I am delighted to be here and share a few thoughts at this seminar.
The theme of the seminar very aptly ties in the two key objectives of
banking regulation - enhancing resilience of institutions and maintaining
systemic stability. In my address today, I would like to dwell, in detail,
about an aspect that has a critical bearing on the soundness of the
banking system - effective and de-risked credit intermediation. While
credit intermediation in some ways describes and defines the role of the
banking system in an economy, it also acts, at the same time, as the key
channel for effective monetary transmission and greater financialisation of
the economy. However, if not regulated appropriately, this channel can
lead to the undoing of institutions and become a source of broader
financial instability. Therefore, the bank regulation and soundness of
financial intermediaries are necessary conditions to facilitate orderly credit
growth. This, therefore, brings up a few issues and challenges in
designing prudentially sound boundaries for the same. In this context I
thought I could share some perspectives on the need for having robust
credit markets and the way forward.
I. Financialisation - what do we mean and how it is relevant?
Let me start with the scope for financialization of the economy.
Whenever we refer to financialization, in popular parlance it is understood
to mean the expanding role of financial markets, financial actors,
and financial institutions in the operation of the economy. Since
independence, our economy has grown substantially, reaching the status
of the world's fifth largest economy, while we set up ourselves on course
to become the third largest economy in the world. This growth trajectory
has been enabled and supported by a multitude of factors including
greater entrepreneurial spirit, policy reforms, structural economic changes
and development of institutional structures.
Effective financialisation has been a key enabler in this journey.
This has been facilitated by the growth of financial institutions in terms of
institutional outreach, last mile presence and availability of banking
services over multiple channels. Expanded bank presence across the
country, growth of nonbank financial intermediation and the concomitant
efforts of the authorities to further financial inclusion and democratise
credit have aided the process. The concepts of door-step banking and
banking correspondents (BCs) have revolutionised the idea of financial
inclusion per se and facilitated overall deepening of financialisation in
India. More recently, the evolution of fintech entities and their interplay
with the formal financial system has been instrumental in transforming the
way financial products and services are delivered to masses. However,
the changes have also brought forth several challenges in using the
existing and conventional approaches for regulating these activities,
which is an issue that we need to address as regulators.
II. Credit growth - Its role in Financialisation & Need for
Orderliness
The word 'credit' has its genesis in Latin word credere which means
'to entrust'. The financial usage of the term 'credit' also borrows the same
idea of trust whereby money is given to an individual or entity on the trust
with the expectation of getting it back with some reward in the form of
interest. Of course, for the financial entity this trust rests on both sides of
the balance sheet. The financial institutions, for example banks, are able
to raise funds from public as the latter trust the institutions to repay their
deposits. At the same time, when such financial entities lend funds to their
customers, they must be able to have a similar degree of trust on the
repayment capability, willingness and abilities of their borrowers. Hence,
money-flow in the system is based on mutual faith. The idea of
financialisation and its success is built on this edifice of trust.
There have been several studies which establish that credit plays
an important role in financialisation. Empirically too, it is observed that the
growth of GDP in India and credit flow to commercial sector by banks are
positively correlated with each other. Over time, the growth in credit flow
has also outpaced the growth of the economy, contributing increasingly to
facilitate availability of capital to the productive sector of the economy. To
give some perspective on this growth, suffice it to say that the credit-to-
GDP ratio which was ranging around 7-8% in 1960s has increased
significantly to around 55% by the beginning of this decade.
While acknowledging the impact of financialisation, let me also
focus a bit on how the changing components of the credit markets have
larger implications for financialisation in India. The traditional form of credit
involving loans extended by financial institutions have dominated the
credit markets in India, but of late there has been an upswing in other
forms of credit instruments. The market linked instruments such as
corporate bonds, debentures, and commercial papers, in particular, have
manifested an upward trend.
Data indicate that, while banks still account for a large proportion of
credit flow to commercial sector, other sources of borrowings such as from
non-banks, or through corporate bonds and foreign borrowings also show
a rising trend.
Credit flow to commercial sector (₹ Lakh Cr)
20
15
10
5
0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Adjusted Non-Food Bank Credit Net credit by Non-Banks including NBFCs, HFCs, AIFIs
Gross private placements by non-financial entities Net issuance of CPs subscribed to by non-banks
Foreign borrowing (ECB, FCCB, Short term credit)
Source: Handbook of Statistics on Indian Economy - 2022, RBI
In a way, these developments are not purely organic; in fact, there
have been some regulatory nudges for deepening the financial sector and
diversifying sources of credit. This begs the question that if credit growth
led financialisation alone can drive economic growth, should we only focus
on the credit growth as the driver of economic growth?
This is unlikely to be the case as there could be two major
consequences of an excessive expansion of credit in an uncontrolled and
unregulated manner - first of all, it may lead to build up of an excessive
leverage in the real sector, and second, as often experienced, episodes
of excessive credit growth may lead to dilution in underwriting standards
by the lending institutions. A combination of these two factors may lead to
systemic crisis and endanger financial and systemic stability. In addition,
this also has a significant influence on the broader aspect of 'trust' in the
financial system. We have learnt this the hard way during the global
financial crisis of 2008 when unbridled credit expansion led to a banking
sector crisis and later manifested into a systemic crisis.
Besides, if the process of unchecked credit growth leads to growth
of money above the level of comfort of the Monetary Authorities, there
would be concerns around controlling money supply and transmission of
monetary policy impulses and may hinder achieving the broader
objectives of price stability. Therefore, it's not just unqualified,
unconditional 'credit growth' which is crucial for economic development,
but 'orderly credit growth' which maintains and anchors financial stability
in system and that in turn ensures sustainable growth over the long term.
Necessity for Regulation of credit market
Given the size of credit portfolios of financial institutions and the
large share which credit risk plays on their balance sheets, it is imperative
that any strategy to maintain financial resilience of the institution and
financial system stability needs to consider 'credit risk' as its core element.
Source: Supervisory Returns, RBI
If we delve a little deeper into the landscape of credit risk, it is
apparent that there are three fundamental elements which need to be
factored in, namely - 'trust', 'prudence', and 'contractual arrangements'
which are also mutually inter-connected. Information asymmetry may
result in vulnerabilities despite having due contractual arrangements in
place which can potentially impede the process of credit intermediation.
Regulatory frameworks and policies come into play here and our
regulatory policies require well thought out frameworks relating to credit
appraisal, due diligence, recovery and resolution, in order to overcome
this trust deficit or compensate for it in some manner or the other. The
policies seek to ensure that the risks associated with lending business are
prudentially measured, managed, and provided for.
From the perspective of this thematic seminar, let me focus on the
'prudential' aspect of credit risk management for which we have a
principle-based regulatory approach. To describe our approach in an
engaging manner, we can call it a 5M framework for risk management
which focuses on the following five elements - measuring, monitoring,
managing, mitigating, and migrating. The elements of this framework are
not mutually exclusive and interact with and relate and reinforce each
other.
To elaborate:
• Measurement: Peter Drucker, the famous management expert once
said that "if you cannot measure it, you cannot manage it". I believe
this to be a universal principle, and banking regulations around risk
management also follows a similar approach. In order to measure the
credit risk, all the regulators around the world, including the Reserve
Bank, have prescribed detailed guidelines to enable a proper
measurement of the risk.
• Monitoring: This aspect of credit risk management largely relies on
the monitoring and oversight exercised by the financial institutions
through their policies which have to be dovetailed with the prudential
norms prescribed by the regulators. The concerned financial
institutions are mandated to frame prudent policies on risk
management, governance, compliance, etc. These norms are
intended to overcome any inherent moral hazard in the system. There
are usually three layers of internal checks prescribed for the
institutions- first, underwriting and due diligence at the time of
origination of loans, second, adherence with internal risk management
and compliance practices, and third, internal audit. This is examined
as part of supervisory oversight wherein apart from assessing the
efforts of financial institutions on these parameters, supervisors also
assess if the general or other provisions maintained by the bank truly
reflect the inherent risk.
• Management: Factoring in the risk-and-reward payoff, the financial
institutions may prefer to bear and manage some risk as part of its risk
management practice. That would be essentially a business call. But
in order to ensure that the regulated entities are well capitalised in
proportion to the risk they are carrying, regulators across the world
prescribe capital adequacy norms where minimum regulatory capital
is provided by the banks based on certain principles. This then
becomes the first level of risk management wherein the risk is
absorbed internally, and adequate capital is provided for the same.
Besides, pricing of credit also influences this risk return trade-off.
• Mitigation: If the risk taken by financial institution grows beyond its
comfort zone ('risk appetite'), then they may have to manage it actively
rather than merely absorbing it. This risk mitigation is enforced at two
levels - first by the regulators - which is mostly prudential in nature
like provisioning norms or exposure limits. Second at the institutional
level, wherein the institutions themselves may prescribe exposure
limits to manage concentration risks or put certain collateral
constraints on borrowers or prescribe stringent covenant to manage
the risks. In addition, financial institutions may also deploy permitted
credit risk mitigants such as loan guarantees, collateralised
transactions, on balance-sheet netting, etc. to mitigate credit risks.
• Migration: This involves taking the risk out of the bank's books. There
could be several tools available for transfer or migration of credit risk,
but I am going to touch upon two of them. First and probably the most
popular way is to simply transfer the asset (loan) and associated risk
to another entity. In this method, the financial institution concerned
may prefer to transfer a single loan or pool of loans to a willing eligible
party through bilateral arrangement or otherwise. The economic risk
gets transferred from the books of transferor to transferee. The second
option is by way of securitisation. In this arrangement, the originator of
loans select a pool of loans and transfers it to a special purpose vehicle
(SPV) which securitises the loans and sells the securitisation notes to
a diverse set of investors. This method diversifies the nature and
concentration of credit risk in the system.
In case of most of the credit risk management tools, especially for credit
risk transfer or migration, the role of markets is extremely important. If the
lender concerned prefers to transfer its risk, it will invariably require a deep
and vibrant market in which it can offload its exposure. Transferring the
economic interests along with risks or securitising the assets through
SPVs requires participation from a broad base of institutions on the other
side of transaction. A deep market will not only facilitate this transaction
smoothly, it will also assist in fair pricing of such assets. Therefore,
developing market enabling frameworks to facilitate smooth migration of
credit risk from one entity to another has been an area of focus of the
Reserve Bank. Let me briefly touch upon some of these initiatives
undertaken in this regard.
III. Recent initiatives and way forward:
While the methods of credit risk management described above will
not be exhaustive, they broadly cover different themes of the risk
management practices in India and World. The Reserve Bank has been
making concerted efforts to provide enabling frameworks for our regulated
entities across these themes. The regulations around the management
and mitigation of credit risk are already quite robust and have stood the
test of time. However, as a part of our recent regulatory initiatives, we
have been focussed on policy measures to improve the mechanics of
migration or transfer of credit risk.
In September 2021, we came up with a revised set of guidelines for
transfer of loan exposures and securitisation of standard assets. These
frameworks were developed after a wide consultative process to
incorporate market expectations and these policy measures are aligned
with global standards to ensure that the credit risk is managed effectively
in the system. As we also need to ensure that such important initiatives
are flexible in their design, we have also established an internal
mechanism to review these frameworks at regular intervals, to assimilate
market feedback and comments from various participants.
Similarly, the guideline on credit default swap (CDS), have been
comprehensively revised in 2022, to facilitate the development of market
for CDS by expanding the participant base. Besides banks and foreign
portfolio investors, the regulations permit selling of protection through
CDSs by all major non-bank regulated entities.
It is pertinent to emphasise here that while our guidelines on transfer
of loan and securitisation cover loans in general, CDS guidelines cover
money market instruments and certain corporate bonds. This makes it a
complementary tool of risk management for two different and important
credit instruments- loans and corporate bonds.
Let me also share some perspectives on the possible way forward.
The credit market of the future is likely be nimbler than what it is at this
point in time. We would also need to have a dynamic secondary market
for loan instruments, a wider base of participants and asset classes in the
market, and a robust framework for risk assessment. Based on these
enablers, it may be possible to ensure smooth interaction between the
different players and provide financial entities avenues to de-risk their
balance sheets.
Development of an active secondary loan market
An efficient market also reduces frictions in financial system. The
growth of market in an orderly manner is necessary to address the twin
challenges of ensuring smooth credit flow and robust risk management.
To develop credit markets for trading of loans, Reserve Bank facilitated
the formation of a Secondary Loan Market Association (SLMA) in 2020.
The SLMA platform, which became operational in 2022, has onboarded
many major banks and is in process of onboarding other major players
including NBFCs. The basic idea of this platform is to enable easy transfer
of loan(s) at a fair price devised through market-based auction mechanism
where quotes are obtained from all interested parties, rather than selling
the loan through a bilateral arrangement. A deep and active secondary
market, which is envisaged to be developed through SLMA, would be
crucial to impart fairness and transparency to transfer of loans and credit
risk among market participants.
Expanding the type of players in loan markets
Conventionally, the credit market in India has been tightly regulated,
primarily driven by the need to ensure banking and financial stability.
However, it has been acknowledged that permitting a diverse set of
participants in the market may actually help it become more vibrant and
efficient. Therefore, the Reserve Bank took the first step for liberalising
the credit markets by allowing entities outside our regulatory purview, but
regulated by other financial sector regulators, to acquire stressed loans
under the transfer of loan exposure framework. Similarly, for standard
assets, the securitisation framework permits diverse set of investors to
subscribe to the securitisation notes of underlying loans. By having a
wider set of participants, it is envisaged that credit markets will become
more vibrant, effective, and transparent.
Permitting securitisation of currently restricted asset classes
The market for securitisation products is quickly catching up in India
and is poised to grow manifold in years to come. Our framework on
securitisation issued in 2021 carries a negative list restricting a few asset
classes from being securitised. But this is not a fixed exclusion. We
constantly monitor the growth and maturity of market and are ready to
take a well-thought-through call if some restricted assets could be
securitised in current environment.
Conclusion
To sum up, while credit is an important driver for the growth of
economy from the financialisation perspective, we need a robust risk
management framework to manage credit risk. The array of tools for credit
risk management have evolved with prudential limits providing the
regulatory back stops. To facilitate transfer of credit risks between entities
in a fair and transparent manner several policy enablers have been put in
place by the Reserve Bank with the objective of developing robust credit
markets.
As you may have observed the discussion of 'risk' was at the core
of my deliberation today. As a regulator, we do acknowledge that risk
cannot be avoided. After all, risk-and-reward dynamics is the soul of entire
edifice of finance! It may be appropriate to recall few lines of a famous
poem "Risk" by the poet William Arthur Ward-
.... To hope is to risk despair,
To try is to risk failure.
But risks must be taken because
the greatest hazard in life is to risk nothing...
So, some risks must be taken. However, it is in our collective interest
that we know the risk we are taking, assess it adequately, and acquire the
capabilities to manage it.
Thank you, everyone.
*******