When in doubt about the economic fundamentals, slow down lending, rather shrink the balance sheet itself. This has been a long standing principle in the lending business. While the effort is understandably to contain credit risk on the balance sheet during the down phase of the economy, such a stance does not easily pass muster with the policy makers. (From the perspective of borrowers too, such a stance on the part of the banker is taken as an example of 'fair weather friend' behaviour!).

For, it is precisely during a phase of deceleration in the economy that government wants counter-cyclical action. Governments do their part through fiscal stimuli and also get Central banks under their charge to do the monetary easing. But it is then up to the commercial banks concerned to transmit the monetary signals through both a higher quantum of lending and lower interest rates.

Globally, one of the prime concerns now is the absolute contraction in bank lending in key markets. Unprecedented though the fiscal and monetary stimuli efforts, it is simply not getting transmitted to the broader economy in the form of lower interest rates and higher lending. To counter this trend, the US and UK are even contemplating setting lending targets for the banks which are getting bailed out by taxpayer money.

Recent bank credit trends

That sounds somewhat familiar to us in India. Indeed, one of the main features of the history of public sector banking in India has been directed and mandated lending. Though a part of their history, it is not clear how much of directed lending accounts for the recent significant increase in the credit portfolios of Indian public sector banks.

Indeed, a notable point about banking sector developments in India in the past year - as the credit crisis has rolled on - has been the sharp divergence between the strong credit expansion of the public sector banks and the anaemic credit flows by private and foreign banks (see Table). Even the above-industry average credit performance of a couple of new private banks has not been able to improve the overall private banks credit performance.

As can be noted, foreign and private banks have attempted to contain the growth of the balance sheet itself. The fact that their deposit growth too has slowed down considerably in the past 12 months clearly points to that. Having not received any bail out funds from the government or other supportive measures from the RBI - unlike their parent companies in the US and UK - foreign banks' branches in India and Indian private sector banks, of course, are under no obligation to increase lending during this phase of economic deceleration.

Are underlying credit fundamentals strong?

But public sector banks are not in that category. The key question then is: how much of the public sector banks' robust credit performance of the past 12 months has been directed/ mandated and not of their own choice? Aside from some macro factors (such as drying up of external sources of funding such as ECBs which has transferred credit demand to the Indian banking system and therefore boosted the credit growth figures) how much of fresh incremental lending has been done by the public sector banks? In other words, how strong are the underlying credit fundamentals so that the public sector banks are able to avoid/ minimise the accumulation of bad loans in this phase?

One cannot make straight inferences about this from the banking data alone. But analysing some developments in the overall financial system suggests that the underlying credit environment may not be that weak.

SKS Microfinance, a leading micro finance institution, has recently securitised Rs.200 crore of receivables. This enables SKS to on-lend the Rs.s200 crore afresh and create fresh loans.

Now, securitisation makes economic sense for the lender (SKS in this case) only if it can generate a continuous pool of loans/ assets which can be securitised. Otherwise, the lender can just generate loans and carry them till maturity and earn the spread. The fact that SKS is securitising shows it is confident of continuously generating 'quality' loan assets. That, in turn, gives some pointers to the quality of the underlying credit environment.