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Asia-PacificJuly 2 2006

Reflections on credit risk

Having spent the past few years building up their retail loans, India’s banks are now considering ways to mitigate the effects of a downturn in the property or equity markets. Kala Rao reports.
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After a rapid build-up in retail assets in recent years, Indian banks are pausing to assess the risks of lending to millions of small borrowers that have a scrappy credit history. The panic is not yet on, but the banks and the regulator are uneasy about how a rise in interest rates, sky-high property prices and a sharp downturn in the equity markets could affect banks’ balance sheets. Retail loans comprise about a quarter of bank credit, excluding food credit to farmers.

In April, Reserve Bank of India (RBI) governor Y V Reddy announced several measures aimed at protecting banks from a possible asset price bubble in the property and equity markets. Provisions that banks must make on standard advances were increased from 0.40% to 1% on personal loans, for loans that involve an exposure to the capital market, large home loans and loans to the commercial real estate sector. The risk weight on bank loans to the commercial real estate sector was also increased to 150% from 125%.

Loan build-up

Those warnings were prompted by the rapid build-up of home mortgage-backed loans and loans against personal assets, such as property and equity shares, on banks’ books as the boom in retail finance took off. About 53% of the Rs3000bn ($65.2bn) bank retail assets on January 20, 2006, comprised loans against home mortgages, and bank loans to the commercial real estate sector grew by 84% last fiscal year.

Moreover, the regulator found evidence that banks may not be assessing the risks involved adequately. Earlier this year, the RBI fined about nine banks after an investigation into a financial scam in which a few individuals cornered shares that were reserved for small investors in several initial public offerings by opening multiple bank accounts. The central bank found that they had flouted rules in advancing loans against shares and had deviated from the Know Your Customer norms in opening customer accounts. The list of banks included reputed names such as HDFC Bank and ICICI Bank, as well as foreign banks such as Citigroup and Standard Chartered.

Timely warning

The warning proved timely when the Indian stocks lost about a quarter of their market value from May to early June in the wake of the pullout by foreign portfolio investors from emerging markets. The rupee fell, prompting the RBI to raise two key interest rates by 25 basis points (bp) on June 8. As a result, banks such as ICICI put up their lending rates again. In the past year, the cost of home loans, car loans and all other personal loans has risen by about 150-200bp.

V Vaidyanathan, head of retail banking at ICICI Bank, India’s largest retail lender, says that the higher cost of funds could dent future demand for retail loans. “It [the RBI’s move] signals an upward bias in interest rates. Demand for credit is rising, while [the rate of growth of] bank liabilities has not kept pace,” he says.

“From being a lender in the money market, we are now a net borrower,” says T S Bhattacharya, the interim chairman of State Bank of India (SBI), India’s largest commercial bank. SBI, like most Indian banks, is protected from an upturn in interest rates on its existing loan portfolio because 87% of its retail loans are contracted on a floating rate pegged to a benchmark rate. Borrowers must bear the burden either by lengthening the term of the contract or by paying more each month.

Quality checks

A possible brake on the growth in retail assets gives banks an opportunity to assess the quality of the portfolio they own. The focus is now on credit quality, debt collections and recovery. The paucity of authentic information to verify the identity or net worth of borrowers was the single biggest risk for Indian banks in growing retail assets.

This is especially true of large public sector banks, whose information technology systems are relatively primitive. Initially, when loan applicants failed to disclose other loans they had taken while applying for a new one or submitted false income tax returns, banks such as SBI had a problem verifying those facts. “Once we centralised our data processing systems these were easier to detect,” says SBI’s Mr Bhattacharya.

Evaluating customers

ICICI Bank uses a model developed by UK credit scoring and fraud detection solutions provider Fair Isaac & Co to evaluate the cash flow of customers. SBI has a retail loan book of more than Rs610bn and 6.5 million borrowers; ICICI Bank has Rs1000bn in retail assets and about five million borrowers.

To supplement the banks’ databases, five years ago SBI and ICICI Bank, along with another large lender HDFC, set up the Credit Bureau of India Ltd (Cibil), India’s only credit information bureau. Cibil, which now counts Citigroup, Standard Chartered, HSBC and GE Money among its shareholders, has collated data on 55 million borrowers from about 90 member banks and finance companies. These share data on all their assets, both retail and wholesale, on either a monthly or quarterly basis. About 50 member banks have begun accessing credit reports on individual borrowers, which may be purchased for a small fee and are usually available in a day.

The challenge that the bureau faces is to determine the quality of data it processes, says S Santhanakrishnan, CEO of Cibil. Partners Trans Union, a US credit information services firm, and Dun & Bradstreet (which each own 10% of Cibil) run technical tests on an ongoing basis to verify the data received by the bureau and send back information to the lender for improvements when necessary.

“The absence of a unique identification number like a social security number for each individual makes pinning down the identity of the borrower a very challenging task,” adds Mr Santhanakrishnan. Without any comprehensive social security cover, the number given by Indian tax authorities to each person who files an income tax return, known as permanent account number, could be used to fix the borrower’s identity, suggests Pranay Mondal, head of retail banking at HDFC Bank.

In reaction to the increased possibility of default, banks have also begun to evaluate their debt collection abilities. Default rates vary across products from 1%-3% on home loans to about 6% on credit cards, which is not alarming by international standards. Although only 3% of its retail assets are in default, SBI decided to go slow on advancing personal loans because it found that its debt collection system was not as robust as it should have been.

Previously the branch managers were responsible for debt collections, a job for which they were not trained. Now SBI is setting up recovery cells at the city level that will employ specialist recovery agents, says Soundara Kumar, the bank’s general manager.

Risk of fraud

Fraud, particularly identity theft, is a growing risk as banks migrate their customers to electronic forms of transacting. Screening customer transactions for suspicious signs and taking timely action, such as ringing up customers to verify a high value transaction on a credit card, has become common practice, says HDFC Bank’s Mr Mondal.

The rising cost of funds and competitive pressures have pushed down margins on retail loans. Few banks disclose how much retail assets contribute to their profits (ICICI Bank says the return on equity on its retail assets is 18%-20%), but a reduction in profits is perhaps the best reason why Indian banks should tread the retail path cautiously.

CITIGROUP MAKES STRATEGIC RETAIL MOVE

In early may, Citigroup decided to buy a 9.3% equity stake from Standard Life in HDFC, India’s second largest mortgage lender, for about $700m. This will take Citigroup’s equity interest in HDFC to 12.3%.

The deal, according to an HDFC spokesperson, represents foreign direct investment by Citigroup and has got clearance from the Foreign Investment Promotion Board. Citigroup will have a member on HDFC’s board of directors.

Sanjay Nayar, Citigroup’s country officer for India, said it was pleased to have the opportunity “to build a long-term relationship with the management team that has established HDFC’s record of success”.

Citigroup has gained a strategic toehold in one of India’s oldest retail lenders at a time when other options such as acquiring a local bank are ruled out. As a finance company, HDFC is not subject to the stringent foreign ownership rules that apply to Indian banks. Foreigners may together own up to 100% of a finance company, while a single foreign shareholder can own up to 15%. For private banks, the limit is 74% combined and 5% for a single foreign shareholder, which may be raised after central bank approval.

Analysts say the deal puts Citigroup in an envious position ahead of the anticipated opening up of the Indian banking sector in 2009. HDFC has a retail home loan portfolio worth about Rs460bn and is a core shareholder in HDFC Bank, which has retail assets of about Rs200bn. Taken together, this makes HDFC the second largest Indian retail lender after ICICI Bank.

Citigroup has a fairly large consumer banking franchise with 5.5 million retail customers and 39 branches, and Citifinancial, a finance company subsidiary.

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