India’s experience with macroprudential policies

Shyamala Gopinath summarises the experience in this excellent speech. BIS has highlighed RBI’s less-well known macroprudential policies. Gopinath helps us understand these policies better.

She says there are three purposes of macroprudential regulation:

• i) To address procyclical elements in the financial system:
• ii) To provide a mechanism to correct the inherently skewed pricing of credit risk by financial institutions through the cycle.
• iii) To attempt pre-empting asset price bubbles in the economy and limit the build-up of financial risks in the system

RBI took following measures before this crisis:

10. During the expansionary phase since 2004, the Reserve Bank had taken various measures to counter pro-cyclical trends. The potential adverse impact of high credit growth in some sectors and asset price fluctuations on banks’ balance sheets at various points in time were contained through pre-emptive countercyclical provisioning and differentiated risk weights for certain sensitive sectors. It was for the first time in October 2004 that the rapid growth in housing and consumer credit was flagged as a concern and as a temporary counter cyclical measure, the risk weight applicable to these loans was increased by 25 basis points. In the context of continuing high credit growth, the limitations of the prudential framework in capturing the ex-ante risks of pro-cyclical nature of bank credit were explicitly recognized in October 2005 which triggered an across the board increase in provisioning requirement for standard assets.

11. To counter the possibility of an asset bubble in addition to concerns about credit quality led to risk weight on banks’ exposure to the commercial real estate (CRE) and capital market being increased from 100 per cent to 125 per cent in July 2005. Given the continued rapid expansion in credit to the commercial real estate sector, the risk weight on exposure to this sector was increased to 150 per cent in May 2006. Further, the general provisioning requirement on standard advances in specific sectors, i.e., personal loans, loans and advances qualifying as capital market exposures, residential housing loans beyond Rs.20 lakh and commercial real estate loans was increased from 0.40 per cent to one per cent in April 2006 and further to two per cent on January 31, 2007.

Year/Month	CRE Risk Weight (%)	CRE Provisions on Standard Assets (%)
December 2004	100	0.25
July 2005	125	0.25
March 2006	125	0.40
May 2006	150	1.00
January 2007	150	2.00

 

She then explains the backdrop behind taking these measures.

While contemplating the measures, we did not have any disaggregated statistical data or evidence to support our concerns on the potential risks of rising bank exposures to real estate, among other sensitive sectors based on the incurred loss method. However, what we did have was a clear trend in significant year-to-year increase in aggregate bank credit. The Indian financial system is still largely a bank-intermediated system and for this reason, the bank credit channel becomes a key monetary policy transmission instrument. Thus the aggregate bank credit growth has always formed an important variable in the conduct of monetary policy. The credit-deposit ratio, particularly on an incremental basis, has been an important indicator.

In view of the rapid credit expansion in the period 2003-2006, in addition to the countercyclical measures being taken, it was explicitly indicated by the RBI in April 2006 that growth of non-food bank credit, including investments in bonds/debentures/shares of public sector undertakings and private corporate sector and commercial paper, will be calibrated to decelerate to around 20 per cent during 2006-07 from a growth of above 30 per cent. Inflationary expectations had also started firming up and as part of monetary management, the repo rate was increased by 175 basis points in stages to 7.75 per cent by April 14, 2007 from its level of 6.0 per cent in September 2004. Further, the CRR was raised by 200 basis points in stages from 4.5 per cent in September 2004 to 6.5 per cent.

She touches on developments in real estate sector:

14. From a regulatory perspective, the key observable features that  tilted the balance in favour of some kind of pre-emptive sectoral action, aimed primarily at preparing the banking sector to better manage the potential downsides, were the following:

(i) The onsite inspections of banks had started giving  indications of the negative fallouts of the euphoria evident in lax underwriting standards and a few frauds that came to light;

(ii) There were emerging signs of underpricing of risks as the real estate prices were spiralling fuelled by ample liquidity and the dominant wealth effect transmittal from the stock market boom. There were clear tax incentives at work here which made utilisation of stock market gains into real estate an extremely tax-efficient arrangement.

(iii) A new factor in the housing credit market that was emerging was the mortgages for investment purposes – the trend for second homes, particularly in metros having a rising population of young, skilled job owners with salaries. Real estate, so to say, had crossed the rubicon to emerge as a true investment asset.

(iv) There was increasing anecdotal evidence of the inventory buildups of completed commercial as well as residential units. These were clearly signs of real estate having crossed the basic demand-supply equation to an investment asset.

(v) There was a visible steep increase in land prices coming from auction results. Large real estate companies could  monetise the huge land banks  on the back of the then booming stock market valuations with a simultaneous increase in bank lending for commercial real estate.

I fail to understand this. When RBI could see the trends then, why is it ignoring the trends now? I had written this post after April 2010 monetary policy. RBI chose to do nothing despite noting worrying trends in housing sector. And again nothing was done in July-2010. Most experts are now saying prices are way above the crisis peaks and have reached these levels in very quick time. Pick up anything- food, basic utilities, housing, financial assets…all are out of reach for majority of the citizens. You may choose not to buy financial assets but can’t ignore the other basics. The inequality and income gap just keeps rising.

All the gaps RBI Deputy Governor points in real estate sector are glaring at your face right now. It will be great if something is done in upcoming policy on 2 November 2010.

Addendum:

I was discussing this with a friend. He had a nice point to make. He said it is in the interest of government to let asset prices keep rising. First, most politicians own large number (and amount) of assets. And second, most people who have assets are happy to see asset price rise. So what if it ignores the others who do not own these assets. It is their problem…