Compromising on provisioning norms : Business Line: 24th November 2008

The RBI’s lowering of the general provisioning requirements for standard assets could be used as a precedent for further easing of norms for sub-standard assets at a later date.
Business cycles are now accepted as being a part of the economic way of life and the prevalence of capitalism only ensures that this process is continuous. While the amplitude of these cycles has come down, they have become more common than before. Joseph Schumpeter had written extensively on the process of creative destruction wherein capitalism ensures that when there are crises, the good are separated from the not-so-good and the system carries on as before, albeit afte r some painful adjustments are made.
Contemporary economic history shows that all such crises are engendered by the monetary authority which then goes through the equally painful process of readjusting the interest rates to counter the crisis; and just as things look good, it is time for the next round.Pumping in liquidity
Central banks across the world are busy trying to increase the flow of liquidity by providing finance to banks as well as lowering interest rates. The lowering of rates by the Federal Reserve once again to 1 per cent (with an effective rate of 0.25 per cent now) brings in the feeling of déjÀ vu as this was also the situation when the derivative-cum-housing bubble evolved.
The RBI has also followed the same path and the extensions that have been invoked should start some fresh debate. The RBI had assiduously increased interest rates from May onwards to counter inflation and has now gone backwards to provide liquidity to address growth. While such fine monetary tuning is debatable, it is still acceptable as the monetary authority has to take a stance one way or the other. But the announcements made relating to provisioning requirements are serious.Lower provisioning
The RBI has reduced the general provisioning requirements on standard assets for residential housing loans as well as personal loans to 0.40 per cent from 1 per cent and 2 per cent respectively. The same has been done on banks’ exposures to sectors such as unrated claims on corporates and loans secured by real estate to 100 per cent from 150 per cent. The issue raised is whether this practice should be encouraged or not?
Banks have had the temptation to lend more to these sectors which is why such relief would be beneficial for banks in such trying times. Lower provisioning actually helps to improve the bottom line. In fact, it could be enticing for banks to lend more to the unrated companies today where they could charge a higher rate at a time when their spreads are under pressure, without the encumbrance of higher provisioning.
Let us look at the ostensible reasons for doing so. Banks do claim that their profit margins would be affected quite obtrusively by the interest rate movements since their lending rates have come down probably due to some pressure being put by the government while the deposit rates cannot move down as they do not have funds and are hence providing higher rates on long term deposits of over a year.
Further, there is a distinct possibility of banks booking losses on their asset portfolio due to their exposures to the CDO and CDS segments as well as the possibility of defaults on mortgage service payments. In this scenario, the RBI evidently is trying to provide support by easing the provisioning norms.Not a right approach
The situation is analogous to one where the pass mark is reduced in an examination to allow more students to pass! Ideally, this should not be a suggested approach because while support can be provided through the interest rate and CRR routes, tampering with prudential norms would not be advisable.
As the RBI has worked quite hard in bringing in prudential norms into the banking system, whereby banks became more conscious of the quality of their assets as well as capital, more in line with Basle I and Basle II requirements, the present move once again raises the issue of a new moral hazard at the institutional level.
Will the banks consider indiscriminate lending with the hope of the RBI providing relief in the form of easier provisioning requirements in the future?
The broader issue really is whether or not the RBI should be concerned about profitability of banks, especially where there is a conflict with prudence. The function of the RBI is to monitor liquidity and ensure that the rate structure is in consonance with the overall macroeconomic targets that have been set forth in terms of inflation and growth.
Banks would need to work their way through these broad parameters that are set. While today the rates have been lowered for standard assets, and hence prima facie looks fairly innocuous, the precedent could be used for further easing of norms for sub-standard assets at a later date. A matter of prudence
It must be realised that the idea of having such norms at a nominal rate for standard assets is a matter of prudence where the provisions actually cumulate to provide for a buffer when assets deteriorate in quality at a later date. The exposures to the mortgage or personal loan segment or even the derivative segment for that matter would actually show as possible pressure points at a later date, for which the present provisioning provides the requisite cushion.
This really goes back to the basic question about how far should the monetary authority go in protecting the banking system?
Ensuring that the deposit holders are not affected looks a convincing stance, though gearing policies towards protecting the profit lines of banks does not work, even at the academic level.