Sustainability of Indian Public Sector Banks & Housing Finance Corporations through the 2008 Financial Crises: A Case Study on the Role of Underwriting, Capital Adequacy & Borrower Characteristics
Kapur, Nipun, Dhanrajani, Sameer, Indian Journal of Economics and Business
Home loan application data for low and middle income borrowers from (1991-2008) was analyzed. Several application score models were built and tested towards understanding the impact of various parameters on defaults. A thorough review and validation of these models was carried out. The validations also included out of sample / time test (after about 2 years) on portfolio. The shortlisted model performed well in all these scenarios. It is identified that borrower characteristics are the key indicator of the defaulting of a loan. The proportion of defaults in certain borrower characteristic is almost 5 times that of the overall portfolio.
It is also inferred that most of the borrowers are risk averse and have lower liabilities. Although, even this trend might be changing for certain sections of the borrowers yet it still holds good. We noticed that even with almost 40% churn in the portfolio the solution was holding good even after 2 years and in spite of significant changes in the economic scenario. It is inferred that the identification of a global optimum solution and significantly low income to installment & Loan to Value ratios resulted in a stable portfolio and a stable solution. Thus emphasizing the fact that in spite of all the debates about underwriting--it is the restraint from the borrower which has been one of the key factors in providing stability to the Indian banks.
Keywords: Risk Management, Economic Crisis, Indian Banks
One of the observations during the recent recession is the ability of the Indian home loan banks and HFCs (Housing Finance Corporations) to sustain and even grow through it. This has been primarily attributed by many to the 'conservative' nature of the banking system towards risk management and stringent regulatory requirements. It is a well known fact that most of the Banks & HFCs are required to have and have a Capital Adequacy Ratio higher than the regulatory capital adequacy requirements (Annual Report RBI' 2009; D&B, 2007; RAMARATHINAM & Bhatnagar, 2008; Nag, 2011).Another aspect being cited is good underwriting typically over the years (HSBC, 2008; Chairman's Speech, 2010).
The more granular/detailed data of about 20K loans from a small set of lenders, show that the rate of home loan defaults (abbreviated as NPAs--Non Performing Assets) have fluctuated over time and show some correlation (around 57%) with interest rates at origination (Figure 1). This does inconclusively suggest a drop (or improvement) in the underwriting standards over time. Moreover, since implementation / of Basal accords, a lot of credit can be freed up from the reserves. This catalyzing the lending by banks & HFCs hence their growth.
[FIGURE 1 OMITTED]
One of the questions that can then be asked is if, with reduced reserves and capital requirements, the banks would still be able to manage their risk effectively? To add to this, the quality of the retail assets has arguably deteriorated with credit growth and eventually deterioration of underwriting standards. So can the Banks/ HFCs afford to free up capital and increase asset base and improve market share? Further how will the rate fluctuations impact underwriting and default?
This paper discusses the research that was carried out towards studying the factors impacting the defaults of home loans primarily from underwriting and associated loss perspectives. It also reviews and discusses the variation of various parameters over time towards any significant changes in the underwriting standards. The focus was low and middle income groups and accordingly restricted to a certain size of the home loans. Various application risk score models were developed to understand the impact of key parameters in a loan application at underwriting stage on its potential for future default. The impact of each of the parameters on default in terms of its' contribution (increase, decrease, no change) and significance (quantification of contribution) is computed and understood. …