Fri, 11 Jul 2008

Y V Reddy on Indian Financial Stability

Reserve Bank of India Governor, Dr. Y V Reddy in a speech at the Meeting of the Task Force on Financial Markets Regulation in the United Kingdom earlier this month talked about how “India has by-and-large been spared of global financial contagion due to the sub-prime turmoil”:

The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by resident in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Financial stability in India has been achieved through perseverance of prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent. As a result, while there are orderly conditions in financial markets, the financial institutions, especially banks, reflect strength and resilience.

First of all, I would have liked the word “yet” to be added while talking about India being spared the turmoil because it is too early to say whether India will emerge unscathed out of all this. It has been my view that the global turmoil is first and foremost about the bursting of an asset price bubble in real estate and secondly about excessive leverage. The specifics of the financial products involved – credit derivatives, financial guarantees, securitization, CDOs and SIVs – are relatively less important. India has not yet had an equally severe correction in property prices though correction in the share prices of real estate companies suggests that such a correction is in progress. I also think that there is a high degree of leverage in Indian real estate and a fair degree of sub prime lending too. One part of the sub prime lending (unsecured personal loans) has already witnessed severe losses mainly for finance companies. A 20% nation wide fall in real estate prices in India is not inconceivable, and if that were to happen, the consequences would be ugly for the financial sector.

Second, the idea that institutions in India are prevented from excessive risk taking is quite incorrect. Indian banks can make bad loans as easily as banks elsewhere in the world, and there is little evidence that the culture of credit appraisal is particularly strong in large parts of the banking system. Low levels of non performing assets in an (until recently) booming economy prove nothing.

Third, the assertion that financial markets in India do not become extremely volatile is plainly wrong. I would recall January 16, 1998 in the fixed income markets, August 20, 1998 in the currency markets and January 21, 2008 in our equity markets as evidence of what can happen in a single day in three different financial markets. Low volatility during benign periods is irrelevant; what matters is the volatility when things go wrong.

The speech refers to several counter cyclical policies of the RBI:

• encouraging banks to create an Investment Fluctuation Reserve
• permitting them to transfer bonds to the Held to Maturity category
• increasing the risk weight for real estate loans, consumer credit and capital market exposures.

The first and the third are valid points and highly creditable. The second is quite dubious as it only allowed banks to avoid mark to market losses.

Posted at 18:22 on Fri, 11 Jul 2008     2 comments     permanent link

Comments...

Anup wrote on Tue, 22 Jul 2008 21:06

Re: Y V Reddy on Indian Financial Stability

Dear Sir,

Are you aware of any literature on the events that led to January 16, 1998 (fixed income markets) and August 20, 1998 (currency market)? I do not have any idea of the significance of the dates. It would be really helpful to read about them.

Rgds.

Sankara Raman wrote on Thu, 28 Aug 2008 10:08

Re: Y V Reddy on Indian Financial Stability

Dear Sir,

As you have rightly said, low NPAs (touted as achievements on promises made by flamboyant Chairmen of many banks in Analyst meetings!) mean nothing in a booming economy. Rate of growth and volumes of denominator (total loans) hide the flaws in the numerator (NPAs). In one informal study done a few years back for a reasonably 'strong' bank in India for one the 'healthy regions', the NPAs jumped as high as 6 - 8% when one considered the aging of home loans - into their 4th/5th year. But then, the booming economy meant that the NPA was only 1 - 2 % in the bank's books. So, if the contagion does spread and there is no reason to believe that we are so different or smart from the rest of the world, it would unravel pretty quickly.

Regards,