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The Impossible Trinity Of Lending

Rapid growth in credit while maintaining margins is seductive. But be mindful of what happens when credit growth comes down.

The Pyramid at the Louvre Museum, in Paris. (Photographer: Alastair Miller/Bloomberg News)
The Pyramid at the Louvre Museum, in Paris. (Photographer: Alastair Miller/Bloomberg News)

The low credit growth in the banking system for the past year has been a source of concern. Demand for credit is a derived demand – it arises from activity in the real economy. Hence, the demand for credit always has a strong correlation with the growth of the real economy.

Data for roughly the past 60 years (from 1962 to 2019) shows that the ratio of banking credit growth to nominal GDP growth has ranged between 1 and 2, averaging at about 1.42. This means that if the nominal GDP grows at 10 percent then the banking credit growth to be expected will be around 14.2 percent.

This average ratio would imply that the current banking credit growth is around 9 percent would be supported by nominal GDP growth of around 6.3 percent. The causality between the two probably goes both ways – lower GDP growth results in lower banking growth and vice versa. Hence, the current low credit growth is partly the cause and partly the effect of low GDP growth.

The Impossible Trinity Of Lending

While studying the credit growth by an individual lender or the whole system two other parameters have to be carefully watched in addition to growth – margins (or spreads) and risk.

These three parameters, growth, margins, and risk also present an impossible trinity – a lender cannot optimise all three at the same time.

At best, a lender can hope to optimise two out of these three – if it seeks to maximise growth while keeping its margins then it inevitably will be taking on a higher risk that will eventually result in a rise in non-performing assets in the future. On the other hand, if a lender seeks to maximise growth and not increase risk in its lending book, then it must sacrifice margins.

This impossible trinity is just an extension of the basic principle of finance – the tradeoff between risk and reward. Higher the risk in any credit higher would be probably the reward but so also would be the cost if things went wrong. Yet, it is remarkable how frequently the logic of this trinity is forgotten and growth in credit is celebrated.

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Peaks And Troughs, Exuberance And Grief

I looked at these three variables for the Indian banking system for the last 20 years from 1998 to 2018. The reason for using only twenty years is that before 1998, the norms on NPA recognition were not very well defined and hence we don’t have reliable data. I looked at the nominal credit growth, margins measured as the spread between the average cost of deposits and yield on loans (rather than the net interest margin to take away the complications created by the structure of the balance sheet) and risk measured by the level of gross non-performing assets at the end of the financial year.

The chart below shows these three variables over the twenty-year period.

The Impossible Trinity Of Lending

This chart shows interesting trends. Lending growth between 2003 and 2008 was way higher than what the underlying nominal GDP growth of around 13-15 percent would suggest, if we apply the average multiple of 1.4. What is also remarkable is that the spread remained essentially flat right through this period at around 3.7-3.9 percent.

So, the banking sector was growing credit at an extraordinarily rapid pace at flat margins.

The impossible trinity would suggest that this would happen only if the risk in the lending group was building rapidly. This risk subsequently showed up in the rapid buildup of NPAs 2011 onwards. There were two reasons for the lag.

  • First, Indian bank loans are dominated by long-term loans. Long-term loans accounted for between 55 percent and 60 percent of all loans during this period. By their very nature, risk in these loans takes time to manifest itself.
  • Second, after the 2008 global financial crisis, the regulator offered several ‘restructuring’ schemes to banks that essentially allowed them deferment of recognising the NPAs.

Generally, there would always be a lag between periods of rapid credit growth and the time when the risk begins to manifest. This lag can lull managements, boards, and even regulators into complacency. Hence, the ‘go-go’ years of unbridled credit growth led to years of ‘grief’ - low growth and high levels of NPAs between 2011 and 2018.

Rapid growth in credit while maintaining margins is seductive for any lender. In the short run, rapid growth of loan books lowers the NPA levels – which is a ratio of bad loans to total loans and goes down as the total loans outstanding grows. A larger loan book with steady margins also gives a boost to accounting profits. This is the reason for the levels of NPAs that had risen during the previous credit boom of 1999 to 2003, to come down sharply during the rapid loan growth of 2003 to 2008. Exactly the opposite happens when the growth rate of credit comes down – NPA levels do not go down as quickly and the growth in accounting profits slows down.

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Vigilant Supervision

The logic of this impossible trinity holds important lessons for stakeholders in the credit system.

At the level of an individual lender, be that a bank or an NBFC, the oversight on credit decisions need to be sharper as the lender starts growing rapidly. The chief risk officer, the risk management committee of the board, its credit committee, etc. play a key role in providing oversight and governance over credit decisions. All these units must be extra vigilant when the lender starts growing the credit book rapidly and out of sync with the underlying economic growth.

The logic of the impossible trinity should also inform regulators. What applies to individual lenders also applies to the entire credit system.

Effective macro-prudential regulation would require the regulators to be extra-watchful when the system credit starts expanding out of sync with the underlying economic growth.

This applies not only to the overall credit but also to the segments of credit – commercial and consumer, secured and unsecured, etc. Any segment showing disproportionate credit growth should raise risk concerns and a regulatory response to contain system-wide risk buildup. The regulator must use all the instruments at its disposal – regulatory capital and risk weights, sectoral caps, supervision, etc to ensure that pursuit of growth is not building risk in the system.

The current low growth in overall credit would suggest that there should be no concern.

However, if we disaggregate the growth, it shows that the strongest growth (over 25 percent) is in unsecured consumer lending (through credit cards, personal loans) while secured consumer lending (such as home loans) is growing modestly and commercial lending is not growing at all for the system. Unsecured lending is the riskiest form of lending. The logic of the impossible trinity would suggest that the regulators might have to look very closely at the growth in this kind of lending and take actions proactively to avoid a bust in the future.

Harsh Vardhan is Executive-in-Residence at the Center for Financial Studies of the SP Jain Institute of Management Research.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.