Subprime Crisis in US :Lessons for India

Introduction

Subprime lending can be simply described as lending at a higher rate of interest than normal rate of interest, on loans to people with poor credit history or paying capacity. Basically it’s lending money at a higher rate of interest to a person who might not have the capacity to pay back. A subprime loan is offered at a rate higher than A-paper (best rated product) loans due to the increased risk. Subprime lending includes subprime mortgages, subprime car loans, and subprime credit cards, among others. A point to note here is that the term “subprime” refers to the credit status of the borrower (being less than ideal) and not the interest rate on the loan itself.

The Crisis Build Up in US

The housing bubble in the U.S. was fuelled by the fall in interest rates after the IT dotcom bubble burst in 2000. The prime rate fell from a high of 9% in 2000 to around 4% in   2002. This resulted in low rates for mortgage encouraging home ownership. This was further given a boost by demand boosting policies of the Bush administration after the 2001 attacks on New York and Washington. The drop in interest rate led to record demand for homes with ownership of homes rising from 64% in 1994 to 69.4% in 2004. This increased valuation of homes triggered refinancing of mortgages with low interest loans. Also, the added value was used to take out second mortgages for consumer spending.

The increase in home prices on the backdrop of low interest rates continued till 2004 when the residence prices touched the record highs. However with a construction boom the inventory of unsold houses began to grow and a demand supply mismatch got created due to rising interest rates. However under these circumstances home owners refused to lower prices from the peaks this further fuelled the growth in inventory. The aggressive lending policies of the lender were a major trigger for the crisis. Securitization of the debt added another lever to this crisis.

Impact

The sub-prime crisis brought the stock market party to an abrupt halt leading to a crash world wide as the unfolding of the crisis put a halt on the excess liquidity prevailing in the market. The hedge fund industry as a whole generated its worst performance since 2000, with the average fund declining more than 3%. The impact is so large that losses from securities linked to subprime mortgages may exceed $265 billion as regional U.S. banks, credit unions and overseas financial institutions write down the value of their holdings. Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds.  These have fallen sharply in value in the last few months, and are now worth between 20% and 40% of their original value for most asset classes, even those considered safe by the ratings agencies. The subprime crisis has given a major setback to the growth in the financial services sector with record layoffs happening. The major companies hit are Citigroup, UBS, Merrill Lynch and the ailed Bear Stearns. Citigroup is likely to cut between 17,000 and 24,000 positions over the course of the year through a combination of layoffs, attrition and selling off businesses.

Lessons for India

Although the economic factors like plummeting interest rates, lack of government oversight and a very lender friendly investor market for credit risk transfer are the major factors that led to the subprime crisis, there are many other factors that can be listed below:

Accounting Issues

Two of the biggest exposures to the subprime market are by Fannie Mae and Freddie Mac – the US government agencies taking care of the mortgage related issues. Recently, feeling the heat of the subprime crisis, Fannie Mae announced that it will sell an aggregate of $5 billion in two placements of preferred stock to qualified institutions buyers. This is in fact the largest capital placement ever undertaken by the mortgage-financing giant. A lawsuit was filed against the top executives of the company accusing them of purposely inflating the price of its publicly traded common stocks to deceive investors about the financial state of the company. The enquiry by the SEC (Securities and Exchange Commission) brought into light many accounting issues the primary being the capital adequacy of the financiers. The issue was that Fannie Mae accounted for some securities as “available for sale” on which there were $ 32.4 billion of losses. Fannie Mae basically did not account for the losses on the cash flow hedges whose effectiveness was spread over a period of 26 years.

The impact on the Indian markets was felt when ICAI asked the companies to mark-to-market derivate transactions and recognize losses or adopt their accounting standard on the subject well before it became mandatory. The root cause was the complex hedges, derivatives and other instruments leading to more accounting irregularities.  India as of now does not have any such complex derivatives and taking steps right now will ensure that these irregularities are not repeated in India.

Complex Model Failure – FICO

FICO score provides a cut-off score to help the lender distinguish the “good customers” from the “bad customers”. But this measure is not 100% accurate. This scoring pattern was very good when it came to scoring prime borrowers and showed good results, but the lenders when overboard when they relied on this system for subprime borrowers too. This resulted in an increase in the number of bad loans that were granted. So ideally, instead of focusing on just one parameter, the idea should always be to consider more parameters to arrive at a better lending decision. This means that excessive reliance on complex mathematical models does not ensure that the decisions are foolproof; it only shows that models are only as good as the results. So models should only be used for supplementing the credit decision that should be based on other parameters evaluated.

Moral Hazard

The basic tenet of the subprime lending is to reduce exposure to any single client by “passing the parcel” — because a predominant portion of debt is structured in form of tradable debt securities. This is good for a bank, but not good for the economy. The bank that floats an issue has no incentive to see that the borrower honours obligations till maturity, because very shortly, its exposure to that client gets reduced to near-zero. This creates a moral hazard — “sub-prime” borrowers find it easy to raise money because of banks’ appetite for debt securities. This is why no bank now believes that an AAA+ rated debt is really a safe bet.

Risk Spreading

Another striking point that came up with this crisis and a follow up of the previous point is that – risk spreading is not the same as risk elimination. In fact as the risk is spread globally it becomes all the more difficult to assess the impact of the loss and its ripple effects show up in the most unthought-of places. So the popular perception prevalent that once the risk is spread, by bundling it with the other assets, it leads to risk reduction is extremely wrong.

Asymmetric Information

Since the investment firms were unaware of the borrower quality and the expected default rate, they bought these securities at a high value as compared to the fair price. This resulted in inflated balance sheets which had to be written down on a marked to market basis putting the capital adequacy of these banks under threat.

Credit Analysis of Borrower

One of the important lessons for India to learn is that no matter what measure you take, the most important step in the lending process – analyzing the credit history of the borrower should be done with utmost due diligence. With the ongoing credit squeeze, stricter lending practices should be followed and there should be a greater background check on the borrower to curtail the foreclosures.

Rating Agencies

Credit rating of the instruments that are created out of this industry should be constantly reviewed by the rating agencies. The rating of the securities should never be a onetime event but should be an ongoing process. An automated and objective mechanism should be put in place. The analysts at the various rating agencies should be made to attend training to bring more standardization within the rating agencies – the methods should be objective, transparent and replicable. Also in the wake of BASEL II implementation, greater regulatory checks should be performed by the rating agencies.

Central bank & NHB

Central bank and NHB – National Housing Bank – that takes care of all the Housing Finance companies should be proactive in formulating stricter guidelines. As such there is not much of a subprime market in India, but measure need to be taken right now to curb any issue that might arise.  Also the system of securitization is not that prevalent in India and so as of now it is easy to trace the instruments, in US this was one of the major issues as the chain of instruments was so large that nobody could decipher their reach.

Conclusions

Considering both the pros and the cons – the potential gains from the subprime lending are huge. It is one of the important sources of financing for home ownership, leads to greater integration of the capital and the financial markets and also leads to an increased source of funds for the banks and other financial institutions.

To sum up all – “Complex mathematical models can supplement other tools when it comes to assessing credit risk, but cannot replace them. There is no substitute for the old-fashioned technique of doing a proper due diligence of the ultimate borrower.”

Retail Lending as a strategic response

Middle class Indian consumers, who were traditionally brought up on principles of restraint, are now giving wings to their dreams, using debt. They are committing a higher proportion of their future receivables to bank’s profit and loss (P&L) accounts. Retail banking consists of both sides that is asset creation as well as deposit mobilization, thus affecting both asset and liabilities side.

Retail banking segment is characterized by small accounts which majorly include individual accounts. It has small ticket business but it includes large number of customers. It includes wide-range of products for large number of products. Of Late, retail banking has become more technology based than ever before. Lastly, the business has witnessed a sea change in the way the business is being marketed i.e. the business has emphasized a lot more on marketing.

Banks now list the retail business among their top-most priorities, due to the strong growth seen in the segment. Though the concept was pioneered by private sector banks, it didn’t take long for PSU banks to toe the line. Retail advances have been widely accepted as the driver of the credit boom, which has seen credit surge in last 5 years. Retail advances are also growing growing like the wild grass in the rainy seasons, outpacing broad credit growth.

What initially began with mortgages has now spread to all categories. Today, Indian consumers are availing of financing options to fund their holidays, automobile purchases and even lifestyle accessories. For instance, credit card receivables and auto loans have posted their sharpest gains in the recent years. Lifestyle changes across consumer categories are also pushing credit demand. According to HDFC Bank executive vice-president (retail banking) Aseem Dhru due to consumers’ higher affordability levels, banks are now concentrating on introducing lifestyle-oriented financing options. And the up-market Indian consumer will continue to fuel the retail lending boom.

The other big attraction of retail is that it helps to lock in captive customers, who can be targetted for further cross-selling of products like investment advisory services or deposit products. Also, though yields for retail assets have been under pressure, they continue to be quite attractive.

Environmental Changes for Retail Banking

Retail Banking is the new weapon of banking industry to answer the changing internal and external environment. Following are some of the factors which have led to this increase in business in the field of retail banking:

•         Macro-economic factors

There are number of macroeconomic factors, which have been changed in recent past to increase the prospects of retail banking business, some of them are listed below:

–              India has been growing at a fast pace in 21^st century, which resulted in increase in per capita income of the households and the risk apetit

–              Secondly, the government has focused on housing as one of the priority sector for the banks which have led to lots of tax incentives for the housing sector

•         Demographic factors

–              The westernization of India has resulted in growing number of nuclear families, which created large opportunities for consumer goods and finally in the retail banking segment

–              The high growth rate of GDP resulted in an increase in the middle-class population of India

•         Active role of RBI

–              RBI has recently reduced risk-weightage on housing loans which has led to increased credit availability for housing loans

–              Of late, RBI has reduced CRR/SLR which has led to increase in credit availability in the market. Thus, Banks have more credit which they have to lend to other retail assets

•         Miscellaneous factors

–              The retail banking business has seen a tilt towards focusing on marketing which is majorly because of increase in media reach

–              The market becomes more efficient when there are more number of players in the market and with increasing presence of multinationals the market has become far more competitive

–              The consumer behavior has changed over time from “increasing preference for loan products - shift from ‘save and buy’ to ‘buy and repay’”

–              Declining prices of consumer durables has led to more demand for these products and thus the banking sector has focused on this as a new opportunity.

Retail Banking: Current Status

Retail banking in India is still in very nascent stage. If we compare the Indian banks with US banks, we found that there is lot of untapped potential in Indian markets. Following are some facts which further strengthen this point.

•         Productivity in payment transactions (4% of US levels)

•         Productivity in loans (11% of US levels)

•         Productivity in deposits (27% of US levels)

•         Overall productivity of Indian banks (in retail banking) is 12% of US levels

•         Potential of Indian banks 90% of US levels

•         Best practice banks are already performing at 55% of US levels

The major reasons for poor productivity of Indian Banks are:

·          Rural branch penalty -illiteracy forces branch staff to fill applications/challans etc

·          Lack of delegation

·          Inadequate automation and centralization of back office operations

·          Cheque clearing mechanism

·          Account opening - centralized back office

·          Query handling process

·          Loan processing - centralized

Indian retail banking industry has to improve the way they conduct the business. The strategy could be looked under the following heads:

•         Customer – Banks need to follow a strategy while acquiring customers’ i.e. when banks look at the customers they should first decide as to what they are looking for and not what they are getting.  For example, in banking business there is this convention which says that the customer that walk into your office are not the customer you are looking for.

•         Cost – After the reform period, the banks have decided that the cost of funds has become a variable for the banks and similarly the return on assets is also a variable. So, now banks have to make sure that they add value while doing the business.

•         Cross-sell – Banks have to indulge in cross selling of products to generate revenues and should try to make profit in terms of profit per customer because sometimes banks have to incur loss while acquiring new customers but will generate profits in subsequent transactions.

•         Credit Quality – While doing business and acquiring customers the bank should ensure that the quality of credit has not been reduced because if that is not done your NPA will increase which will result in losses and also increase the risk weighted cost of capital and return.

Change in the composition of Asset side of Banks

Recent trends have shown that the Asset side of Banks has seen major changes which are described below:

-          The corporate banking division includes few large customers which gives them bargaining power and in the end reduces margins for the banks and thus as a response to that retail lending as a recourse to that as here banks have the bargaining power and can derive good margins out of it which can further be used to compensate losses on account of corporate lending.

-          Secondly, after the reforms in the financial sector. Equity market as emerged as a popular source of finance for the corporate sector which led to the decline of the popularity of banks as a source of finance and thus the corporate lending has not been witnessing much growth which again makes space for retail banking to fill the gap.

Challenges for Retail Lending

Some of the major challenges faced by Indian banking industry are :

•         Financial inclusion - Despite making significant improvements in all the areas relating to financial viability, profitability and competitiveness, there are concerns that banks have not been able to reach and bring vast segment of the population, especially the underprivileged sections of the society, into the fold of basic banking services.

•         Responsible lending – The credit rating agencies in India are not so profound , hence banks has to be extra careful in lending , so as India will not be another

•         Long-term savings – Protection of saver’s interest should be the prime concern for increase in long term savings. Factors like high inflation make the consumer save less , which ultimately hurts the lending capacity of banks and future growth potential of country.

•         Regulation and financial crime prevention- In India, the level of financial crime is on a rise. We have to take some strong actions to curb these wrong practices now or we would be facing Sub-Prime crisis in India.

Retail banking Strategy – Inclusive and Responsible Retail Banking

Introduction: Retail banking in India has seen a dramatic change over the years. It has evolved from a time when the mindset of a traditional middle class Indians used to be debt averse, which preferred managing under their thrifty means to the current mindset which doesn’t hesitate in taking loans for spending. To keep in pace, the retail banking environment today is changing fast. The changing customer demographics compel to create a differentiated platform based on latest technology, improved service and banking convenience. Indian retail banking is expanding very fast with total revenue is expected to be $20 billion.

The Retail Banking environment today is changing fast. The changing customer demographics demands to create a differentiated application based on scalable technology, improved service and banking convenience. Higher penetration of technology and increase in global literacy levels has set up the expectations of the customer higher than never before. Increasing use of modern technology has further enhanced reach and accessibility.

Present day tech-savvy bankers are now more looking at reduction in their operating costs by adopting scalable and secure technology thereby reducing the response time to their customers so as to improve their client base and economies of scale.

The solution lies to market demands and challenges lies in innovation of new offering with minimum dependence on branches – a multi-channel bank and to eliminate the disadvantage of an inadequate branch network. Generation of leads to cross sell and creating additional revenues with utmost customer satisfaction has become focal point worldwide for the success of a Bank.

Consumer Insight: Loyalty towards banks and debt shyness is typically the characteristics of Indian customers but there are different customer segments which attracts significant amount superior service .Traditional middle class and lower middle class income group customers prefers the service of large state owned bank which largest developing tech savvy generation X higher middle class customer value the service of foreign banks. Middle age group customers (30-39) showing inclination towards mortgage although the penetration is quite low(6%) as compared to Asian average(18%).Credit card penetration is low (18%) as compared to Asian average(45%) and older segment of customer(45 years and more) is the largest in number.

Wealth management segment in India is unorganized and primarily dominated by Tax Advisors and agents but has significant potential as sizable percentage of customers are willing to pay for the service. Also the adaptation of alternate delivery models of banking service like internet banking, mobile banking  and ATM services are growing at a rapid rate specifically 20-29 year old age group of customer segment.

In a nut shell although loyalty towards bank is still predominant but customers are ready to judge new services and products. Also choosing decision is a guided by knowledgeable investment advice, reasonable waiting time, the quick resolution of problems and a full range of products and services.

Drivers of Retail Growth: Main reasons for growth in retail banking are

v  Growing disposable incomes

v  Youngest population in the world

v  Increasing literacy levels

v  Higher adaptability to technology

v  Growing consumerism

v  Fiscal incentives for home loans

v  Changing mindsets-willingness to borrow/lend

v  Desire to improve lifestyles

v  Banks vying for higher market share

Competition: To combat  the competition  from upcoming sector like mutual funds, insurance and  other  third party  products,  Banks  have  entered  into  tie  ups  with  the  above  mentioned  companies  and enjoys  commission  i.e.  Noninterest Income.  Thus  banking  industry  should  combat  the  competition  from private and  foreign banks   by   having    a    control   of  interest   fluctuation avoiding   money   laundering   , outsourcing agencies for verification having proper standard  and qualification .The  pressure  to  adhere  to  aggressive  Basel  II  deadlines  for  many  first  –  wave institutions has meant that additional business benefits such as better management of risk/ returns enhanced  pricing, and  more sophisticated risk management  practices  have  lar gely  been  left by the wayside . Basel  II  implementations  have  been  progressing  for  the  past  five  years  within first-  wave  institutions.   This momentum has  reached  significant  milestones  in  Europe and, to varying degrees, in the Asia – pacific region and elsewhere. The past few years have seen large–scale, resource – intensive projects deliver the new Basel framework, with firms spending on average  between $  50  - $  100  million  (or  3-  7 bps of  assets)  on their  Basel  II programs .However despite  good  progress  towards  deadlines  this  year  for  first  –  wave  institutions many  firms  have  focused  on  completing  the  regulatory aspects of Basel II .  

Industry Response: Industry responded with flexible banking (ATM,net banking,improved processes/bundled product offerings like insurance, mutual fund ,brokerage wealth management, faster services and better process oriented operation like case manager approach of handling client started by ICICI Bank. Also some of banks try to differentiate by creating customer specific products like Doctors Loan, Loan to small trader etc. Other than this bank’ customer has replaced ‘Branch’ customer through decentralization and transfer pricing mechanism to promote products, focus on understanding customer needs/ preferences, segmentation/differentiation of customers, customer driven strategies and building relationships are the area where bank is devoting more time.

Future Of Retail Banking : The accelerated retail growth has been on a historically low base  penetration continues to be significantly low compared to global bench marks share of retail credit expected to grow from 22% to 36% and retail credit expected to grow to Rs.575,000 crs by 2012 at an annual growth rate of 25%. Dramatic changes expected in the credit portfolio of Banks in the next 5 years with housing will continue to be the biggest growth segment, followed by Auto loans. Banks need to expand and diversify by focusing on non urban segment as well as varied income and demographic groups. Rural areas offer tremendous potential too which needs to be exploited.

Various issues and challenges: First  retention  of  consumers  is  going  to  be  a  major  challenge. According to  a research  by  Reich help and Sesser in the Harvard Business Review, 5 percent increase in customer retention  can  Increase  probability  by  35  percent  in  banking  business,  50  percent  in  insurance  and  brokerage, and  125 percent  in the consumer credit  card market. Thus, banks need to emphasize retaining customers and increasing market share.  Second,  rising  indebtedness  could  turn  out  to  be  a  cause  for  concern  for  the  future.  India’s   position,  of  course,  is  not  comparable  to  that  of  the  developed  world  where household debt  as  a    production  of  disposable  income  is  much  higher.  Such a scenario creates high   uncertainty.  expressing  concerns  about  the  high  growth  witnessed  in  the  consumer  credit  segments the Reserve bank has, as a temporary measure, put in place risk containment  measures  and  increased  the  risk  weight  from  100  percent  to  125  percent  in  case  of  consumer  credit  including personal loans and credit cards.  Third, information technology posses both opportunities and challenges.  Even with ATM  machines  and  interest  banking,  many  consumers  still  prefer  the  personal  touch  of  their  neighborhood branch  bank.  Technology has made  it  possible to  deliver services throughout the  branch bank  network,  providing instant  updates to  checking  accounts  and rapid  movement of  money  for  stock  transfers.  However,  this  dependency  on  the  network  has    brought    IT  Department’s  additional  responsibilities  and    challenges  in  managing,  maintaining  and  optimizing  the  performance  of  retail  banking  networks.  Illustratively, ensuring that all bank products and  services  are available,  at all  times, and  across the entire organization  is essential  for  today’s  retail  banks  to  generate  revenues  and  remain  competitive.  Besides, there are network  management  challenges,  where  by  keeping  these  complex,  distributes  networks  and applications  operating  properly  in  support  of  business  objectives  become  essential.  Specific challenges  include  ensuring  that  account  transaction  applications  run  efficiently  between  the branch office and data centers. Fourth,  KYC  issues  and  money  laundering  risks  in  retail  banking  is  yet  another  important issue. Retail lending is often regarded as  a low  risk area for  money  laundering because of  the perception  of  the  sums  involved.  However, competition for  clients  may  also  lead  to  KYC procedures being waived in the bid for new business. Banks must   also consider seriously the type of identification  documents  they   will  accept  and  other processes to be completed.

Strategic prerequisites: As   par one study conducted by McKinsy and IBA banks must consider following points before making a strategy

v  Performance oriented leadership

v  Sophisticated marketing and sales

v  Efficient distribution channels

v  Process efficiency and ease of scalability

v  Superior credit policy, procedures and skills

Strategies for Future: With the above discussion on market dynamics, competition and challenges banks need to focus on following strategies

v  Reaching to masses   :   Need to customize for different customer segments

v  Customer segmentation/differentiation

v  Data mining/CRM based campaigns

v  Products per customer/loyalty

v  Promoting low risk retail lending products

v  Offer an array of products and financial advisory.

v  Cost effective expansion

v  Renewed emphasis on superior execution by front-line employees

v  Grow through Alliances: Hospitality, Education, Retailers, Automobiles, Consumer Durables, Housing/Construction

v  Innovation for micro lending products for Financial Inclusion

v  Separate business model for lending into Microfinance Institution, Agriculture credit

v  Effective IT strategy to incorporate UID based banking once UID operational

v  Focus on world class risk management practices

Conclusion: There is a need of constant innovation in retail banking.  In bracing for tomorrow, a paradigm     shift    in    bank    financing    through    innovation    products   and mechanisms involving   constant   up   gradation and revalidation of   the   bank   internal   systems  and processes is  called  for  .  Banks now need to use retail as  a  growth  trigger.  This requires product  development  and  differentiation  ,  innovation  and  business  process  reengineering  , micro   –   planning   ,   marketing   ,   prudent   pricing   ,   customization   ,   technological up gradation, home/electronics/mobile banking ,  cost reduction  and cross selling. While retail banking offers phenomenal opportunities for growth, the challenges are  equally  daunting. How  far  the  retail  banking  is  able to  lead  growth  of  the  banking industry in  future  would depend  upon  the  capacity  building  of  the  banks  to  meet  the challenges and make  us e of

the opportunities   profitably. However the  kind  of technology used and the  efficiency  of   operations  would  provide  the  much  needed competitive  edge  for  success in  retail  banking  business  .    Furthermore,   in all these customer interest   is of paramount   importance.  The   banking sector in India in demonstrating it very well. At the end of the day the bank that best addresses and anticipates customer’s needs, delivers consistently higher quality service and connects to the customer via their channel of choice wins.

My Opinion

It is clear from above discussion that Indian retail banking is in high growth stage. But steady focus on urban segment of customers is a continuous and dangerous trend which does not contribute to the inclusive growth of the economy. For Financial Inclusion banks need to look at the other developing countries for new business models used to reach under banked and unbanked population. Last couple of decades banks expanded their retail presence in rural areas by branch network,BC model, rural bank kiosk, partnership with retailers and mobile operators. Recently SBI tied up with Airtel to provide banking service on mobile phone.Infact Vodafone has done splendid job in Kenya by its m-peso mobile banking platform and same success story can be learned and applied into Indian context.

ICICI bank also collaborated with IIT Bombay to develop rural ATM which can significantly reduced ATM installation and maintenance charges and can be deployed successfully in rural environment. Also existing cooperative and NGO distribution channel can be effectively used for rural banking penetration. Another delivery channel is e-account collaboration between bankers and mobile service providers.WIZZKITT in South Africa, Global Telecom in Philippines applied such type of model. IT can be used to tackle some of the cost saving measures for rural retail banking and FINO has helped many banks to achieve that. Also commercial bank can help in promoting credits to small scale industries apart from SIDBI to promote rural commercial credit. Now risk management system in all banks need to be modernized to process large number of rural credit and existing processes need to be streamlined so that risk can be mitigated.  Cooperatives can play a vital role in this regard. Recently Union Bank of India collaborated with GCMMF to supply credit to milk producers. This shows the success stories cooperative and bank joint initiative can increase the rural credit to substantial amount.

Another opportunity of delivery channel comes from Indian postal service network which has fairly large rural penetration. If RBI collaborate with Indian Post to deliver banking services than bank does not have to go for rural branches or third party BC network. Already various mobile customers are using postal networks for promoting their products. It will be win win situation for postal department and banks where revenue sharing model can be implemented to benefit both the stakeholders.

Innovation in delivery channel and products can help banks to take advantage of vast rural unbanked market and can make a difference in millions of life.