Risk Aversion   Banks? preferences impact Project Financing   Financial Express Published on March 27, 2004

 

The Indian banking system?s preference for interest rate risk over credit risk and the impact upon long-term industrial project financing is the outcome of several factors. Traditionally, the short-term and long-term lending turf was divided between the commercial banks and development finance institutions. The government and the RBI provided low-cost funds to DFIs and restricted commercial banks from financing longer tenure projects.

 

This segmentation was to prevent maturity mismatches in the assets and liabilities of these institutions. The respective Narasimham Committees, which argued that DFIs should be converted into banks over time, revisited this segmentation; they emphasised mergers between strong banks and DFIs to optimise synergies. The idea was to harmonise the banking segment and consolidate the financial sector into two forms of intermediaries: Banking companies and non-banking finance companies to facilitate regulation and supervision.

 

With this architecture in mind, financial reforms withdrew the protective policy environment for the DFIs while commercial banks were encouraged to diversify into various activities. The distinctions between commercial and investment banking have thus become blurred with banks providing both working capital and term loans to corporates and DFIs competing with commercial banks for deposits (although they cannot accept short-term deposits).

 

The gap left in long-term financing by the exit of these institutions was to be offset by the emergence of a well-developed long-term debt market. The outcomes have been slightly different though. There has been a lack of correspondence between the development of the financial sector and financial markets, which implies that the undeveloped bond market cannot currently fill the gap in long-term industrial financing.

 

The DFIs are ailing, with the withdrawal of low-cost funds and large levels of NPAs. Parallel to this has been another impact of financial reforms upon the commercial banks ? the application of international standards in capital adequacy, asset classification and provisioning norms to strengthen their balance sheets to prepare the financial sector for eventual integration with the world economy.

 

With their past disastrous experiences in lending and the supervisory pressure to lower NPA levels as well as vigilance pursuits following financial scams, bank managements have naturally turned risk averse as far as fresh commercial lending is concerned. This has directed their attention to investments in government securities and retail loans. Though the two categories are subject to interest rate risk, it must be noted that as far as home loans are concerned, the average loan size is so small so as to make a negligible impact upon the banks? balance sheet.

 

Investments in government paper also make it easier for banks to meet the revised provisioning norms. These structural distortions will obviously take time to iron out. While one of these will, no doubt, be the hardening of interest rates in the future, it must be realised that for banks to go ahead with investment banking, the contract enforcement environment must be strengthened to remove the credit risk aversion they have accumulated.