A Reserve Bank of India (RBI) committee report recently recommended deepening the secondary market for corporate loans, which, experts believe, will not only help banks improve their profitability, but also revive the lacklustre corporate bond market amidst the ongoing credit squeeze. However, operational concerns need to be addressed as the central bank prepares the regulations.
Some of important recommendations include creating an online marketplace to auction/sell loans; setting up a self-regulatory body of participants, which will finalise detailed modalities and suggest amendments in regulations issued by Sebi, IRDAI and PFRDA to enable participation of non-banking entities such as mutual funds, insurance companies and pension funds.
"The latest set of recommendations offers hope. A fairly large investor base with some restrictions from respective regulators exists even today, but is restricted to shorter tenure loans in the form of corporate bonds. The recommendation to permit more participants and to encourage existing participants through change in regulations is welcome and should encourage liquidity," says Ravikant Bhat, Research Analyst at IndiaNivesh Securities.
How will things change?
1. Better churning of funds
Currently, the secondary loan market in India is largely restricted to sale to asset reconstruction companies and ad hoc sale to other lenders including banks, but there is no formalised mechanism to deepen the market. So, options are limited and demand unknown. "Developing the loan market will benefit banks because selling off existing loans will enable them to mobilise their funds better, thus enhancing the credit flow in the economy," says Krishnan Sitaraman, senior director (financial sector ratings & structured finance ratings), Crisil Ratings.
2. Exposure/ALM management
The move will help banks realign their portfolio and balance asset liability mismatches (ALMs) along with improving profitability. "Banks will be able to offload any excessive exposure to a particular company or a group. If they have long-term loans in the books, they can shorten the maturity by selling these long-term assets to other investors. This could be an alternative source to fund liabilities too. Besides, their return on assets and return on equity metrics will improve as they can improve their bottom-lines without increasing the asset base," added Sitaraman of Crisil.
3. Better price discovery
In case banks fail to judge the credit assessment of a corporate or potential of a project appropriately, and values the loan at lower or higher than the required interest rate, trading it in a secondary market may correct the loan pricing. "Market forces determining the pricing of loans will, of course, be more efficient. If the market deepens, better price discovery happens," says Shishir Mehta, partner at Khaitan & Co.
1. Banks not doing due diligence
There could be a possibility that some of banks do not execute due diligence when originating the loan (being in a hurry to meet targets) knowing that they can sell it off later. "The quality of due diligence by banks could be of different qualities. The way smaller banks show laxity in credit check in consortium-led lending, that may happen in the new set-up also because they know they can offload loans in the secondary market," says Madan Sabnavis, Chief Economist, Care Ratings.
2. Savings of common people could be at risk
Mutual funds, insurance companies and few other investors pool in savings of common people. They need to be careful about which corporate loans they buy in the secondary market as any default or delay in loan repayments may put their funds at risk. "As evidenced by experience, the probability of default cannot be zero. Even the highest credit rating only signifies 'highest safety'. However, some of the more recent default events have triggered a review of the risk management systems including the role played by credit rating agencies. These checks and balances will continue to evolve and fine tune," said Bhat of IndiaNivesh.
Experts also advise caution regarding illiquidity in the market, as not all investors will be willing to buy large bank loans. They advise a secondary market only for mid-sized loans first, while the central bank and other regulators streamline the processes.
The report by a six-member taskforce, headed by Canara Bank Chairman T.N. Manoharan is comprehensive in its suggestions. It is open for public comments until September 30.