State of the Indian Banking Sector in the context of the Global Financial Tsunami

1. Centre for Asia Studies State of the Indian Banking Sector in the context of the Global Financial Tsunami A Presentation F. R. Joseph RD, RBI Chennai April 04, 2009

2. The Presentation Path • Causes of the Global Turmoil • The Unfolding Crisis • Indian Banking Sector • Stitch in Time : Pre-emptive Action • Impact on India • Outlook for India

3. Causes of the Financial Turmoil • Low interest rate regime : Specially in US and in Developed Countries from 2001 and 2004 • Search for Yield and Income • Complacency afforded by stable growth and low inflation • Under-pricing of risk: increase in sub-prime mortgages • High prices leading to oversupply of housing in US • Financial Innovation: Securitization and structured and complex derivative products

4. Causes (2) • Mortgages were sold by the originators, parceled into complex securities, multi-layered and distributed across the world • Role of credit rating agencies: faulty and inadequate • Excessive leverage and weak risk-management systems • Greed: incentive structure encouraging excessive risk taking by fund managers • Regulatory gaps and lax supervision

5. Pools of Assets = Structured Finance Instruments • Asset-backed securities(ABS) are bonds or notes based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. • Mortgage-backed securities (MBS) are asset-backed securities whose cash flows are backed by the principal and interest payments of a set of mortgage loans. • Collateralized mortgage obligations (CMOs) are securitizations of mortgage-backed securities. • Collateralized debt obligations (CDOs) consolidate a group of fixed income assets such as asset-backed securities into a pool, which is then divided into various tranches. • Collateralized bond obligations (CBOs) are CDOs backed primarily by corporate bonds. • Collateralized loan obligations (CLOs) are CDOs backed primarily by leveraged bank loans. • Credit derivatives are contracts to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset. • Collateralized Fund Obligations (CFOs) are securitizations of private equity and hedge fund assets.

6. The Trigger • Change in interest regime • Starting June 2004 US Fed increased rates 17 times from 1.00% to 5.25% • EMIs revised upwards leading to sub-prime defaults and foreclosure of mortgages • House prices fell and value of securities based on these mortgages were eroded Due to the inherent opaqueness of the products and the financial institutions the contamination of portfolios was not easily assessable and hence not adequately monitored or mitigated

7. Trigger (2) • Inadequate information about the quality of assets in portfolios heightened counterparty risk perception and led to extreme risk aversion • Frantic deleveraging to meet the maturing liabilities • Leading to near freezing of money markets • Assets held by non-depository financial instruments (investment banks, hedge funds, etc) being largely financed by short term money market instruments that could not be rolled over • Erosion of confidence in counterparties • Liquidity dried up and funding difficulties pervasive

8. The Unfolding Crisis • Started as Sub-Prime Crisis • Led to Liquidity crisis • Became a pervading Credit crisis • Developed into a Solvency issue • Financial Crisis with contagion effect • Global Economic Crisis

9. Crisis Unfolding… In the US Three major Investment Banks have ceased to exist (Bear Stearns (JPMC), Merrill Lynch (BOA) and Lehman Brothers - insolvency) Goldman Sachs and Morgan Stanley constrained to convert to commercial banks and brought under the banking regulator viz., Fed Reserve Nationalization of Freddie Mac and Fannie Mae AIG one of the world’s largest insurer taken over by US Govt Several banks have declared bankruptcy in US

10. Crisis Unfolding… In Europe Northern Rock was nationalized Halifax Bank of Scotland was taken over by Lloyds TSB Bail out of banks in Germany and Denmark Large write-offs: HSBC ($27bn), RBS ($14bn) UBS ($44bn), Deutsche Bank ($11bn), Credit Suisse ($10bn) There were substantial write offs by Japanese banks ($15bn) and other Asian banks including Bank of China ($3bn)

11. Fire Fighting • Direct Lending by central banks to deposit taking and other financial institutions – eligible collaterals included equity • Cut in interest rates – monetary easing • Swapping of illiquid assets with liquid assets • Lender of Last Resort function to the fore • More financial entities brought under central banks’ control: moral hazard ? • Government take over of financial institutions • US Govt set up massive funds to purchase mortgage and other impaired assets from banks

12. Global Outlook • Total write-downs (losses) could be in excess of one trillion USD • Sub-prime loans (USD1.3 trillion) defaults may cease but Alt-A floating mortgage loans (USD1.4 trillion) are due for interest rate reset and consequential more delinquencies • Central banks support inadequate: greater fiscal support needed • Concern shifted from fighting inflation to restoring financial stability Confidence in Free Markets shaken !

13. Financial Sector in India • Financial sector in India continues to exhibit stable conditions enjoying the confidence of its stakeholders • Banks are well capitalized and their portfolios are healthy in terms of quality of assets • Banks in India have made substantial profits for the year ended March 2008 and unprecedented profits in the third quarter of the current year • Their mark to market losses are minimal and will not affect this year’s results • Fiscal support (tax payers money) to the banks at less than 2% of GDP – paid back with interest How did it all happen…….

14. Financial Sector Reforms • First phase of Financial Sector Reforms launched in 1991 – based on Narasimhan’s Committee Recommendations • Prudential Norms introduced on capital adequacy, asset classification and income recognition • More autonomy and flexibility for operational efficiency • Greater transparency and disclosures • Reduction in pre-emptions • New generation banks and greater competition • Technology and customer driven • Less Regulation and tighter Supervision • Disinvestment of PSBs and greater market discipline

15. RBI’s Approach and Strategy • The RBI while giving highest priority to price stability aimed to assure financial stability maintaining the growth momentum at reasonable levels • Financial stability achieved in India through perseverance of prudential policies which prevented institutions from excessive risk taking • These policies also prevented financial markets from becoming volatile and turbulent and keeping near orderly conditions in markets

16. Prudential Foresight • In 2000 when the interest rates were declining, the RBI conducted a stress test of the banks’ investment portfolio in an increasing interest rate scenario • The findings made RBI direct the banks to build up an Investment Fluctuation Reserve to meet the adverse impact of interest rate risk • This counter cyclical prudential requirement enabled banks to absorb the impact when interest rates began to climb since late 2004 • Banks were also advised to maintain capital charge for market risk since March 2006

17. Prudential Foresight… • International standards are being set for classifying and valuing banks’ investments ensuring prudence and transparency; to provide for net losses and ignore the net gains • The measures were dynamically flexible and essentially counter-cyclical • In 2005 RBI advised banks to have a Board mandated policy for real estate advances covering exposure limits, collaterals to be taken, margins to be kept, etc. • The risk weight on banks’ exposure to commercial real estate was increased to 125% in 2005 and to 150% in 2006. • However risk weight for individual housing loans was kept at 50%

18. Prudential Foresight… • To maintain the quality of lending in the light of rapid credit expansion, the risk weight for consumer credit and capital market exposure was increased to 125% • The provisioning requirement for standard assets in respect of personal loans including credit card receivables, loans to capital markets, real estate loans excluding residential housing loans and loans to large NBFCs was raised to 2.0% during 2005-07. (0.25% for Agricultural and SME sector and 0.40% for all other advances) Exposure ceiling limits have been fixed for single borrower (15% of capital funds) and for a borrower group (40%). The limit is 10% for borrowers in NBFC sector

19. Prudential Foresight… • RBI also addressed the concentration risk on the Liability side of the banks’ balance sheets as uncontrolled liability of banks have systemic risk and implications • Prudential limits were fixed for banks’ Inter-Bank Liability at 200% of their net worth; 300% if the CRAR is at 125% of the regulatory minimum. • Prudential limits for banks on borrowing from (100% of the banks capital funds) and lending (25%) in the call money market fixed • RBI issued Securitization guidelines in early 2006 applicable to all financial institutions. • This envisages a conservative treatment of securitization exposures for capital adequacy especially in regard to credit enhancement and recognition of income on sale of assets

20. Prudential foresight.. • Detailed prudential guidelines were issued in regards to banks investments in non-SLR securities. • Banks were advised not to be solely guided by the ratings of the external rating agencies but should make their own internal credit analysis and rating • Banks sensitized to monitor unhedged foreign currency exposures of their clients, banks’ reliance on non-deposit resources to finance assets, their excessive reliance on wholesale deposits and uncomfortable LTV ratios in respect of housing loans, etc. RBI has been cautious in introducing credit derivatives like credit default swap and has not encouraged ‘originate-to-distribute’ model in India

21. Impact on India • Why was India hit: Growing integration with world economy. Ratio of total external transactions (gross current account flows and gross capital flows) to GDP rose from 31% to 117% in 2008 • How India has been hit: - Financial Channel – equity, forex and credit markets - Real Channel – slump in exports (goods and services), lower GDP, lower remittances, etc - Confidence Channel – Business / investment decisions getting deferred and banks becoming more cautious about lending

22. Impact on India: Financial Markets & Sector • Financial Institutions have not been affected: No exposure of Indian banks to the sub prime market and negligible exposure to financial institutions like Lehman Brothers, etc • Sensex has sharply fallen and FIIs have disinvested from equity markets in 2008 • USD-INR exchange rate depreciated sharply due to less capital flows and widening trade deficit • More demand for credit due to drying up two other major sources: the external funding and capital markets

23. Indian Response • Government – Fiscal Stimulus packages • RBI • Maintaining comfortable Rupee Liquidity • Augmenting forex liquidity • Ensuring Credit delivery to productive sectors • Counter cyclical Measures

24. Rupee Liquidity Measures • Repo rate reduced from 9 to 5% and reverse repo to 3.5 from 6% • CRR reduced from 9 to 5% • SLR reduced by 1% to 24 • II LAF auction introduced • Term repo facility of Rs60,000 crore (1.5% of NDTL) under LAF to ease liquidity stress faced by MFs & NBFCs • Buyback of securities issued under MSS • SPV formed to address the liquidity constraints of NBFCs. It will purchase CPs and NCDs

25. Forex Liquidity Measures • Direct intervention in the market to augment supply • Interest rate ceilings on non-resident deposits increased • ECB Policy liberalized; interest rate ceiling dispensed up to June 09 (including relaxation for infrastructure NBFCs and for hotel, hospital and software sectors) • Premature buy-back of FCCBs

26. Credit Delivery and Counter cyclical measures • Relaxation in interest rates for exporters • Contribution to SIDBI and NHB to boost their lending • Relaxations on asset classification norms and provisioning • Reduction in provisioning of standard assets and assignment of risk weights • Special dispensation to MFs, NBFCs and real estate

27. Outlook for India • Resilience and not much turbulence in the financial markets • Banking system remaining sound, healthy, well capitalized and prudently regulated • Lower inflation and commodity prices • Comfortable foreign exchange reserves • BoP and Current Account deficit discomforting • Moderation in GDP growth and declining exports

28. Concerns and challenges • The Cause and Outcome of the Global Crisis: ‘Banks have stopped lending’ • Excessive parking of funds in Govt securities and with RBI in the short term • Keeping up the credit flow to all productive sectors and to MSMEs in particular • Better Risk management – Basel II Obligations • Financial Inclusion

29. Thank You