Better cautious than sorry

The world financial market is going through an upheaval which has emanated from the subprime crisis in the US. With the globalization of the financial sector, this crisis is spreading to other parts of the world.

The genesis of the subprime crisis lay in mortgage loans by banks to higher risk borrowers with lower income and poor credit histories. The strategy of high-risk lending, against conventional banking wisdom, sustained during the period of housing asset price rise between 1996 and 2006. The basic assumption in such lending: the asset financed by such lending will hold on to its value in case the borrower is not able to meet his debt obligations. However, with the drop in the US housing prices, the defaults and foreclosure of these loans started significantly affecting the financial services sector there. Through securitization of these portfolios, a large part of these loans had also been sold by the originating banks to other banks within the US and outside, thus spreading the risk widely. While there is considerable debate about the possibility of the US-originated subprime crisis spreading to emerging markets, it is also time for us to worry about another crisis that may affect emerging markets such as India.

In the past decade, banks have diversified their portfolio from corporate lending to personal lending, to take advantage of the growing market as also for risk mitigation. While housing loans are one part of this portfolio, banks have also moved aggressively into risky areas of lending such as personal loans and loans against credit card obligations.

This is a relatively new activity in India. The growing market has brought in a new set of customers, whose expenditure requirement, be it for weddings, travel or any other special occasions, are funded through these loans. In many cases, even the margin for housing loans are being funded through personal loans. All these lead to a situation where an individual customer is substantially leveraged. My personal experience has been that many customers have started using these loans to meet their normal cash flow mismatch, which may also lead to serious debt traps.

While the developed countries have a relatively well-developed system of individual credit rating, in the emerging markets, there is a complete lack of customer information. We in India also have a major drawback: the lack of a unique identification number. Hence, a customer can manage to borrow such loans from a number of banks within a short span of time. This is made worse by a lack of a good system of intermediaries through which financial institutions do their lending. These intermediaries are relatively less developed, lack a history of performance and are also not quite regulated.

With increasing competition in the banking sector and the entry of a number of new players, we find innovative (as also more risky from banks’ point of view) product designs including “teaser rates” of low initial interest rates, “interest only” in the initial period as also offer of other freebies.

Further, most banks follow a system of substantial automatic loan top-ups. There are also invitations from competing banks for loan transfers, sprinkled with interest holidays and further top-ups. All these work well in a growth market scenario and, as the US subprime crisis illustrates, can lead to substantial problems when market sentiments turn negative.
While the overall market outlook may continue to be positive for emerging markets such as India, perhaps it is time to throw in some caution and build in an element of old world banking conservatism to this area of personal finance. It is better to be cautious than be sorry.

Published in Mint: Wall Street Journal on Feb 25, 2008