Risk-based pricing - Are India's credit markets moving towards this paradigm?

Executive Summary

There is growing consensus amongst economists that a sound financial system is essential for an economy to achieve a high and stable rate of growth. The financial sector reforms in India in the last decade have enjoyed many important successes. At the same time, India’s financial system has many glaring shortcomings.

Perhaps the most serious concern for many is the fragility of some of our financial institutions. For others, it is the growing liabilities of the government while yet others worry that our arm’s length securities markets have not taken off, and seem to be periodically laid low by scandal after scandal.

These problems may be linked. At a conceptual level, because of a variety of institutional deficiencies, there appears to be too little private risk bearing capacity in the economy. The stance of public policy, as well as the increasing competition in credit markets, in numerous aspects, has served to stifle the ability of regulated finance companies to bear risk. What this means then is that even though the liberalization of the economy has increased competition and hence the level of risk in the economy, the risk is not being allocated well. Because risk is concentrated in the wrong places, incentives of key players are distorted, and economic outcomes are sub-optimal.

This paper seeks to outline the key elements of a financial system that India will need in the quest for higher growth rates and the challenges and solutions chalked out for the same.

Introduction

The Indian financial sector has undergone a sea change since a decade of reform started in the nineties. These improvements have helped it in shedding its archaic image and portray an

image of globally competitive sector. But a lot needs to be done before it can finally get the accolades for unfettering itself from shackles of pre reform period.

This paper tries to assess the impact of previous reforms on the Indian Banking Sector as well as the pressing need for future reforms with special focus on the possibility of Indian Credit Markets moving towards the paradigm of risk-based pricing being the norm instead of it being the exception as under current circumstances. It talks about why risk-based pricing is so important from a stable financial sector’s point of view and deals with techniques for proper implementation of the same with comments on possible challenges and solutions.

Risk-based pricing – The Holy Grail?

As economies grow and diversify, their agricultural and manufacturing sectors expand, and their services sectors develop and grow, their banking sectors need to keep up. Growing economic complexity is, of course, an inevitable consequence of growth. It means that the benefits of efficient credit allocation rise – that efficient credit allocation is financing investments where the payoff is highest. But it also means that the challenges for those assessing alternative loan applicants mount. They must develop means of allocating credit among competing needs. They must learn to assess business plans and identify and manage risk.

In practice, it doesn't work quite like that. Governments the world over find it hard to resist the temptation to show that they can do better than the market. Even some of the most successful emerging market economies continued to ration credit after growth started to accelerate. And who can blame them? Industrial countries, too, continued to try to outperform the credit market. Even now, some European countries are reluctant to leave industrial credit entirely to market forces.

Yet there is plenty of evidence that government-directed credit does not achieve the intended results; it leads to a misallocation of resources, it reduces the overall return on capital and therefore has a dampening effect on growth. And the more sophisticated an economy becomes, the more harm that government rationing of credit can inflict.

Credit rationing causes problems for both banks and industry. After all, if it is the government deciding where credit should be allocated, private firms wanting to expand may be constrained from obtaining the finance they need—because credit is not being allocated on the basis of what loans will deliver the best return. Savings are deterred. Banks' profitability is lower because they are not able to lend what they want and where they want.

And when credit is rationed at low or negative real interest rates, banks naturally lend only to the safest of customers – which might not offer the highest returns. The experience of many countries with credit rationing showed that it kept high-cost firms in business and so lowered the overall return on capital. That in turn kept economic growth below its potential.

India – Pre-Reforms Scenario

In the first decades of the postwar era, India benefited less from globalization than some countries because the economy was less integrated into the world economy. Central planning and high trade barriers restricted India's growth rate – the so-called Hindu rates of growth – of the 1950s, 1960s and 1970s.

India – Post-Reforms Scenario

From 1991 there was a significant degree of deregulation in the Indian economy. Many of the reforms introduced were aimed at integrating India more closely with the rest of the world, and quite a number of those reforms directly affected the banking sector. Indeed, reform of the financial sector was a key part of the comprehensive program of reforms begun in 1991. There were significant changes in the banking sector, aimed at improving the supervisory regime, enhancing competition and the role of market forces and in technology. There were also important reforms in the government securities and foreign exchange markets with a rise in the number of instruments and more extensive use of hedging and swaps.

The financial sector reforms of the 1990s differed from previous reforms in that they formed part of a well thought out and comprehensive agenda of reform. It can be seen from the fact that there has been no reversal of direction in the financial sector reform process in the past fifteen years. Freeing up the domestic markets and starting to lower trade barriers has brought large and tangible gains for Indian business.

Risk Management Systems in India

With increasing pace of globalization and easy flow of money across the globe, banks in the country will be exposed to several new kinds of risks, prominently country risk, besides the traditional risks like credit risk, market risk, and operational risk. In this backdrop, banks will

be required to strengthen their risk management and surveillance systems and improve their credit assessment and risk management skills.

Reserve Bank of India has already initiated steps to improve risk management systems in Banks. RBI has introduced, on a pilot basis, Risk Based Supervision of Banks. The model for the Indian banks, in this regards, will aid in factoring the Basel II requirements with regard to Capital Adequacy Assessment Processes. This will be necessary as the emphasis will shift towards the quality of bank’s risk management processes, and its ability to assess risk exposure properly.

Most banks have placed a lot of emphasis on building up their risk management practices. A key factor in these endeavors is the quality of MIS available. This impacts the management of risk to a large extent and entails major investments in technology. For example, under the Internal Rating Based (IRB) approach, a bank will need several core inputs for each credit facility:

- The probability of default for Borrowers (assigned to each internal borrower grade)
- The expected Loss rate Given Default, appropriate to each type of exposure
- The expected amount of exposure at default for each type of exposure which would also reflect credit lines that have not been drawn, and the maturity of exposure.

Though the models developed by banks will be validated by the RBI, there will be a need for the banks to gear up their procedures and practices.

The Path Ahead…

As competition in the industrial sector increases, and as Indian firms move from being asset based to becoming knowledge based, they will have to increasingly obtain finance from arm’s length markets. Firms and institutions will need a greater equity cushion because of greater risk they will face. Similarly, as margins become tighter and old monopolies lapse, it will be harder for investors to stay confident about the safety of their investments. They will need more information. Markets can help in generating information, and providing incentives for agents to generate information.

With a greater frequency of failures likely, there will be need to recognize failing firms and to take resources away from them quickly before they are dissipated. If the system is not transparent enough so that potential problems can be recognized quickly, and efficient enough that they can be isolated and dealt with, losses can mount and feed on themselves. When the government plays a major role in finance and industry, these losses will often eventually be transferred to the government. Economic growth and equity will both suffer.

We therefore need a program for reform that will enable the financial sector and its activities to keep pace with changes in the environment.

The following points are a must to improve the credit markets keeping in mind their current maladies:

- Improving transparency and governance
- Resolving failure in the industrial and financial sector
- De-linking the government and private sectors
- Fostering innovation
- Supervising and regulating risk taking

Challenges

(i) Improving profitability: The most direct result of the above changes is increasing competition and narrowing of spreads and its impact on the profitability of banks. The challenge for banks is how to manage with thinning margins while at the same time working to improve productivity which remains low in relation to global standards. This is particularly important because with dilution in banks’ equity, analysts and shareholders now closely track their performance. Thus, with falling spreads, rising provision for NPAs and falling interest rates, greater attention will need to be paid to reducing transaction costs. This will require tremendous efforts in the area of technology and for banks to build capabilities to handle much bigger volumes.

(ii) Reinforcing technology: Technology has thus become a strategic and integral part of banking, driving banks to acquire and implement world class systems that enable them to provide products and services in large volumes at a competitive cost with better risk management practices. The pressure to undertake extensive computerization is very real as

banks that adopt the latest in technology have an edge over others. Customers have become very demanding and banks have to deliver customized products through multiple channels, allowing customers access to the bank round the clock.

(iii) Risk management: The deregulated environment brings in its wake risks along with profitable opportunities, and technology plays a crucial role in managing these risks. In addition to being exposed to credit risk, market risk and operational risk, the business of banks would be susceptible to country risk, which will be heightened as controls on the movement of capital are eased. In this context, banks are upgrading their credit assessment and risk management skills and retraining staff, developing a cadre of specialists and introducing technology driven management information systems.

(iv) Sharpening skills: The far-reaching changes in the banking and financial sector entail a fundamental shift in the set of skills required in banking. To meet increased competition and manage risks, the demand for specialized banking functions, using IT as a competitive tool is set to go up. Special skills in retail banking, treasury, risk management, foreign exchange, development banking, etc., will need to be carefully nurtured and built. Thus, the twin pillars of the banking sector i.e. human resources and IT will have to be strengthened.

(v) Greater customer orientation: In today’s competitive environment, banks will have to strive to attract and retain customers by introducing innovative products, enhancing the quality of customer service and marketing a variety of products through diverse channels targeted at specific customer groups.

(vi) Corporate governance: Besides using their strengths and strategic initiatives for creating shareholder value, banks have to be conscious of their responsibilities towards corporate governance. Following financial liberalization, as the ownership of banks gets broad based, the importance of institutional and individual shareholders will increase. In such a scenario, banks will need to put in place a code for corporate governance for benefiting all stakeholders of a corporate entity.

(vii) International standards: Introducing internationally followed best practices and observing universally acceptable standards and codes is necessary for strengthening the domestic financial architecture. This includes best practices in the area of corporate governance along with full transparency in disclosures. In today’s globalized world, focusing on the observance of standards will help smooth integration with world financial markets.

Conclusion

A successful, competitive and well-regulated financial sector is a vital part of the policy mix. Indian banks should be capable of competing with the best in the world. Given the size of the domestic market, it should be possible for Indian banks to become truly global players—and I look forward to that happening as part of the story of Indian economic development and closer integration with the rest of the world.

Although there has been increased competition in the credit markets in India, the current Indian banking system does have the potential to overcome its inherent structural deficiencies and move towards the paradigm of risk-based pricing.

Economic success is not some secret recipe known only to a few. We know what works, and why – and we have clear empirical evidence. India has already taken important steps in the right direction. Bigger steps, taken more boldly, would bring correspondingly greater rewards.

References

- New directions in Indian financial sector policy - Raghuram Rajan and Ajay Shah
- Banking Needs of A Global Economy - Keynote Address by Anne O. Krueger
- Indian Financial Sector - Akshat Gaur and Qaynat Sharma