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.
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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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The above is a reproduction of a Tweet thread I made on my handle @vrk100 on 23 February 2018 >
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. #RiskManagement
— RamaKrishna Vadlamudi, CFA (@vrk100) February 23, 2018
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:
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