact on the overall composition and quality of their assets. Thirdly, the NPBs have also a larger exposure to the sensitive sector, which comprises commodities, real estate and capital markets. NPBs had as much as 34.5% of its total advances to this sector, with the highest being in real estate where 32.3% was parked. This ratio was lower at 16.5% for PSBs. Growth in these segments is worrisome as their very nature should put one on guard.
Fourthly, the financial models that underlie the build-up of these assets deserve comment. The cost of deposits for NPBs rose from 3.6% to 4.7% in FY07, while that for PSBs rose only by 20 bps. Evidently, in order to claim a larger share of the deposits pie, they have increased the rates on deposits. Also, the NPBs have stacked short term deposits of less than one year (60% of total deposits) as against PSBs with 29%. This subjects them to the risk of re-pricing which could be at higher interest rates as was the case last year. PSBs on the other hand have around 29% of their deposits locked in tenures of over three years as against only 4% for NPBs, which provides stability to the P&L account. Lastly, the rate of return on advances also increased by 100 bps from 7.3% to 8.3% between FY06 and FY07. This would not have been a cause for concern, but for the fact that this lending has been to relatively high risk sectors. This is the classic case of possible relaxation of credit risk standards which comes at a higher cost especially on the retail side. Real estate loans qualify for this phenomenon where individuals in the sub-prime saga got loans easily without due diligence. Higher interest rates here could be a buffer, but cannot by itself prevent the build-up of an infected portfolio. With aggressive growth strategies being associated with greater risk, there is an ideological issue that needs to be sorted out. Should banks over stretch prudential credit norms for the sake of business, considering that they are dealing with public money? On the other hand, every business entails risk, and it’s true even for the banking sector. But the risk cannot always be evaluated accurately. Where does one draw the line?