Credit Risks during Inflationary Times
The Reserve Bank of India (RBI) raised the repo rate to 4.90% this week, amidst fears of rising inflation that went beyond its expectation. Banks took little time to pass on this rise to their borrowers. The implications have to be seen from the point of view of credit risk, particularly at a time when, due to the enhanced growth expectations post-pandemic in India, banks' risk appetite increased in certain sectors of the economy. The chief economist of State Bank of India (SBI) expects the repo rate to peak at 5.5 to 5.75% within the next two months—by August 2022.
The good news is that loans to the micro, small and medium enterprises (MSMEs) during May 2022 have increased manifold—and more specifically to the micro and medium-sized enterprises in the manufacturing sector—could see dampening trends are long because interest rate risk for the enterprises is going to hit badly. 
Supply-chain disruptions started surfacing with cost of raw materials, both from the domestic and external markets at one end and high interest rates penetrating the pricing risk in competitive markets. 
Except a few states like Telangana and Tamil Nadu, energy shortages are dampening the production in manufacturing of key sectors. Imports of coal that started would add up to the costs of production in coal-based industries like rubber, iron and steel and thermal energy.
Credit Risk
Credit risk or default risk involves the inability or unwillingness of a customer or counterparty to meet commitments to lending, trading, hedging, settlement and other financial transaction risk or default risk and portfolio risk. The portfolio risk, in turn, comprises intrinsic and concentration risk.
The credit risk of a bank's portfolio depends on both external and internal factors. The external factors are the state of the economy-wide swings in commodity and equity prices, foreign exchange and interest rates, trade restrictions, economic sanctions, and government policies. 
The internal factors are deficiencies in loan policies and administration, absence of prudential credit concentration limits, inadequately defined lending limits for loan officers and credit committees, deficiencies in the appraisal of borrowers' financial position, excessive dependence on collaterals and inadequate risk pricing, absence of loan review mechanism and post-sanction surveillance.
Another variant of credit risk is counterparty risk. Counterparty risk arises from the non-performance of the trading partners. The non-performance may arise from the counterparty's refusal or inability to perform due to adverse price movements or from external constraints that the principal did not anticipate. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than a standard credit risk.
Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting, borrowers with a weak financial position—and, hence, placed in the high credit risk category—should be priced high. Thus, banks should evolve scientific systems to price the credit risk, which should have a bearing on the expected probability of default.  
The pricing of loans normally should be linked to risk rating or credit quality. The probability of default could be derived from the past behaviour of the loan portfolio quality and provisioning or change off to equip themselves to price the risk. But the value of collateral, market forces, the perceived value of accounts, future business potential, portfolio or industry exposure and strategic reasons may also play an important role in pricing. Flexibility should also be made for revising the price (risk premia) due to changes in rating and value of collaterals over time. 
Large-sized banks across the world have already put in place a risk-adjusted return on capital (RAROC) framework for the pricing of loans, which calls for data on portfolio behaviour and allocation of capital commensurate with credit risk inherent in loan proposals. 
Despite banks having a mine of data on the entrepreneurs and capabilities to use artificial intelligence (AI) for tracking the behaviour of entrepreneurs, there is no evidence of using this instrument while pricing the credit risk when viewed from the client's perspective. 
For example, proprietorships and partnership concerns (most of them are family concerns) do not distinguish between the expenditure incurred for the family as different from the firm. They also tend to spend money for social purposes, higher education for their children, and marriages from the firm's cash flows. This causes disharmony in cash-flows of the firm. Banks did not yet start financing the MSMEs based on cash flows. Hence, the best firms are likely to default in times of inflation and supply-chain disruptions.
Under RAROC framework, the lender begins by charging an interest mark-up to cover the probability of default rate and expected loss of the rating category of the borrower. The lender then allocates enough capital to the prospective loan to cover some amount of unexpected loss- variability of default rates. Generally, international banks allocate enough capital so that the expected loan loss reserve or provision plus allocated capital cover 99% of the loan loss outcomes. Had this happened, banks would not have landed up in huge non-performing loans across the sectors.
Sectoral risks and sovereign risks also increase when the budgetary expenditures deviate from the announced budgets to cater to the needs of the voters indiscriminately or under competitive populism among the states.
Interest Rate Impact
The outlook for interest rates has important implications for bank's profits because the bulk of bank profits are derived from net interest income (NII). In the broadest sense, banks are inherently asset sensitive because they derive a significant portion of their funding from essentially free resources such as equity issues or demand deposits.
Thus, banks with a large retail base and not using large chunks of purchased money from markets (or unable to source cheap wholesale funds) tend to do well in periods of high interest rates.
However, fluctuations in interest rates do not have an absolute influence over NII because banks usually tamper with deposit rates both through duration and amount. We have already witnessed that banks did not pass on the benefit of the repo rate increase to the depositors. Second, even when they decide to pass on, they do it in fractions of what they do to lending rates. 
However, enterprise-wide risks would enhance significantly as they tend to pass on such risks to the customers unless they see disappointing markets. Consumer sentiment started moving adversely and this would see the firms putting two steps backwards with one step forward in pricing their products. 
Further, if the regulator starts pressing for climate risks to be declared in the credit risk mapping, the firms will have no option to enhance the prices and calibrate their production streams in tune with the market expectations. 
For the present, since there is no fear of global competition with several nations worst-hit by inflation and the surge in oil prices compounded by the unforeseen risks of the Ukraine-Russia war, adverse trends in domestic markets may not surface for at least another six months.
The economy is passing through risky times now more than ever. The capabilities and capacities of banks would be tested in such times. Much of the touted financial stability may whittle down gradually if banks and non-banking financial companies (NBFCs) are not seriously planning to counter the credit risk eventualities mentioned above. The winners would see the other side of the risk coin, namely, reward. 
(The author is an economist and risk management specialist. The views are personal.)
Kamal Garg
2 weeks ago
Nice and detailed analysis of credit risk and risk management practices in banks. However, traditionally, banks in India have been funding/financing a business enterprises based upon its 'assets/collateral' ; whereas now a greater emphasis is being placed on the 'business cash-flow, returns from the asset and strategic expansion versus uncalled-for expansion in assets/capacities, etc.'
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