RBI sees sub-prime woes raising interest rates

The Reserve Bank of India (RBI) believes that any uncontrollable adjustments in the global financial markets may result in a sharp increase in interest rates.

This in turn will affect the repayment of the loans as it will result in an increase in defaults in home loan collection and mark-to-market losses on investments by banks in India.

The report released on trends and progress of banking in India during 2006-07, RBI, said, “Banks are exposed to some degree of market risk in the near term. The major source of such risk is the financial markets. Recent developments in the US sub-prime mortgage market have caused volatility and uncertainty in financial markets.”

RBI said though global financial imbalances had slide down, but they continue to be a cause of concern. Any uncontrollable changes in financial markets would lead to changes in interest rates and liquidity shifts. The market risk could shape up into credit risk in banks’ books.

RBI stated, “Sharp rise in interest rates may result in marked to market losses on the investment portfolio of banks. Sharp rise in interest rates would also have some impact on housing prices and may expose the balance sheet of households to interest rate risk. This may have adverse impact on the balance sheet of banks through increase in loan losses.”

RBI proclaimed that the interest rates in India had toughened and the spread between AAA-rated corporate bonds and government bonds had widened.

However, the investment portfolio of banks as a percentage of total assets declined sharply to 27.5 per cent at the end of March 2007 from 31.1 per cent at end-March 2006 and 36.9 per cent a year earlier.

Banks might experience higher default rate in the coming years on account of rapid growth in credit of the past three years. The slowdown in credit during 2007-08 possibly will result in banks reporting higher NPA ratios.

The high credit offtake and increased supply for bad loans had so far helped banks report lower levels of non-performing assets to advances, despite a rise in misconduct.

Though the NPAs, ratios of banks showed a decline, the fresh slippages for the year ended March 2007 were more than the recovery of NPAs.

RBI stated, “Owing to rapid credit expansion of the last few years, it is possible that banks experience high delinquency rate in the near future. This, combined with the slowdown of credit, might lead to rise in the NPA ratios of banks in the coming years. However, such rise is not expected to be significant and, on the whole, credit risk environment would continue to be benign.”

A decline in the equity market might show some default on loans given for investment in the equity market.

But the impact of a fall in equity market would not be serious for banks as they have only meek direct and indirect exposure to the equity market.

“However, sharp adjustments in the real estate prices might have some implications on the balance sheet of the banking sector,” said RBI. The banks however have flexibility to withstand any adverse development in financial markets.

Banks’ profitability has improved and their capital position continues to remain strong.

According to the reports the banking system has the ability to cope with the situation arising out of any adverse development and a strong domestic growth will continue to have a positive impact on the balance sheet of the banking sector.