India: The Central Bank's Risk Pricing Initiative and Implicit Increase in Interest Rates


D Tripati Rao

The Indian economy is buoyant. The Central Statistical Organisation (CSO) has revised the real GDP growth for the year 2005-06 from 7.5 per cent to 8.1 per cent. It has also been revised upwards twice by the central bank (RBI) from 7.0 per cent to 7.5 to 8.0 per cent in its Annual Statement on Monetary Policy for the Year 2006-07. This upward revision is mainly due to the recovery in agriculture and sustained growth momentum in the industry and services sectors. Robust industrial growth of an estimated 9.4 per cent is mainly led by manufacturing sector growth. The stock market is on a roll with FIIs pumping money continuously and the BSE Sensex crossing the 11,500 mark. The business consumer confidence index remains optimistic with sustained domestic as well as export demand.

Given the heightened growth prospects in the economy, credit growth has been burgeoning. The non-food credit dispersed by banks has seen an unprecedented sustained growth for over 30 months of 37.3 per cent. Apart from the service sector being the major recipient, real estate (up by 84.4 per cent) and retail and personal loans have also grown. All this is resulting in 'indecent exposures' with huge credit risks. The sustained demand for credit putting pressure on the market liquidity is firming up the interest rate since the last quarter of the year. The short-term call rates on an average increased by 180 basis points from the level of 5.12 per cent with an increase across the term structure of interest rates. Also compelling the rise in domestic interest rates is the upward trend in world interest rates. The federal funds rate increased for the 16th time in two years to 5.0 per cent with an indication of future hikes.

The upward price movement in commodities, currencies, equities, and interest rates and bank's exposure in the area of these financial assets are contributing to a huge quantum of price risk. Given these signs of a robust domestic economy in tandem with heightened risks in the financial markets - pressure on liquidity and rise in interest rates - the monetary authority had to take recourse to risk pricing. The thrust of this year's annual monetary policy is risk management with a focus on managing the former.

Banks' PLR (prime lending rate) is a combination of the cost of funds plus default risk plus a capital adequacy risk premium. Banks can mitigate expected losses by making provisioning for bad loans; while capital adequacy addresses unexpected losses. Also banks are now advised to provision on anticipated losses based on a standardized approach whereby the RBI sets the provisioning rates. When the RBI increases the provisioning rate, default risk increases; and when it increases risk weights then the capital adequacy requirement increases and thus there is an increase in the capital adequacy risk premium. Prudential provisioning on standard assets increased from 0.25 per cent to 1.0 per cent excluding direct advances to agriculture and to small and medium enterprises (SME). In lieu of high credit growth, the general provisioning on advances for personal loans, capital market exposures, residential housing loans and commercial real estate loans has been increased from 0.4 per cent to 1.0 per cent. The risk weights on commercial real estate loans have been increased from 100 per cent to 150 per cent.

Is the Central Bank then directing risk pricing? The policy focus is now on credit diversification, appropriate exposures and effective credit risk management both at the transaction level and the portfolio level. Apart from the need for micro activity in credit diversification, in order to address the price risk, a continuous articulation of macroeconomic cycles (downturns), stress scenarios, interest rate movements and market risks emerging from liquidity shifts is needed. A dynamic revision of risk limits may be required to mitigate trading losses. RBI has already advised banks to move from a maturity gap approach to a duration gap approach to quantify interest rate risk more effectively. It is high time for banks to articulate on interest rate movement, pricing of loans and deposits.

WATCHPOINT: It remains to be seen how successful the Central Bank will be in nudging the banks towards risk pricing and, in turn, in implementing appropriate pricing of loan advances to different sectors.


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