Home Business Build-up of excessive leverage consequence of excessive expansion of credit: RBI Deputy Governor

Build-up of excessive leverage consequence of excessive expansion of credit: RBI Deputy Governor

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Build-up of excessive leverage consequence of excessive expansion of credit: RBI Deputy Governor

Build-up of an excessive leverage in the real sector and dilution in underwriting standards could be the two major consequences of an excessive expansion of credit in an uncontrolled and unregulated manner, cautioned M Rajeshwar Rao, Deputy Governor, RBI.

This observation is significant as bank credit has shown a robust growth of 19.39 per cent year-on-year as on August 25, 2023, per RBI data.

“It is observed that the growth of GDP in India and credit flow to commercial sector by banks are positively correlated with each other.  

“Over time, the growth in credit flow has also outpaced the growth of the economy, contributing increasingly to facilitate availability of capital to the productive sector of the economy,” said Rao in his recent address at at IIM Kozhikode.

Credit-to-GDP ratio, which was ranging around seven-eight per cent in 1960s, has increased significantly to around 55 per cent by the beginning of this decade.

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“There could be two major consequences of an excessive expansion of credit in an uncontrolled and unregulated manner – first, it may lead to build up of an excessive leverage in the real sector, and second, as often experienced, episodes of excessive credit growth may lead to dilution in underwriting standards by the lending institutions,” said the Deputy Governor.

A combination of these two factors may lead to systemic crisis and endanger financial and systemic stability, he added.

In addition, this also has a significant influence on the broader aspect of ‘trust’ in the financial system.

“We have learnt this the hard way during the global financial crisis of 2008 when unbridled credit expansion led to a banking sector crisis and later manifested into a systemic crisis,” said Rao.

Besides, if the process of unchecked credit growth leads to growth of money above the level of comfort of the Monetary Authorities, there would be concerns around controlling money supply and transmission of monetary policy impulses and may hinder achieving the broader objectives of price stability.

“Therefore, it’s not just unqualified, unconditional ‘credit growth’ which is crucial for economic development, but ‘orderly credit growth’ which maintains and anchors financial stability in system and that in turn ensures sustainable growth over the long term,” the Deputy Governor said.

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CDS norms

Rao emphasised that while RBI’s guidelines on transfer of loan and securitisation cover loans in general, CDS (credit default swap) guidelines cover money market instruments and certain corporate bonds. This makes it a complementary tool of risk management for two different and important credit instruments — loans and corporate bonds.

“The credit market of the future is likely be nimbler than what it is at this point in time. We would also need to have a dynamic secondary market for loan instruments, a wider base of participants and asset classes in the market, and a robust framework for risk assessment.

“Based on these enablers, it may be possible to ensure smooth interaction between the different players and provide financial entities avenues to de-risk their balance sheets,” Rao said.