Walk the streets of Mumbai — India’s commercial capital — and it’s hard to avoid billboards from companies such as GE Money, CitiFinancial Consumer Finance and Indiabulls Credit Services promising quick loans with minimal fuss. India’s retail lenders have been in high spirits in recent years for reasons that are easy to understand. After all, profits of India’s largest publicly listed companies have been growing at 25% to 30% for the past eight quarters; the country’s GDP has grown at its fastest pace in 18 years, rising 9.4% in 2006-07 on top of 9% in 2005-06; and surveys show that wages in India — pushed up by shortages of skilled labor — are rising fastest among the Asia-Pacific nations. All this should make for the golden age of consumer credit in India, right? Well, not quite.

As the sub-prime credit meltdown in the U.S. shows, fast-growing financial markets often conceal hidden weaknesses. Signs have begun to appear that India’s consumer finance markets — while they may not face a credit crunch of the type that confronts the U.S. economy — could be slowing down. Industry experts say that as non-performing loans and defaults rise, Indian lenders are becoming cautious about their portfolios, especially loans to weaker borrowers. Firms are rethinking their strategies and re-examining risk management processes to ensure that they don’t face the kind of risks that have led some U.S. financial institutions to go belly up.

According to finance industry executives, bad bank loans — or net non performing assets (NPAs), as illustrated by earnings reports for the most recent quarter to June 2007 — are rising and could go up further. The State Bank of India — the country’s largest bank — saw gross NPAs increase to Rs. 107.6 billion ($2.63 billion) from Rs 97.2 billion ($2.3 billion) in the corresponding quarter ended June 2006. This is the highest in the last 14 quarters. Net NPAs, too, increased by 5% at the bank, which accounts for almost a fifth of Indian banking system assets. In a move that sent a shiver through the markets, SBI increased provisions for loan losses by 160.9% for the quarter ended June 2007 to Rs 5,381 million ($131.5 million).

Loan loss provisions by HDFC Bank — one of the most valuable private sector banks in India — increased 61.7% year on year to Rs 2,997 million ($73.24 million). Similarly, the Union Bank of India, one of the most profitable state owned banks, saw its loan loss provisions rise by 91% to Rs 1,280 million ($31.28 million). “We see a steady increase in NPAs ahead,” says a recent Citigroup study. The brokerage arm of the world’s largest bank estimates that bad debt charges at listed Indian banks it tracks more than doubled from Rs 9,068 million ($221.6 million) in the quarter ending June 2006 to Rs 20,610 million ($503.67 million) in the quarter ending June 2007. Macquarie Securities, a unit of Australia-based Macquarie Bank group, forecasts that gross non-performing loans for ICICI Bank — India’s second largest bank — will rise from 2.4% in 2007 to 3.2% in 2008.

Into the Debt Trap

These difficulties have not yet sunk any credit provider in India, but since retail loans account for a quarter to two-thirds of a typical bank’s portfolio, there’s no room for complacency either. At ICICI Bank, the retail segment accounts for 65% of the net additions to gross NPAs during the quarter ended June 2007, says Mumbai brokerage ASK Securities. “Typically, defaults in retail loans tend to peak when there is a surfeit of lending because of a feel-good environment, good markets and excessive optimism that may misguide customers to overstretch themselves,” says Keki Mistry, managing director of the Housing Development and Finance Corporation (HDFC), India’s largest dedicated mortgage lender.

He may well have been describing the mood in India until a few weeks ago. But now things are changing. The industry has seen delinquencies rise by between 10% and 20% in recent times, according to Dipak Gupta, executive director at Kotak Mahindra Bank. This is a major change from the risk-free perception of retail loans that once existed among credit providers in India.

Traditionally, Indians have been debt averse. Until a decade ago people were reluctant to borrow money except from family and friends — or perhaps the local moneylender. Salaried employees were able to borrow up to 35% of their annual salaries from employers for personal needs like the marriage of a loved one or the purchase of a scooter. Now, firms often avoid lending money to staff, due to a change in taxation rules. “Instead, these advances against salary or accrued retirement benefits have been replaced by funding from banks and financial service companies willing to lend up to 85% of an individual’s annual income. These unsecured loans are used for consumption expenditure and have led to a huge rise in personal indebtedness,” says Manmohan Agrawal, executive director of Axis Bank.

The race for market share by credit providers keen to justify their high market capitalization has also contributed to the increase in non-performing loans. It’s not uncommon to be accosted at a supermarket in India by sales agents keen to sign you up for a credit card on the sole basis of your last credit card statement, or a photocopy of your existing credit card issued by a rival bank, or a cash purchase bill of Rs 1,200 from the supermarket, or by showing that you own a cellular phone. “If you produce your plane boarding pass, you might be able to obtain a credit card as you exit the airport terminal,” says Agrawal.

Weaker Lending Standards

“Distressed assets are primarily the result of the loan provider choosing a poor credit risk — you either lend money to someone who should not have been loaned any money, or you lend more money to the individual than you should have. In a minority of cases, a change in the circumstances of the borrowers affects their ability to repay on time and in full,” says Gupta. Having lent the money, recovering it is a far more arduous task. “If good underwriting systems are put in place upfront, then problems get minimized later on,” says Tejpreet Singh Chopra, CEO of GE India, whom India Knowledge at Wharton interviewed recently.

Rising interest rates have also pushed up defaults, Gupta points out. Mortgage interest charges have risen from some 7.5% a year to 12% a year over the last two years. The attractiveness of leverage declines significantly when rates rise by 50% to 60% and so does the ability of borrowers to repay loans on time. “If there are more interest rate hikes, we as a company will have to absorb them as our borrowers now lack the capacity to bear further hikes in rates,” says Gagan Banga, CEO of Indiabulls Credit Services.

When interest rates started rising around two years ago, banks tried to keep the monthly mortgage payments — or equated monthly installments (EMIs) — of borrowers steady by increasing the term of the loan. As a result, a 12-year mortgage became a 20-year to 24-year loan. Banks that typically raise short-term deposits of up to five years have been unwilling to extend the maturities of mortgages beyond 20 years.

“Mortgage EMIs typically tend to be 50% to 60% of the net take-home pay of borrowers,” says Gupta. If banks increase the term of the loan to, say, 25 years, they run the risk of a serious asset-liability mismatch and also take on risks of a borrower having to pay EMIs into the silver years of their working lives when other expenses like medical bills tend to balloon. “Since we have provided loans to borrowers based on their maximum ability to service debt, it is difficult to expect them to pay a higher EMI now,” says Banga. Lenders face tougher problems with borrowers who have fixed-rate loans. “Banks who have given fixed-rate loans at 7.5% are bleeding on those portfolios now,” says Hemant Kaul, president of retail banking for Axis Bank.

Home mortgages are hardly the only trouble spot for financial services firms. Unsecured personal loans patronized by young men and women working for the booming business process outsourcing industry also may cause headaches. These workers often borrow 150% to 200% of their annual salary to fund their lifestyles. “A rise in interest rates hits the lower end of the market and those borrowing unsecured loans more,” says GE’s Chopra, whose consumer finance division has $1.3 billion in assets in India. “Economic growth results in a rise in aspirations. Some consumers who are stretching to get to the next level can get affected by higher interest rates.”  

Responding to the increase in non-performing loans, credit providers have put the brakes on loans for durable products such as two-wheelers. At Axis Bank, the minimum eligibility standard for personal loans has now been raised from a salary of Rs 7,500 a month ($183.29) to Rs 10,000 ($244.38) a month. More importantly, such banks are now benchmarking their interest rates, operating risks and credit risk models to international best practices.

Managing Risk

“India has seen significant improvements in the ability to manage risks. Today, one can hedge the currency risk on a 10-year foreign currency loan, swap floating-rate loans for fixed-rate ones or vice versa. This level of risk management was not possible 10 years ago,” says HDFC’s Mistry. At GE India and HDFC, for instance, no asset-liability mismatches are run. This means their portfolio of fixed-rate mortgages is backed by a corresponding amount of borrowings at fixed rates for similar tenures and similarly for floating rate mortgages. As a result, the spread between the borrowing and lending costs of these two firms is protected and they avoid any maturity mismatches as well.

Indiabulls engaged Fractal Analytics, a Mumbai-based analytics firm, to design a scorecard on which to base credit decisions. Kotak Mahindra, one of the oldest providers of retail finance, uses a combination of automated scorecards and credit screens used by risk officers to process, approve and price retail loans. Not all international best practices, though, can be easily applied in India. “A good scorecard requires two basic ingredients — the provider’s own history of delinquency and the history of rejected cases. Historically, most credit providers in India have not kept data on customers who were refused loans. The Credit Information Bureau India Ltd. (CIBIL), too, does not have a long enough history of individual delinquencies. It has data only on current loans,” says Gupta. While a good scorecard may need a five- to eight-year history of delinquencies, many lenders began focusing on this business only around four years ago. CIBIL commenced full operations in 2004.

According to GE’s Chopra, “A robust risk management model has to be built in India over years; it can’t just be bought off the shelf. Unlike the U.S., where you have quite a few credit bureaus with detailed credit histories, in India this choice does not exist. We at GE India have built a database over a decade, developing a scorecard based on the segment of the borrower, the product sought to be financed, the dealer it’s being purchased from, etc., to determine how much we should lend. Our model uses demographic data and historical payment patterns in the geographical area and that of the customer, respectively, to give us a holistic view of the risk.”

Of course, lenders have also tried to hedge credit risk by diversifying their portfolios by way of assets financed and geography, and by securitizing portfolios to ensure they retain only those risks they can manage. Indiabulls, for instance, aims to hold on toretail portfolios it originates for around two months before selling the receivables via direct assignment or rated securitization pools.

Credit rating agency Moody’s Investors Service says domestic issuance of structured finance transactions in India grew 90% to $5.5 billion in the first half of 2007 from $2.9 billion in the first half of 2006. Deal numbers almost doubled as well in the 2007 period. “With the retail lending business in India likely to grow, we expect ABS (asset-backed securitization) issuance to increase in the second half of 2007,” says Dominique Gribot-Carroz, a Moody’s assistant vice president in Hong Kong.

Mortgage securitizations, however, have been slow to take off since mutual funds and financial service companies are often unwilling to buy extremely long dated securities. Pension funds and insurance companies, which typically invest in such longer-term debt globally, find themselves constrained by investment regulations in India from taking the lead role here.

So it’s hardly surprising that like other emerging markets, risk management is an area which is still developing in India. While some companies may be on par with global standards, for the average credit provider it’s still a case of work in progress. “There are three risks loan providers face: credit, operating and interest rate. The first has received the maximum focus so far, with firms only now realizing the importance of the second and putting in place systems to deal with those risks. As regards the third, the record is mixed,” says Kaul. According to him, a three-day delay in depositing post dated checks for monthly installments results in check returns spiking up by 7% to 10%. “Realizing this, many public sector banks have now started setting up centralized loan factories like ours to process all documents and take charge of operating the account,” he says.

Robust systems help track overdue accounts and enable corrective action to be taken immediately. “Once you let an account become an NPA, chances are it will always be behind schedule. It’s therefore imperative to prevent such a scenario with proper follow-ups,” says Banga. Others, like GE, claim to have built in processes to pick up trends in the marketplace before they become problematic. “That way we can tighten lending practices for fresh exposures and follow up existing exposures to see if restructuring is required,” says Chopra.

With retail loans still growing more than 20% a year, lenders are investing heavily in software systems and appropriate processes that can help them contain the downside risks. At Axis Bank, an online loan processing system does not permit any discretion on eligibility norms. “We have nipped moral hazard in the bud by centralizing loan processing, ensuring an automatic query is sent to the credit bureau for any application, and freeing up branches to collect deposits with a separate team marketing loans,” says Kaul. He notes, however, that the best insurance is to identify the customer segment based on the bank’s positioning and then price appropriately for the risk.