The government in India has pumped USD 37 billion into ailing banks in the past three years. Lenders have been forced into mergers, and the central bank has wrested more than a dozen companies from the control of tycoons who defaulted on their debt.
But cleaning up the financial system has been like playing whack-a-mole. India’s banks still sit on the biggest pile of bad loans, relative to total loans, among the major economies. They’re about 9 per cent of debts.
And now S&P Global Ratings is warning that the country’s banks risk getting swept up in a crisis in a less-regulated pocket of the financial system known as shadow banking. Shadow banks are companies that lend money but typically don’t take deposits from savers—they’re funded by mutual funds and regular banks. After one major shadow lender, Infrastructure Leasing & Financial Services Ltd, neared collapse in late 2018, others began to have a harder time getting funding, and they’ve had to rein in their own lending.
Shadow banks make loans to everyone from consumers to real estate developers to manufacturers, so the pullback is being felt throughout the economy. There’s been a record slump in car sales, and residential building projects have stalled. A collapse in consumption has dragged the country’s gross domestic product growth down to 5 per cent, from a world-beating 8.1 per cent at the start of 2018. The Reserve Bank of India, the central bank, has tried to stimulate lending by slashing interest rates.
But low rates may not be enough. "This is the classic crisis of confidence. We are reaching a point wherein the RBI needs to move decisively to try and restore faith as a lender of last resort," Nilanjan Karfa and Harshit Toshniwal, analysts for Jefferies India Pvt. in Mumbai, wrote recently. In other words, Indian lenders and borrowers need reassurance that money won’t dry up.
The origins of this bad-debt mess go back to efforts to clean up an earlier one. In the wake of the global financial crisis, companies in steel, power, textiles, and construction started defaulting on bank loans. Commercial banks retreated to mend their balance sheets, opening up room for the shadow banks. But risky loans still found their way onto some banks’ books, albeit indirectly.
Institutions that might have been shy of extending credit to real estate developers, for example, could lend to a shadow bank targeting the very same borrowers. "The credit profile of a bank could deteriorate sharply due to outsized exposure to weak entities," an S&P team led by Geeta Chugh wrote on Oct. 22.
There are problems lurking in parts of India’s financial system beyond shadow banks. The Punjab & Maharashtra Co-operative Bank Ltd., an institution that accounts for a small fraction of loans in the banking system, sent a shudder through markets in September after it revealed it had lent money to a troubled developer. The bank used “dummy accounts” and other methods to hide its loans from regulators, according to a letter to the RBI from the lender’s managing director, who’s since been removed.
To stave off more defaults among shadow banks, the RBI has allowed banks to lend more to the companies, providing partial credit guarantees and easing mandatory liquidity ratios. Vishal Kapoor, chief executive officer at IDFC Asset Management, says he’d like to see more government support, which would likely come through shoring up state-run banks with more capital injections. Getting state-run banks “better capitalized and stepping up on lending will help improve the sentiment and reduce funding cost,” he says.
Ananth Narayan, a finance professor at SP Jain Institute of Management & Research, has called in a column for India’s CNBCTV18.com for a way to quarantine stressed assets into a separate company. This so-called bad bank would allow lenders to cut their losses and move forward. Bloomberg Opinion writer Andy Mukherjee has proposed a land bank to buy property projects from struggling developers, who could then repay their loans.
Whatever the solution, the RBI also has to be careful not to encourage companies and banks to keep making bad loans. Although it’s maintained that it won’t allow another systemically important lender to fail, the central bank has also said it prefers market-led solutions rather than being shadow banks’ lender of last resort.
"The government and regulators have made it clear that they are unwilling to build moral hazard within the system," says Kristy Fong, a director for Asian equities investment at Aberdeen Standard Investments. But in a nation facing a slowdown and hungry for jobs—1 million people join the workforce every month—it may be difficult to find the right balance.