Understanding Credit Concentration Risk
In a series of tweets on 23rd and 24th of February 2018, I have expressed my opinion on credit concentration risk faced by Indian banks with some data points. Please go through the points.
0/ CREDIT CONCENTRATION RISK IN BANKS: In their normal lending and borrowing activities, banks are exposed to a variety of risks. One such risk is credit concentration risk.
1/ As a prudent measure, banks should avoid too much credit exposure to a single company, a single group of companies, a single geography or a single sector. Other parametres to avoid credit concentration risk include credit rating, country or product-specific exposures.
2/ Diversification of a bank's loan portfolio among many borrowers , economic sectors and different geographies is a desirable goal for banks. In times of economic downturn, a well-diversified credit portfolio will keep a bank in good stead.
3/ However, in pursuit of growth, banks often over stretch themselves and increase their exposure to a single borrower or a group of companies under the same management. Any downward trend in the prospects for the company or the group may put the bank in jeopardy.
4/ We have witnessed how banks in India had exposed themselves to this credit concentration risk in sectors such as iron/steel, infrastructure, telecom, construction, power, capital goods and others.
5/ With a view to limiting concentration risk, the Reserve Bank of India more than two decades ago prescribed maximum limits on banks’ exposure to a single borrower and a group of borrowers. Since then, these norms have undergone several changes.
6/ As per RBI norms, a bank's credit exposure (both fund-based and non-fund-based credit limits) to an individual borrower must not exceed 15 percent of the bank's capital funds. Capital funds are Tier 1 and Tier 2 capital, after adjustments as per RBI's capital adequacy norms.
7/ For infrastructure companies, banks can raise the exposure by 5 percent to 20 percent for a single borrower. In addition, a bank's credit exposure to a group of companies under the same management must not exceed 40 percent of the bank's capital funds.
8/ In the case of infrastructure companies, the credit exposure may be increased by 10 percent to 50 percent for a borrower group.
9/ The exposure limit for a single borrower is 25 percent of capital funds for oil companies that were issued oil bonds by the government of India. Exposures to public sector undertakings are exempted from group exposure limits.
10/ Exposure comprises credit exposure (funded and non-funded) and investment exposure (including underwriting and similar commitments). Non-fund based exposures are calculated at 100 percent including those under forex forward contracts and other derivatives.
11/ As prescribed by the RBI, banks have to set internal limits of exposure to specific sectors, subject to periodic review by the banks. For example, ICICI Bank fixed a ceiling of 15 percent on their credit exposure to any one industry (other than retail loans).
12/ After the bad experience with overexposure to certain industries and groups, banks now want to control the credit concentration risk by taking various steps. Banks now focus more on a diversified portfolio of retail lending and reduce their exposure to a single company or a group.
13/ In addition, banks now intend to lower their exposure to low-credit rated companies, sell their loans at a discount, monitor loan portfolios proactively and some are approaching the newly-formed insolvency regime for resolution of sticky loans.
14/ Why do banks in India pursue retail lending so feverishly in recent years? Is over-exposing themselves to a single sector prudent for banks? What assumptions do banks make while increasing their retail loans?
15/ With the benefit of hindsight one could say banks have made mistakes in the past boom credit cycle by over lending to infrastructure, power and steel sectors and to certain groups of companies. Now, they are doing a course correction.
16/ They have been increasing their retail loans and decreasing corporate loans. The biggest attraction of retail lending for banks is the lower risk weight (RW) of 75 percent for a well-diversified loan portfolio (in banking parlance, this is called 'regulatory loan portfolio').
17/ Retail loans include mortgage loans, two-wheeler loans, car loans, small business loans and commercial vehicle loans. But individual housing loans attract a risk weight of 35 to 50 percent, depending on loan-to-value ratio and loan size.
18/ Personal and credit card loans are basically unsecured, which means they are not backed by any collateral / asset. Due to their unsecured nature, those loans attract a risk weight of 125 percent, as stipulated by the Reserve Bank of India.
19/ In comparison to risk weight of 75 percent for retail loans, corporate loans attract risk weights ranging from 20 percent (for AAA-rated firms) to 150 percent (for a company with below investment grade).
20/ Other reasons banks are chasing retail loans lately include: lower NPAs in retail loans versus corporate loans; retail loans offer strong growth due to under-penetration, better demographics in India, urbanization; and more data from credit bureaus such as CIBIL.
21/ But retail lending is no panacea, if you go by the past experience in the mid-2000s. ICICI Bank had trouble with retail loans and credit card lending in 2006-2007 period. To sum up, banks need to maintain a fine balance between retail and corporate lending.
22/ As per RBI guidelines, banks have to maintain a minimum total capital of 10.875 percent (including capital conservation buffer of 1.875 percent) as a percentage of their risk-weighted assets (RWAs) for the current financial year ending 31 March 2018.
23/ Suppose a bank has a retail loan portfolio of Rs 100 crore. With capital adequacy ratio (CAR) of 10.875 percent and risk weight of 75 percent, the bank has to maintain a capital of Rs 8.16 crore (=100 x 0.10875 x 0.75) for this Rs 100 crore-loan.
24/ Now, let us come back to credit concentration risk. How do we assess whether a bank is exposed to credit concentration risk? One measure is to check banks' total exposure to twenty largest borrowers. Data from a sample of ten banks: Please see the exhibit -->
25/ From the above exhibit, we can see SBI, Canara Bank, HDFC Bank and ICICI Bank have reduced their exposure to top 20 borrowers between 2016 and 2017; whereas PNB, BoB and Axis Bank have increased their exposure in the same period.
26/ One could glean banks' financial statements to find out their exposure to different sectors of the economy. Data from RBI reveal banks' over exposure to industry sector and other sub-sectors of the industry. Please check the exhibit below -->
27/ From the above exhibit, it is obvious that stressed assets (gross NPAs plus restructured standard assets) in industry are 23.9 percent of total advances to industry as of September 2017, and they rose from 19.3 percent in March 2016.
28/ Among the sub-sectors of industry, the most vulnerable to stressed assets are sub-sectors such as, infrastructure, basic metals, engineering and textiles. Please check the exhibit below -->
29/ The above exhibit shows stressed assets ratio in infrastructure sub-sector is 19.6 percent (Sep.2017) versus 16.7 percent (Mar.2016). And total credit to infrastructure is 34.1 percent (Sep.2017) of total credit to industry, indicating concentration risk.
30/ The story is similar in other sub-sectors such as steel / metal, engineering, textiles and food processing as shown in the above exhibit. This is how credit concentration risk has impacted the profitability and the very survival of some banks.
31/ However, if the Indian economy undergoes an upturn in the coming years, we could see improvement in the prospects of these vulnerable sectors and the concomitant boost in the profitability of banks that got exposed to such loans.
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Disclosure: I've vested interested in Indian stocks. It's safe to assume I've interest in the stocks discussed.
Disclaimer: The brief analysis provided here is only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets. He blogs at: