The elusive ‘optimal' housing finance model

It is not difficult to understand financial sector regulators being extra cautious in their approach to markets and instruments in the wake of the crisis of 2008 (or is it also 2009, 2010 and 2011?). A step-by-step approach to financial sector liberalisation, in fact, was the highlight in the emerging world even before the crisis.

Given that background, one is more than mildly surprised to note the Reserve Bank of India advising the use of financial derivatives by Indian commercial banks in their lending operations.

Indeed, more interesting is the RBI recommending the use of interest rate derivatives in precisely the area – housing finance — which caused the historic upheaval in global financial markets and the economy in 2008.

Indeed, there is no gainsaying that complex housing finance – with its core being short-term liabilities whose risks were hedged through complex interest rates, mortgage and credit derivatives — was one of the root causes of the cataclysm in global markets. (Lehman, Fannie Mae, Freddie Mac, Northern Rock, AIG among others should immediately come to mind here).

Globally, the search is now on for that “optimal” housing finance model which can enable safe, sound and at the same time, profitable housing finance lending to be carried on. All stakeholders and economic agents realise that long-term fixed rate loans are optimal from not only the borrowers' but also from the perspective of overall financial stability. The search consequently has narrowed to designing a long-term fixed rate funding option for housing lenders.

(Students of financial and economic history can note here that the S&L crisis in the US in the late 1970s/early 1980s was caused precisely by the short liability/long asset model going completely awry when the Paul Volcker-Fed hiked interest rates decisively to kill double-digit inflation).

In other words, what is sought after now is a very conservative financial strategy. Lenders would issue long-term bonds to match their long-term housing loan assets.

The bonds would have to be callable to protect against the pre-payment risk on the loans.

A financial institution following the classic strategy is protected against all interest-rate shocks.

There is no risk from interest-rate fluctuations because the duration of assets and liabilities match. Prepayment risk is handled by issuing callable bonds and then calling them when assets pre-pay. The institution's risk is confined to the credit risk on the assets. Credit risk can be managed and mitigated in various non-esoteric and orthodox ways. The profitability of the financial institution then depends, to a very major extent, on the interest-rate spread between the assets created and the bonds issued to finance them, at the time of the transaction.

(The “covered bonds” concept in European mortgage markets seems very pertinent here).

Backdrop to RBI's Swaps Move

That is the macro and global background to the RBI's recommendation on commercial banks using interest rate swaps to create “synthetic” long-term liabilities. Indian financial markets, unlike some overseas financial markets – particularly in Europe – seriously lack a long-term fixed rate funding instrument for housing lenders or more generally for all categories of long-term lending. Indian banks rely pre-dominantly (slightly more than 80 per cent) on deposits up to three years for their balance sheet funding. The phenomenon of “teaser” rates on home loans – offered by some leading financial institutions in the recent past and which has generated a fair amount of interest and controversy - also appears to be a key driver behind the RBI's move on interest rate swaps.

As part of its 10-point action program on improving customer service in banks, the RBI says that “Banks may also offer long-term fixed rate housing loans to their customers and address their asset liability mismatch (ALM) issues by recourse to the Interest Rate Swaps (IRS) market.”

To be sure, issuing short-term liabilities and undertaking interest rate swaps (IRS) does “almost” create a synthetic long-term liability for the bank.

IRS caveats

Going beyond the practicalities of whether the Indian IRS market – which is not that large and liquid currently – can take in large amounts of hedging activity of the kind which may be necessary if banks were to do balance sheet hedging through that market, there are also other technicalities to be reckoned with.

(The practical aspects, in fact, could be even more important than the technical ones.

Indian public sector banks almost never use the extant IRS market for any kind of hedging.

Activity in this market is only by some foreign and private sector banks which also only trade their short-term interest rate views.

In other words, there is no history of this market being used for hedging in any sense. One can, of course, ask: where is the need for hedging when interest rate risk on bank balance sheets is almost non-existent.

On loans, risk is passed on to borrowers. On investments, the entire SLR is immune since it need not be marked-to-market.)

An IRS “almost” (but not exactly) creates a long-term liability for the bank which does the swap.

“Basis risk” explains why the IRS may not exactly create a long-term liability for the bank.

Basis risk arises whenever we use a derivative hedging strategy or contract which is not identical with the risk or exposure being hedged.

In the instant case, one has to examine if the Mumbai Inter-bank offered rate (MIBOR) is identical to or at least influences significantly the short-term liabilities or funding costs of Indian commercial banks.

For, in a MIBOR-based IRS where the bank pays a fixed rate and receives a floating rate, what is being hedged is the risk of MIBOR rising.

If there is not much consonance between the MIBOR and the overall short-term weighted borrowing costs of a bank, the bank will run a basis risk by doing an IRS.

In particular, if the short-term weighted average borrowing costs of a bank are at a good spread over MIBOR and this spread also fluctuates, the exposure to basis risk could be quite high.

Banks' Funding Costs

But, wait here. Basis risk is serious only if the weighted average funding costs for a bank are above the MIBOR. What if they are lower? In that case, there may not even be any need for a bank to do an elaborate IRS.

Banks can straightaway do long-term fixed rate housing finance without too much risk. The spread on lending should take care of interest rate risk. For the borrower, “payment or EMI certainty” is the trade-off.

But, are Indian banks' cost of funds lower than even the average money market rate?

Indeed, they are going by the aggregate statistics put out by the RBI.

For the public sector banks as a category, their overall cost of funds (defined as interest paid on deposits and borrowings/average deposits and borrowings) is even lower than the weighted average call money rates in the past six years.

The cushion significantly seems to come from the zero-interest demand deposits.

If banks are still not doing pure long-term fixed rate lending, that can only be ascribed to the high level of uncertainty about the financial system and overall policies.

Is it then time for a serious move towards “covered bonds” in India?

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. Views are personal.)