Just prior to the announcement of the Reserve Bank of India’s monetary policy for the second quarter of this year, attention was focused on the question whether the central bank would raise interest rates and rein in liquidity to curb inflation. Food price inflation, while moderating, was still high, as it has been for the last few months. Since the government had run out of ideas on how to deal firmly with this problem, the burden of addressing inflation had fallen on the RBI. Not surprisingly, the debate on whether the RBI would sacrifice growth in its effort to limit inflation dominated the financial media. While one section stressed that the central bank has no option but to raise interest rates and tighten monetary policy, others were of the view that since inflation was moderating nothing should be done that would hurt growth. The RBI has partly satisfied both shades of opinion. It has maintained the Bank Rate at 6 per cent. It has raised the repo and reverse repo rates by 25 basis points each to 6.25 and 5.25 respectively. And it has not attempted to constrain liquidity in the system on the grounds that the increase in credit flow is close to target.
With interest focused on this development which was largely benign, another aspect of the monetary policy review received less attention than it deserved. This was the attempt by the central bank to send out a strong signal that it wants the commercial banking system to rein in the boom in housing finance. The RBI’s concern stems from the evidence of a sharp pick up in lending for housing. Over the period April 1 to September 25, 2010 housing credit has increased by Rs. 16,195 crore as compared to Rs. 7,891 crore over the corresponding period of the previous financial year. What is more, during the 5-month April to August period net credit provided by the housing finance companies also rose by Rs. 7,519 crore as compared with Rs. 3,581 crore during six months stretching from April to September 2009.Banks have adopted a number of techniques to expand this market. This included the practice of offering these loans at lower “teaser” interest rates during the first few years, with the rates being subsequently reset to much higher levels.
The sub-prime crisis in the US had made amply clear that it was dangerous to expand the universe of borrowers in this manner. It inevitably required the dilution of income standards and documentation requirements and attracting borrowers by offering initial “affordable” interest rates. Such practices tend to attract sub-prime borrowers who do not have the ability to meet their future commitments but hope to either develop that capacity to do so or benefit from an increase in housing prices in the interim. Since this is a mere hope and can be belied, the probability of default tends to be high. If the proportion of such borrowers are small banks can manage the resulting losses, partly through foreclosure and the sale of the collateral, which normally is the housing property concerned. But if the number of borrowers is large and defaults numerous, housing prices collapse and banks have to provide for substantial losses resulting in systemic problems.
The RBI has done well to learn from that lesson and try and rein in the housing finance lending spree. It has done this with four sets of measures. First, it has put a ceiling of 80 per cent on the Loan to Value (LTV) ratio, which reduces leverage by requiring borrowers to commit their own equity to the extent of at least 20 per cent of the value of the asset at the very beginning. This reduces the risk burden on the lender. Second, in a reversal of policies adopted earlier it has decided to raise the average risk weight associated with larger housing loans. A higher risk weight requires banks to set aside a larger volume of regulatory capital for a given loan size. When the risk weight on a particular credit type is 100 per cent and the capital adequacy requirement is 12 per cent, capital equivalent to 12 per cent of the loan has to be invested in specified “regulatory” assets. Since regulatory capital is supposed to be in forms that are safe and relatively liquid, the return on such assets is lower and reduces average bank revenues. So increasing risk weights on any kind of lending is expected to discourage that kind of lending.
Till the recent policy review, the risk weights on residential housing loans with LTV ratios of up to 75 per cent was 50 per cent for loans up to Rs. 30 lakh and 75 per cent for loans in excess of that amount. For loans with LTV ratios greater than 75 per cent, the risk weight was 100 per cent irrespective of the size of the loan. In addition to capping the LTV ratio at 80 per cent, the RBI has now decided to increase the risk weight for residential housing loans of Rs. 75 lakh and above to 125 per cent, irrespective of the Loan to Value ratio associated with any particular loan of that size.
Third, the RBI has sent out a strong cautionary signal with regard to the practice of offering teaser rates. In its view: “This practice raises concern as some borrowers may find it difficult to service the loans once the normal interest rate, which is higher than the rate applicable in the initial years, becomes effective. It has been observed that many banks at the time of initial loan appraisal do not take into account the repaying capacity of the borrower at normal lending rates.” Finally, having recognised that loans offered with teaser interest rates have higher risk associated with them, the RBI has decided to increase the provisioning required for these assets categorised as standard assets from 0.40 per cent to 2 per cent, so as to take care of that subset of loans that turns non-performing.
Put together these measures constitute a significant effort at prudential regulation of a banking sector that is increasingly diversifying into retail lending involving personal loans of various kinds. They are to be welcomed and hopefully signal greater regulatory caution on the part of the central bank.