High inflation coupled with rise in borrowing costs adversely impacts finances of households and their loan repayment capacity, which can have implications for lending banks, cautioned the Sub Committee of the Financial Stability and Development Council (FSDC-SC).

Identifying different measures of risks using individual home loan data, it is found that a twin shock in the form of a simultaneous increase in inflation and lending rates can put even households with sustainable repayment capacity at risk and double the loans-at-risk (LaR), the Council said in its half-yearly Financial Stability Report (FSR).

Residential asset price

According to Reserve Bank’s quarterly residential asset price monitoring survey (RAPMS), it was observed that in March 2023, the largest share of home loans (more than 40 per cent) was owed by households (falling in the tax bracket) in the top 20 per cent income bucket (households with monthly income more than ₹1.40 lakh).

The average income of the households in this bucket is more than 12 times of the bottom 20 per cent (Households with monthly income ₹20,001 - ₹42,000), while the average loan size (at about ₹90 lakh) is more than 5 times. As a result, the EMI-to-net income ratio improves with income.

Households in the lower buckets with thinner buffers are more likely to face difficulty in servicing their debts in the event of interest rate shock and/or expenditure shock, per the FSR.

Household sector: Financial Margin Framework

Referring to households’ financial margin, which is defined as income net of estimated taxes, EMI on the housing loan and expenditure on basic necessities, the report said households with a negative financial margin are likely to face acute financial difficulties and may miss out on their EMIs. A rise in interest rates or rise in prices or both further accentuates their plight.

Such loans are said to be at risk – the number of such loans (in per cent) and the share of their total outstanding loan amount are termed as loan-at-risk (LaR) and debt-at-risk (DaR), respectively, which are used to measure potential risk.

Households with EIR (EMI-to-Income Ratio) of more than 60 per cent are more at risk of a negative financial margin although in the lowest income bucket, negative margins are observed in EIR levels of 40-60 per cent as well.

Households in lower buckets where basic expenditure takes up a larger part of the income will have less disposable income for their EMI. Conversely, in upper buckets, basic expenditure takes up less proportion of the net income leaving a bigger disposable income for payment of EMI.

Inflation impact

High inflation increases the expenditure on basic necessities, and the ensuing tightening monetary policy cycle increases the EMI, producing a significant impact on the financial margins of households.

The weighted average rate of interest of fresh home loans calculated for every round of the RAPMS shows that this simultaneous rise in inflation and lending rate has had a significant impact on the financial margins of households.

On adjusting the expenditure on basic necessities with the current consumer price index (CPI) and recalculating the EMI using the rate of interest calculated from the latest round of the RAPMS, the number of loans with a negative financial margin almost doubled, taking the figure to 31.6 per cent

The increase was observed across all income buckets. Even the DaR for the bottom 40 per cent income bucket increased substantially to around 10.8 per cent of the total loan.

A noteworthy finding is that due to the coupling effect of inflation and rate increases, even the households with sustainable levels of EIR (20-60 per cent) are at a risk of having negative margins. Another cause for concern is the significant impact it can have on banks’ capital.

“While the capital-to-risk weighted assets ratio (CRAR) of the sample banks remained above the 9 per cent threshold when inflation and rate rise were not accounted for, CRAR of two banks with sizable housing loan portfolios fell below the threshold level,” per the report.

RAPMS collected data on fresh home loans disbursed across select cities from 11 public sector banks (PSBs) and 9 private sector banks (PVBs) covering around 20 lakh housing loan accounts and representing around 15 per cent of the active housing loan accounts and 35 per cent of the outstanding housing loan amount of the banking sector.

Sensitivity analysis

Sensitivity analysis was conducted by RBI under three scenarios - scenario 1: the rate of inflation is assumed to be at the upper tolerance level of 6 per cent with a possibility of a rate hike of 25 basis points (bps); scenario 2: the rate of inflation is 7 per cent with a rate hike of 50 bps; and scenario 3: the rate of inflation is 7.5 per cent and rate hike is 75 bps.

The results indicate up to 9 percentage points increase in LaR and a consequent increase of 8 percentage points in DaR under various scenarios

At an overall level, however, these losses have a marginal impact of about 80 bps on the overall CRAR of the sample banks. At an individual bank level, the impact is negligible with no additional banks failing.