US Financial Crisis and its Impact on Indian Banks

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Date added: 17-06-26

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Introduction: The 2008 financial crisis was triggered by a dramatic rise in mortgage delinquencies and foreclosures in the US, which had adverse impact on banks and financial markets around the globe. But, Indian banks unlike other developed countries and emerging markets were not seriously affected. It is not surprising as Indian banks have very few branches overseas. Also, they had virtually no direct exposure to European or US mortgage market, and their exposure to complex derivative instruments whose value fell dramatically during crisis was miniscule. Some Indian Banks which have foreign exposure suffered a bit. Notably, ICICI bank faced significant loss of 375 crores as its London subsidiary had exposure of 57 million euro (375 crores) in Lehman Brothers, which had filed for bankruptcy in US [1] . As Indian Economy is now a relatively open economy, there were indirect impacts due to the crisis, especially on GDP growth, exports, exchange rates etc. India which had capital inflows of more than $100 billion during 2007-08, saw a net increase in capital inflows of $10 billion. During this time, it was also difficult for Indian companies to raise money from foreign markets. Exchange rate rose dramatically during this time as compared to previous years hitting liquidity and importers badly at same time. A snapshot of historical exchange rate is provided below. Exchange Rate INR vs USD

Indian Banks Performance:

BSE SENSEX vs BSE BANKEX [2] Historically, Indian banks have been well regulated and capitalized and they have also performed well financially. A comparative performance of BSE sensex and BSE bankex has been shown in the above plot. It clearly shows how Indian banks were hit during 2008 crisis, and how they performed post crisis. Though underperforming during the crisis, Indian banks have done fairly well post crisis.

RBI Policies and Liquidity Condition:

Repo, Reverse Repo and Mibor rates vs Time [3] 2008 US financial crisis has shown liquidity risk can rise multifold during adverse conditions. In the Indian Financial System context, we can see during the crisis how dramatically Mibor rates had shoot up. In these conditions, it becomes very difficult for financial institutions to borrow money from market to meet their liquidity requirements. Reserve Bank of India (RBI) has already put in various ways to mitigate the liquidity risk at short term, systematic level and institution level. Some of the methods include limit of borrowing and lending in the inter-bank call money market, limit on inter-bank liabilities, monitoring of credit deposit ratio of each bank. RBI has also given guidelines on Asset Liability Management (ALM) for banks, and SPVs. RBI has so far not allowed some complex instruments, which are operating in foreign markets. Before the crisis many banks were accusing RBI of its tightening monetary policies (as can be seen from increasing CRR below). But, later they were appraising RBI for taking prudential policies even before the crisis, and during crisis. The Chairman of HDFC, Deepak Parekh quoted "He saved us" of Dr. Y.V. Reddy (RBI Governor during the crisis). Nobel Laureate Joseph E. Stiglitz commented "if America had a central bank chief like Y. V. Reddy, the US economy would not have been in such a mess." CRR Ratio vs Time [4]

Policy Response:

Though, RBI had already taken various steps observing global financial system, it took an active role in protecting Indian banks in terms of providing support for liquidity through various mechanisms. Support from government thorough fiscal policies helped Indian banks and economy to recover faster as compared to other economies in the world. Monetary Policy Response: RBI advised banks to report their exposure to Lehman Brothers and related entities, as soon as Lehman Brothers filed for bankruptcy under chapter 11. During that time of 77 reporting banks, 14 banks reported their exposure to Lehman Brother and its related entities including India and abroad. In the aftermath of the turmoil caused by bankruptcy of Lehman Brothers, RBI announced a series of measures to facilitate financial stability and orderly operations of financial markets, which predominantly included providing additional liquidity support options to banks. RBI was able to manage the situation with appropriate use of a range of mechanisms available to manage the liquidity in the economy such as Cash Reserve Ratio, Statutory Liquidity Ratio, Liquidity Adjustment Facility and Open Market Operations including Market Stabilization Scheme. As seen from the plot of Repo, Reverse repo and Mibor rates with time, 2007 had seen a large capital inflow, leading to excessive liquidity, which was absorbed by RBI through mechanism such as LAF, MSS and CRR. But during crisis, RBI started loosening the tighter monetary policy to provide additional liquidity in the system. In the first phase the cash reserve ratio (CRR) was cut down from 9% to 5.5% (sharpest reduction ever in CRR). The CRR reduction released Rs 1,50,000 cores of primary liquidity in less than a month to the liquidity stressed economy. Statutory liquidity ratio (SLR) was reduced from 25% to 24%. Also RBI allowed a temporary relaxation in SLR to the extent of 1.5%. This facility was granted to enable banks to borrow the RS 60,000 crores of additional liquidity to lending to mutual funds. RBI also cut repo rate from 9% to 4.75%, reverse repo from 6% to 3.25%. Other steps included, increase in the interest rate ceiling on NRI and FCNR bank deposits to attract deposits, providing export credit refinance and reducing provisioning norms on housing loans, real estate loans, personal loans etc. Fiscal Policy Response: Finance minister P. Chidambaram announced that RBI would provide temporary liquidity support of 250 thousand crores to commercial bank and NABARD, against the first debt. The government has decided that the limit of foreign investment (FII) in corporate bond would be raised from $3billion to $6 billion. SEBI also played a celebrated role in managing the flow of money from abroad. The promoters were now allowed to increase their holding in their company up to 75% through creeping acquisition route Earlier restriction prohibited them from acquiring more than 55% company's equity.

Recommendations:

Several lessons could be learned from the US financial crisis, which could help us to avert any similar future crisis. Especially for Indian Banking System, which was luckily not so entangled with the US or Europe financial system, various guidelines and policies could be recommended. Capital requirements for complex structured products, whose risk assessment is difficult, could be increased from current prevailing norms. Soundly managing, reporting of off-balance sheet items. Capital requirement treatment for off-balance sheet items could be strengthened. Helping banks to oversight the firm level and market level risks arising in future. Discourage the use of complex structured products, which are risky in nature, for banks.
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