Issues with bank lending standards and the lack of transparency with bank loans in India is a problem that has been evident for a while. Repeated incidents of lending malpractices tell us that creating transparency and liquidity in the bank loan market in India isn’t a choice but a necessity for the country. Transparency and liquidity, the two much needed features can be created via a fully functioning and deep secondary market in bank loans in India. While this process will take years to complete, the government must start today.
The fundamental problem with the absence of a secondary bank loan market in India is “moral hazard”. The problem of “moral hazard” leads to some lenders in banks making loans with little or no “skin in the game” with lower lending standards than ideal. To add to the problem, the bank that originates the loan holds on to the entire loan on its balance sheet with little or no transparency about the loan quality. Poor lending standards are encouraged and discovery of problematic loans is too late in the credit cycle. Invariably a corporate with poor credit can borrow from multiple banks, even as good quality corporates get crowded out of the market. Essentially, a bank loan market with little or no secondary market liquidity in India leads to aggregation of risk with a few banks and very little transparency on loan quality information. This is one of the major reasons for Non-Performing Assets (NPAs) and lending malpractices. Trading in bank loans to some extent is a must to resolve the issue of poor lending standards.
A liquid and deep secondary bank loan market would go a long way in improving lending standards. The lender would have strict regulations in terms of how much of the originated loan they can hold on to their balance sheet. This would induce the lender to maintain higher standards of lending, since they will have to get other investors to partake in the loan eventually. This is where independent credit rating agencies will have to come in to assist investors in loans to analyse and rate the loans in question. This rating by the third-party rating agency will not only be on the credit of the corporate involved in the loan, but also on the actual loan covenants and collateral involved. A loan specific rating will assist investors to invest in loans made by banks. Such investors investing in the loans will lead to both higher quality lending a well as diversification of risk with each lender holding a smaller proportion of the total risk.
The secondary market in bank loans should start with certain standardized loan formats that can be traded. Eventually the market needs to build on these standardized formats. Once the market gets liquidity, variants of the standardized loan format can be introduced. The aim of the market must be to create a “mark-to- market” for bank loans. In the more developed capital markets independent valuation agencies such as Markit provide month end pricing on loans. Indian policymakers will have to come up with measures such as month end pricing to begin the process of mark-to- marking loans to a secondary market price. This will create data transparency in the market and a demarcation of credit in terms of quality, assisting investors and lenders to gauge credit quality. The current situation of an opaque market with very little clarity on credit leads to poor lending decisions in a loose credit cycle and penalisation of good borrowers in a poor credit cycle, hence leading to economic losses both ways. Mark-to- market valuation of loans will also ensure that information is priced in by the market in a gradual way, instead of the sudden information spurts in the current situation.
In summary, bank loans must be established as an asset class with greater liquidity. The three features of a standard asset class are a wide investor base, transparent pricing and some level of liquidity. A secondary market will help in diversification of risk and mark-to- market valuation of loans. Both factors will create transparency and data availability, therefore rewarding borrowers with good credit quality and penalising poor credit quality borrowers. A well drafted and effectively implemented secondary bank loan framework will go a long way towards shoring up the banking system in India.
By Taponeel Mukherjee
(The views expressed in this article are personal and that of the author.)