Banks in Europe are being called upon to accept a haircut on the loans they made to the region’s governments, as part of the effort to resolve the crisis in Europe. When the losses are accounted for, many of them could see a substantial erosion of their base capital. Even though there is an accompanying promise of “official” support for recapitalisation of the banks, that move is proving controversial and is likely to be delayed. This could result in bank failures and even a banking crisis in the near term. How far things would go once this process begins to unravel is not clear. But a substantial restructuring of European banking seems on the cards.

As and when that restructuring occurs, India would be affected too. Ever since liberalisation began, foreign bank engagement with India has been on the increase. The ratio to India’s GDP of foreign claims on India reported by banks in all countries covered by data from the Bank of International Settlements (BIS) rose from 9.7 per cent in 2005 to 16 per cent in 2007. And even after the crisis that ratio declined only to 15.3 per cent by 2010. Thus, foreign banks matter for India, even if it is still a small contributor to the aggregate portfolio of these banks.

Among foreign banks, European ones have a special place. At the end of the second quarter of 2011 banks in European countries reporting to the BIS had foreign claims of close to $159 billion outstanding vis-a-vis India. Faced with increased competition at home these banks had been seeking out developing countries to expand their business and sustain profitability. India too successfully attracted such capital by liberalising its financial policies. In 2011, claims on India outstanding for banks in all reporting countries were $289 billion. Thus, around 55 per cent of these foreign claims of the global banking system was on account of European banks. This figure too was down from 65 per cent level prior to the crisis broke, which forced these banks to retrench some of their assets.

Thus, the concentration of India’s exposure to banks from a region that is in the throes of a crisis increases India’s vulnerability. The experience during the 2008-09 crisis showed that the vulnerability of developing countries on this score stems especially from one source. Crisis-hit banks have to cover losses at home, recapitalise themselves and improve the risk profile of their lending. One way they do this is by garnering surpluses from retrenching positions in profitable emerging markets. In the current context, European banks are likely to look to retrenching assets in their global operations. India would be affected by such moves.

The impact is likely to be greater because of a disconcerting feature of European bank claims in India. They seem to have been driven to a substantial degree by short-term, speculative supply side developments in these countries. Claims on India rose by $91 billion between the first quarter of 2005 and the first quarter of 2008. Subsequently, the impact of the crisis resulted in a net withdrawal of more than 20 billion dollars by the second quarter of 2009. And when the post-crisis liquidity infusion made available cheap capital in large quantities to the banking system, India was a location for an expansion of European bank claims to the tune of $46 billion in just two years. A capital surge of this kind makes the region even more vulnerable to a capital outflow or a mere cutback in lending by foreign entities.

This vulnerability needs to be assessed in the context of the collateral damage that a banking crisis in Europe can result in. It would worsen the recession in Europe, which is an important destination for exports from India. The recession in Europe would in turn worsen the second dip that can damage India’s foreign exchange earnings and growth even more. And finally, the European banking crisis could trigger a global crisis, not just in banking but in the financial sector generally, given the multiple institutions and instruments through which financial markets are interlinked today. If that occurs, what matters is the aggregate exposure of emerging markets to global capital: and that is indeed substantial.

In sum, we have at hand a problem that should worry the government and the central bank. They may do better addressing vulnerabilities such as this rather than just railing against Moody’s for its decision to downgrade Indian banks. Moody’s and the other credit rating agencies have been amply discredited by the crisis. It is only because official Indian policy still seeks to attract volatile capital from a financial sector in crisis that their opinion matters.