Flawed risk assessment: Have Indian banks been underpricing corporate loans?

In the 1990s, we had large-scale defaults on corporate loans, which felled IDBI and IFCI. For some time, we thought that we had learned our lessons, that micro-prudential regulation had improved, so that such failures would not recur. Has this happened? There is cause for concern.

1) After these bailouts of slightly over a decade ago, we haven’t had a big banking crisis with a collapse of banks such as IDBI or IFCI. But there is a worrisome scale of regular injections of capital into public sector banks by the Ministry of Finance. If the government puts Rs 100,000 crore into an episode of bailing out banks, we say there is a banking crisis. This is not too different from putting Rs 10,000 crore every year for 10 years. Have we had a chronic sub-clinical banking crisis for a long time? Some will argue that all healthy banks raise equity capital as they grow. But there is an unmistakable element of bailout in the equity capital that has gone into PSU banks. On this subject, see Harsh Vardhan and me from October 2012, and this blog post from October 2011.

2) India did not have a big financial crisis in 2008. All we have had was a business cycle downturn that’s come after a big credit boom. Yet, we’ve now got a serious mess in banking on our hands.

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These two difficulties suggest that micro-prudential regulation has not improved adequately.

When we open the black box of Indian banking, two problems are visible. Most banks have little skill in credit risk assessment. What passes for ‘risk management’ in Indian banks, too often, is the mechanical adherence with RBI regulations – regulations that micro-manage and are often wrong. There is low ability in the essence of credit analysis: to understand a firm, and make forward-looking forecasts about default. In addition, all banks suffer from high levels of loss, given default owing to the lack of a bankruptcy code.

The objective of micro-prudential regulation of banks is to put down requirements through which the failure probability of banks stays at acceptable and low levels (though not zero). The heart of this is ensuring that the accounting value of each loan is aligned with market value. This was not done. Banks have systematically failed to recognise and provide for bad loans. I feel a distressing deja vu when I hear stories today about what has gone wrong in Indian banking; we heard those exact same stories in 1999. We did not learn; the problems weren’t fixed.

Given these weaknesses of micro-prudential regulation, banks have had a merry time, showing accounting profits while giving out loans at artificially low prices, and building up an ever larger inventory of loans where the book value is in excess of the market value. Better micro-prudential regulation would have created a set of rules through which bad loans were valued at market price. Better micro-prudential regulation would have hindered, and not helped, banks in covering up bad news.

Better micro-prudential regulation would have created incentives for banks to charge higher prices for corporate lending, with interest rates that better reflected their own weaknesses in corporate credit risk assessment, and the high values of loss given default. Mistakes in micro-prudential regulation gave us a systematic under-pricing of risk.

The great credit boom of 2004-2007 has traditionally been interpreted as mistakes of macro policy: This came from the pegged exchange rate. The RBI bought dollars in order to prevent the rupee’s appreciation, with incomplete sterilisation, which gave low interest rates at a time of a boom in business cycle conditions. This gave us the biggest ever credit boom in India’s history. I would add one more ingredient in our understanding of that credit boom: Mistakes in micro-prudential regulation of banks. Mistakes of macro and micro came together to give that party.

Looking forward, improving the thinking in micro-prudential regulation of banks is an important priority. It will take years for India to reverse public sector domination of banking, and the consequential weaknesses of credit risk evaluation. It will take years for India to reduce the loss given default, by enacting an Indian Bankruptcy Code.

In the short term, these problems must be treated as given. For the coming two years, the agenda must be to break away from the failures of the last 20 years in banking regulation, while treating the presence of PSU banks and the lack of a bankruptcy code as a given. At present, the landscape of banking regulation is riddled with mistakes [ example, example]. The fair price of a bank loan to a corporation is probably much higher than what we’ve thought it should be.

This post first appeared on Ajay Shah’s Blog.