Business Standard

Mispricing Risk, Repressing Borrowers

As the Indian economy grows, its financial system should not just grow in size, but also evolve to become more sophisticated and allocate capital more efficiently.

By Harsh Vardhan

Published on January 10, 2015
min read


This article originally appeared in Business Standard. The primary objective of any financial system is to efficiently allocate capital. And an important step in allocating capital efficiently is to assess and price risk correctly. The correct pricing of risk ensures that it is properly distributed—capital providers get to hold assets that reflect their risk appetite and present an efficient risk-reward tradeoff for them. The Indian financial system is bank-centric. Banks are the predominant vehicle to convert savings into investment in the economy. The task of allocating capital (in other words, savings) is primarily performed by banks. It is, therefore, critical that banks price risk correctly. How are Indian banks pricing risk? Figure 1 shows the average risk premium charged by the banking system on commercial loans in comparison with the risk spreads on various ratings of bonds. What this shows is that private-sector banks priced their loan books as if they were rated between A and AA, whereas public-sector banks priced loans as if they were rated between AAA and A. The risk spreads spiked in 2008-09—the year of the global financial crisis. The years from 2006 to 2008 appear to be "carefree" lending years, when the system charged the smallest risk premium. (Click for graphs) This analysis may be challenged on several points: Indian corporate bond markets are not deep enough to provide reliable risk spreads Loan risk spreads cannot be compared to bond risk spreads, as loan covenants are generally tighter than bond covenants Banks' loan books carry a significant retail lending portfolio which is generally of much lower risk, bringing down the risk of the whole lending book The first criticism is valid—the bond market is indeed very shallow, and that hampers our ability to read information from it. First, in Figure 2 we show the rating distribution of the top three rating agencies in India for the years 2009 and 2013. These three agencies account for over 95 per cent of all bonds rated in India. The data show that the median and mean rating of the bonds was BBB in both years—and, in fact, the overall rating profile has deteriorated over these four years. Also, it is important to keep in mind that the companies that issue rated bonds are typically larger in size and more established. Banks' customer portfolios, on the other hand, comprise a much large proportion of small and medium enterprises (SME) which are, as a group, considered riskier than large companies. Thus, it is fair to expect that the average rating of the portfolio of banks should be worse than the average bond rating. Is this an issue of underestimating the risk, or of bad pricing? Unfortunately, the analysis does not throw much light on the cause of mispricing. But here is another piece of data that may be insightful. In 2011-12, India's banking system had about 76 million worth of commercial loan accounts (i.e., loan accounts for commercial loans excluding individual loans). Of these, about 72,000 are loan accounts of over Rs 5 crore, and together they are over 80 per cent of the loan book of the banking system. Currently around 40 per cent of these accounts are rated by rating agencies. (Under Basel-II, banks are allowed to use external rating for their loans.) This means that about a third of the banking system's loan book by value is rated by the same rating agencies that rate bonds. It's unlikely that they will use radically different (and lower) standards of rating bank loans. This implies that the cause of underpricing may not be underestimating risk but underpricing it. The second criticism, of loan covenants assigning better rights to the lender (i.e., banks) than bond covenants is plausible. It is hard to test empirically unless we get the data on recovery rates of loans versus bonds. I feel that while this is a factor at work, it cannot explain the significant difference between loan spreads and bond spreads. Finally, the point about retail loans in the portfolio. It is true that retail secured lending (for example, housing and car loans) has demonstrated a much better risk profile over the last decade or so. However, it is important to note that retail lending constituted less than 20 per cent of the overall loan book of Indian banks and hence lower risk on retail is unlikely to significantly lower the overall risk. Why would there be such systematic mispricing? There are two possible reasons—first, excessive competition, especially in the larger and relatively better-rated lending, drives pricing down. We have a very fragmented banking system and that results in excessive price competition. The other reason is more nuanced. Historically, a significant part of the banks' deposits base (about 33 per cent) was under interest rate regulation—these are the famous CASA (current accounts, savings account) that the whole banking system chases. Figure 3 presents some interesting analysis. Consider this: if the banking system as a whole did nothing but take CASA deposits and invested in risk-free 10-year government securities (we call this the risk-free margin on CASA), the margin it would make is more or less the same as the pre-tax profits of the banking system! In fact, over the last decade, the risk-free margin on CASA was more than the pre-tax profits of the system except in a few years when the yields on government securities fell precipitously—2002-03, 2003-04 and 2008-09. This is a "lazy" pool of profits that the regulation has created. It is this profit pool that allows banks to underprice loans, effectively creating a system-wide wealth transfer from CASA depositors to commercial borrowers. Most banks use a cost-plus approach to loan pricing, where the loans are priced at a margin over the cost of funds—which is kept low by interest rate regulation. It is no surprise that despite lifting the SA interest regulation a couple of years ago, only three relatively small banks have changed their SA pricing. Using sources of funds whose cost has been kept low by regulations to underprice risk in lending effectively engineers a large-scale wealth transfer from depositors to borrowers. This wealth transfer can be interpreted as being an integral part of the system of financial repression which is in operation in India. Systematically mispriced risk will result in misallocated capital. Is this one of the reasons that the system regularly runs into non-performing asset-related crises? Is this systematic transfer of wealth the reason why households avoid bank deposits and prefer to hold other kinds of assets? As the Indian economy grows, our financial system should not just grow in size, but also evolve to become more sophisticated and allocate capital more efficiently. With a monolithic system dominated by public-sector banks, we have not seen such evolution. Banks today look and behave the same way they did ten years ago—they are just a lot bigger. Fundamental change in the framework for financial economic policy will give a banking system that allocates resources better, and is safer.

This article originally appeared in Business Standard.

The primary objective of any financial system is to efficiently allocate capital. And an important step in allocating capital efficiently is to assess and price risk correctly. The correct pricing of risk ensures that it is properly distributed—capital providers get to hold assets that reflect their risk appetite and present an efficient risk-reward tradeoff for them.

The Indian financial system is bank-centric. Banks are the predominant vehicle to convert savings into investment in the economy. The task of allocating capital (in other words, savings) is primarily performed by banks. It is, therefore, critical that banks price risk correctly. How are Indian banks pricing risk? Figure 1 shows the average risk premium charged by the banking system on commercial loans in comparison with the risk spreads on various ratings of bonds.

What this shows is that private-sector banks priced their loan books as if they were rated between A and AA, whereas public-sector banks priced loans as if they were rated between AAA and A. The risk spreads spiked in 2008-09—the year of the global financial crisis. The years from 2006 to 2008 appear to be "carefree" lending years, when the system charged the smallest risk premium. (Click for graphs)

This analysis may be challenged on several points:

Indian corporate bond markets are not deep enough to provide reliable risk spreads
Loan risk spreads cannot be compared to bond risk spreads, as loan covenants are generally tighter than bond covenants
Banks' loan books carry a significant retail lending portfolio which is generally of much lower risk, bringing down the risk of the whole lending book

The first criticism is valid—the bond market is indeed very shallow, and that hampers our ability to read information from it. First, in Figure 2 we show the rating distribution of the top three rating agencies in India for the years 2009 and 2013. These three agencies account for over 95 per cent of all bonds rated in India. The data show that the median and mean rating of the bonds was BBB in both years—and, in fact, the overall rating profile has deteriorated over these four years. Also, it is important to keep in mind that the companies that issue rated bonds are typically larger in size and more established. Banks' customer portfolios, on the other hand, comprise a much large proportion of small and medium enterprises (SME) which are, as a group, considered riskier than large companies. Thus, it is fair to expect that the average rating of the portfolio of banks should be worse than the average bond rating.

Is this an issue of underestimating the risk, or of bad pricing? Unfortunately, the analysis does not throw much light on the cause of mispricing. But here is another piece of data that may be insightful. In 2011-12, India's banking system had about 76 million worth of commercial loan accounts (i.e., loan accounts for commercial loans excluding individual loans). Of these, about 72,000 are loan accounts of over Rs 5 crore, and together they are over 80 per cent of the loan book of the banking system. Currently around 40 per cent of these accounts are rated by rating agencies. (Under Basel-II, banks are allowed to use external rating for their loans.) This means that about a third of the banking system's loan book by value is rated by the same rating agencies that rate bonds. It's unlikely that they will use radically different (and lower) standards of rating bank loans. This implies that the cause of underpricing may not be underestimating risk but underpricing it.

The second criticism, of loan covenants assigning better rights to the lender (i.e., banks) than bond covenants is plausible. It is hard to test empirically unless we get the data on recovery rates of loans versus bonds. I feel that while this is a factor at work, it cannot explain the significant difference between loan spreads and bond spreads.

Finally, the point about retail loans in the portfolio. It is true that retail secured lending (for example, housing and car loans) has demonstrated a much better risk profile over the last decade or so. However, it is important to note that retail lending constituted less than 20 per cent of the overall loan book of Indian banks and hence lower risk on retail is unlikely to significantly lower the overall risk.

Why would there be such systematic mispricing? There are two possible reasons—first, excessive competition, especially in the larger and relatively better-rated lending, drives pricing down. We have a very fragmented banking system and that results in excessive price competition.

The other reason is more nuanced. Historically, a significant part of the banks' deposits base (about 33 per cent) was under interest rate regulation—these are the famous CASA (current accounts, savings account) that the whole banking system chases. Figure 3 presents some interesting analysis. Consider this: if the banking system as a whole did nothing but take CASA deposits and invested in risk-free 10-year government securities (we call this the risk-free margin on CASA), the margin it would make is more or less the same as the pre-tax profits of the banking system!

In fact, over the last decade, the risk-free margin on CASA was more than the pre-tax profits of the system except in a few years when the yields on government securities fell precipitously—2002-03, 2003-04 and 2008-09. This is a "lazy" pool of profits that the regulation has created. It is this profit pool that allows banks to underprice loans, effectively creating a system-wide wealth transfer from CASA depositors to commercial borrowers.

Most banks use a cost-plus approach to loan pricing, where the loans are priced at a margin over the cost of funds—which is kept low by interest rate regulation. It is no surprise that despite lifting the SA interest regulation a couple of years ago, only three relatively small banks have changed their SA pricing.

Using sources of funds whose cost has been kept low by regulations to underprice risk in lending effectively engineers a large-scale wealth transfer from depositors to borrowers. This wealth transfer can be interpreted as being an integral part of the system of financial repression which is in operation in India.

Systematically mispriced risk will result in misallocated capital. Is this one of the reasons that the system regularly runs into non-performing asset-related crises? Is this systematic transfer of wealth the reason why households avoid bank deposits and prefer to hold other kinds of assets?

As the Indian economy grows, our financial system should not just grow in size, but also evolve to become more sophisticated and allocate capital more efficiently. With a monolithic system dominated by public-sector banks, we have not seen such evolution. Banks today look and behave the same way they did ten years ago—they are just a lot bigger. Fundamental change in the framework for financial economic policy will give a banking system that allocates resources better, and is safer.