There are fairly obvious lessons that we can learn from the sub-prime mortgage market crisis in the United States. Lax credit norms breed the possibility of large-scale default; financial over-engineering enhances rather than mitigates the vulnerability of the financial system.
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The corollary is that banks and institutions should go back to the basics -- avoid dodgy borrowers and stick to simple lending structures that are easy to monitor and whose risks are easy to evaluate.
There is perhaps another lesson that Indian regulators and bankers can draw from the American mortgage mess -- that the path to financial 'inclusion' or 'inclusive banking' is fraught with peril. Under-banked segments are by their very nature risky or 'sub-prime'.
Over-regulating credit or product delivery to these segments makes the process of inclusion unviable -- tighter regulatory norms translate into a higher cost of credit, which these target segments cannot afford.
The government can choose to subsidise some of the financial products but that is hardly sustainable over the long term. The challenge in making banking more inclusive is to offer affordable finance to risky borrowers without running the risk of high default.
The boom in the US sub-prime mortgage lending was an experiment in finding this balance. "I was aware that the loosening of mortgage credit terms for sub-prime borrowers increased financial risk," former Fed Chairman Alan Greenspan wrote in his recent memoir, The Age of Turbulence: Adventures in a New World. "But I believed then that the benefits of broadened home ownership are worth the risk." Mr Greenspan's bet appears to have gone terribly wrong. The question is: can Indian banks and the RBI do any better in taking their agenda of inclusive banking forward?
Let me elaborate on this. US bank regulators, particularly Mr Greenspan, have come in for a lot of flak for turning a blind eye to the problems of poor credit appraisal standards in the mortgage market. Some of this negligence could be due to sheer incompetence or callousness.
However, it was also driven by the belief that the rapid growth of the financial market was fulfilling some critical social objectives, helping large swathes of the population realise an integral part of the great American dream -- that of owning a home.
Let me share some data with you that support this. The sub-prime boom started in 2000 and by 2006, more than 70 per cent of US households owned a home as the size of this market touched a whopping one and a half trillion dollars. This meant that the more economically disadvantaged segments of the population participated extensively in this boom. A 2005 study of the 331 US metropolitan areas showed women were more likely to get sub-prime rather than prime loans in every area.
Sub-prime loans were more prevalent among the blacks in 98.5 per cent of the metropolitan areas, while Hispanics were more apt to hold a sub-prime mortgage or refinance loan in nearly 89.1 per cent, according to the National Community Reinvestment Coalition, a non-profit organisation focused on lending and community-development issues. Anyone looking at these numbers before the crisis unfolded in 2007 would have thought that it was the perfect experiment in financial inclusion.
It is difficult to identify when and how things started going wrong in this market. By 2004, default and foreclosures had started rising. The US Fed should have perhaps stepped in then and made sure that the market cooled off. Lending norms could have been tightened. There is an endless list of policy measures that in hindsight seemed like the best course of action when the trouble started brewing.
The point in writing this is not so much to identify the turning points in the current crisis but to emphasise that a programme in any economy (including India) designed to penetrate under-banked segments is likely to share some of the key characteristics of the US sub-prime market.
First, as in the US, loans will have to be extended to entities that have dodgy credit history or have no history at all. (In India, the absence of a large database of credit behaviour for the bulk of households can only compound this problem.) Second, these loans will have to be given at relatively low interest rates that perhaps do not adequately reflect the inherent credit risk.
As the recent decline in retail credit demand in India suggests, household borrowing is highly sensitive to interest rates.
Can this be done? Or does the US experiment prove that the idea of financial inclusion by its very nature leaves the banking system open to large systemic shocks? I have no ready answers. Clearly one of the problems of the US was the speed of expansion of the sub-prime market, which ultimately proved to be its undoing.
As the pace of market expansion ramped up, US banks and institutions jettisoned even the most of elementary principles of risk appraisal to get a piece of the action. The deterioration in the quality of borrowers thus kept pace with the growth in sub-prime loans.
The lesson in this seems to be that the best route to financial inclusion is a long, slow one with a number of regulatory roadblocks on the way. Any attempt to put a process of financial extension to riskier and poorer borrowers on the fast track has to be viewed with a great degree of caution.
Second, transparency in pricing is the best policy. One of the reasons that poorer American households defaulted was that although the 'teaser' rates that enticed them were low, banks and other lenders passed on a number of hidden costs that they could not bear. If financial institutions had been more candid about the 'true' cost of loans, there would perhaps be fewer takers for this product but a systemic crisis could have been averted. Caveat lender?
The author is chief economist, HDFC bank. The views here are personal.