Price credit risk properly: RBI

The Reserve Bank of India (RBI) is of the view that banks in India do not price credit risk appropriately and are in danger of adopting a compliant attitude towards risk management and capital adequacy.

"Mispricing of credit risk is an issue, which apart from introducing systemic vulnerability, has welfare implications for small borrowers," said Rakesh Mohan, deputy governor, RBI, at the inaugural programme of the Centre for Advanced Financial Learning in Mumbai.

The pricing of various types of risks reveals whether the banks have risk management at the centre of their business operations or on the sidelines. Currently, interest rates charged by banks on different loans and advances varies within an unusually wide range of 6 to 16 per cent and even higher in some cases.

This wide range could be because banks are substituting high credit price for the cost of credit appraisal, with the cost higher on smaller loans, said Mohan. In the context of Basel II, he said, proper pricing of risks is the key issue, as no amount of capital can make a financial institution absolutely secure.

"If a purely compliant attitude is taken, with respect to risk management and capital adequacy, then there is a danger that it may lead to 'seat belt law' banking. As experience has shown, in many countries that have mandatory use of seat belts, drivers were prepared to take more risks, believing themselves to be safer," said Mohan.

Banks need to manage their risks properly and should integrate risk management with the activity of risk taking while avoiding risks that are not well understood, he said.

Banks are well-equipped to re-orient their rating processes to assess the credit line of the borrower, in addition to the conventional assessment of the borrower. The introduction of credit information bureaus may be expected to make a material difference in credit appraisal practices. Banks also have access to relevant credit information of borrowers and potential borrowers and are well positioned to use this to their advantage while discriminating between various grades of risk, said Mohan.