Credit Risk Insights from India's Frontline: A Q&A with Shashi Ramachandra

Over the past year, amid the COVID-19 pandemic, India's banking system has been plagued by increases in non-performing loans and credit write-offs. Public-sector banks (PSBs) are struggling to raise additional capital at a time when asset quality is deteriorating rapidly due to government-mandated lockdowns.

Shashi Ramachandra, the former chief risk officer at Canara Bank - one of India's largest PSBs - is well-versed in the credit risk management issues facing Indian banks. Throughout her four decades of experience, Ramachandra - who currently serves as an independent director at a non-bank financial company in India - oversaw the implementation of the Basel I, II and III capital frameworks.

Recently, she talked to Risk Intelligence about the evolution of current state of capital, credit underwriting, credit analysis and credit loss modeling at Indian banks.

Risk Intelligence (RI): Given their adoption of Basel provisions and their conservative approach to capital standards, why have PSBs faced high credit write-offs and capital shortfalls?

Shashi Ramachandra (SR): The Basel provisions are designed to ensure adequate capital to meet unexpected losses. Asset quality is dependent on other factors, such as underwriting standards, management experience and business strategy of institutional counterparties. It's also dependent on the impact of economic and socio-political factors on India's need for capital investment.

The deterioration in asset quality can be attributed to the credit boom of 2006-2011, when bank lending grew by 20% on average. At the time, we saw lax credit appraisal and post-sanction monitoring standards; project delays and cost overruns ensued.

Efforts to restructure corporate debt did little to resuscitate these troubled assets, as India's bankruptcy law was not yet in place. Regulators subsequently tried to minimize the risks posed by non-performing assets and took steps to supervise troubled markets.

The RBI also formalized a process to review asset quality. Implementation of India's Insolvency and Bankruptcy Code (IBC) in 2016 created a standardized approach for classifying asset quality among lenders, providing greater transparency for sharing of information through a formal consortium and informal banking arrangements.

While improved borrowing and repayment practices can be attributed to the IBC code, much work remains to further streamline these practices.

RI: How do retail vs. wholesale credit underwriting standards differ in India?

SR: Retail credit underwriting is based on schematic parameters and scorecard evaluations. In contrast, wholesale underwriting standards are based on a borrower's industry; a company's business model; the nature of the underlying project to be financed; procurement and selling patterns; and industry standards for debtor and creditor levels.

Final lending decisions and sanctioning are aligned with a bank's risk governance structure.

RI: How is fundamental credit and financial statement analysis performed?

SR: The credit analysis process is defined by a bank's internal policies and operational guidelines. Due diligence has strengthened over time and is typically conducted by the risk management team. It often includes a fundamental evaluation of the borrower's credit risk profile, and the potential alignment of that risk with the bank's underlying risk appetite.

Risk ratings are typically assigned by a risk analyst - independent of the credit approval process and based on internally-generated credit scores. Financial analysis is completed by the rating analyst using acceptable parameters and industry benchmarks defined by the bank's senior management. Credit exceptions are escalated, if justified.

RI: How is credit modeling done?

SR: Most banks employ a standardized approach (SA) to credit risk modeling. Risk appetite statements and tolerance limits are developed based on an analysis of risk weighted assets (RWA) and capital allocation.

Larger banks often use proprietary models, or an internal ratings-based approach, for estimating counterparty credit risk, defining risk appetite, setting credit limits, and developing stress testing and reverse stress testing models. Banks continuously work on improvements in their models to enhance risk management decisions and optimize capital allocation decisions.

RI: Can you please compare the credit loss experience at India's PSBs with loss experience at global banks that have access to liquid capital markets and structured credit products?

SR: The strength of Indian PSBs can often be linked to the economic objectives of the Indian government, and is dependent on local macroeconomic factors over time. PSBs are required to allocate 40% of their lending capacity to support economic growth in industry sectors prioritized by the government - including education, agriculture and renewable energy. The return on these loans is typically lower than yields on other commercial loans.

PSBs also actively support the financing of infrastructure projects, which inherently have longer gestation periods and higher implementation risks. Project delays or non-performance can adversely impact asset quality, creating higher credit losses for PSBs, while focusing on lending support for government-backed economic initiatives.

The Indian government effectively backstops PSBs, providing capital support as needed. Access to capital markets may occur after non-performing assets are resolved. Bankruptcy filings under the IBC, moreover, help facilitate the resolution process and improve PSBs' ROE/ROA.

In contrast, private-sector banks and foreign banks may allocate capital to India's Rural Infrastructure Development Fund (RIDF), an alternative lending vehicle for funding rural development and other state-backed economic initiatives. These banks receive a nominal return on capital deployed through the RIDF, guaranteed by the Indian government.

The Indian financial system does not support a liquid market for structured credit products, and liquidity in the corporate bond market is too thin to be an effective source of funding or investment. Indeed, there is much room left to explore the structured credit and corporate bond products to tap into funding and investments.

Corporations will remain dependent on PSBs as their primary source for funding, unless a deeper, more mature corporate bond market develops.

Shashi Ramachandra is the former group chief risk officer of Canara Bank, one of the largest public-sector banks owned by the Government of India. She is currently a board member at a non-bank financial company in India.

Michael Sell is a senior VP and head of global business development and institutional outreach at GARP.