In a scene in the recent Hollywood film Now You See It , a group of young magicians disclose the bank balances of the audience and then — to everyone’s amazement — transfer funds from their billionaire patron’s bank account to the audience’s accounts. It is poignant because it points to the pauperisation of the famed American middle-class and its lifestyle built around suburban homes and SUVs.

Like everything else in India, the impact of financial markets too is localised. What happens in Mumbai seems remote not only in Guwahati, but even in Gadchiroli next door. Although banks in India have contributed significantly to the creation of housing and other assets by the middle class, it is apparent that massive investments are needed to upgrade housing quality to the standards in other developed/ developing countries. Home ownership remains low — the reported numbers are inflated due to joint families living together, often in cramped conditions.

Undoubtedly, there is an attractive long-term opportunity to finance residential mortgages, but with the spectre of the US sub-prime mortgage crisis looming over the world, there has been little enthusiasm for this sector. There are multiple reasons, mostly related to land acquisitions, inefficient zoning, lopsided urban infrastructure, and short-sighted builders catering to equally short-sighted ‘investors’. While the housing sector seems mired in troubles, the regulatory architecture on the financing side is well developed and kept pace with the world. Hence, policy direction will depend on the desire and ability to use risk weights as a tool.

Indeed, the Reserve Bank of India’s recent move to introduce granularity to the risk weighting of commercial real estate (CRE) by introducing the lower-weighted CRE-RH (residential housing) category comes when US regulators too are revising the risk weights for different categories of residential mortgages from 35–200 per cent. In fact, a quick look at the two regulations reveal the nature of the two markets in terms of product differentiation and the willingness of regulators to create an incentive structure in a granular way.

How effective are risk weights as a measure of micro- and macro-prudential regulation? This has been asked repeatedly in the post-crisis regulatory rethinking as risk weighting itself remains fractured across jurisdictions, depending on the version of Basel and the regulatory stance in each country. Globally, benchmarks such as leverage ratio are becoming a popular means to neutralise the false comfort that can creep in, particularly in the case of banks following advanced Internal Rating-Based approaches.

In India, the Basel I regime has proved useful, and regulators have used risk weights for both macro- and micro-prudential purposes. Most notably, in 2005 and 2006, the RBI increased the risk weights on commercial real-estate lending, which slowed significantly. Interestingly, Australia had raised the risk weights for uninsured residential mortgages in 2004, which changed the nature of bank lending from uninsured to insured. In this context, given the low home-ownership, and the need to increase quality residential real-estate, the current lower risk weights (40–100 per cent) based on loan-to-value and amount of loan is welcome. The impact on re-allocation of resources from CRE to CRE-RH remains to be seen. For regulators in India, giving out a negative signal always works, not only because of the capital impact from increased risk weight but also as a signal of ‘regulatory displeasure’ and a directional indicator of public policy. However, an incentive to marginally save capital should compete with other objectives such as profitability and counterparty risk. After all, the Capital to Risk Assets Ratio (CRAR) is just one ratio!

The author is Executive Director, PwC India

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