Banks Tied Down By Risky Products

Availability of instruments for banks to transfer risks to other banks and leveraged investors has translated into fewer incentives for lenders to effectively screen and monitor borrowers, according to Reserve Bank of India (RBI) deputy governor Shyamala Gopinath.

This wider distribution of credit risk within the global financial system should, in principle, limit risk concentrations and reduce the risk of a systemic shock.

Recent events, however, suggest some reservations about this positive assessment, Gopinath said in her address at a derivatives conference on Wednesday.

The US sub-prime crisis has engulfed a large number of financial institutions as mortgage lenders had transferred the risks from their books to them via securitisation.

One reservation is that banks have become increasingly able to sell even the equity tranches of their loan portfolios (retaining no exposures) quickly. This means they have fewer incentives to effectively screen and monitor borrowers.

A systematic deterioration in lending and collateral standards would, of course, entail losses greater than historical experience of defaults and loss-given-default rates would indicate, she said. “It is not clear whether current risk management practices make enough allowance for this.”

Over the past decade or so, the business models of global banks have evolved from a buy-and-hold to an originate-to-distribute model. Instruments to transfer risks from the balance sheets of the originating institution have developed in size and complexity, Gopinath said.

Risks have been repackaged and spread throughout the economy. The greater part of these risks is sold to other banks and to leveraged investors, very often the originating bank itself funding the investors. Small and regional banks, in particular, were significant buyers of sub-prime and other structured products in the US.

The recent episode of financial turbulence has provoked a debate on the measurement, pricing and allocation of risk by way of derivatives, which can hold important lessons for India, she said.