Why more of India's shadow banks need to go bust

The government should remove any illusion that they will bail out institutions engaging in risky lending. 

Published: 30th July 2019 02:07 PM  |   Last Updated: 30th July 2019 02:07 PM   |  A+A-


Reserve Bank of India (File Photo | PTI)


The slowdown that began among India’s shadow banks is spreading. Sectors that had come to depend on credit from what in India are called non-banking financial companies (NBFCs) are posting awful numbers. Insurance is slowing and real estate is troubled. The automobile sector - which contributes half of India’s manufacturing output - is shrinking as stressed shadow banks prioritize survival above lending growth.

Naturally, Prime Minister Narendra Modi’s government is worried. But it, and the Reserve Bank of India, should avoid any attempt to succor the shadow-banking sector with liquidity. Giving NBFCs the false appearance of health would only increase, not decrease the chances of a systemic crisis.

Speaking to Bloomberg News recently, RBI Governor Shaktikanta Das warned that the central bank sees “some signs of fragility,” particularly in shadow banks that are exposed to the housing sector. The question is what to do about it.

On the one hand, Das sought to reassure investors that the RBI would prevent another large NBFC from collapsing. (The current crisis was set off when highly connected Infrastructure Leasing & Financial Services Ltd. defaulted last year.) On the other hand, he said, “If NBFCs have undertaken certain governance practice and certain ways of function and they have to a price for it, they will have to pay a price for it.”

If those two statements don’t quite seem to go together, that’s because Indian policymakers and businesses are split over the right course of action. Many executives, and some ruling-party politicians concerned about growth, would like to see the sector bailed out. Anil Ambani, a tycoon with a large stake in financial services, has said that NBFCs are in intensive care and, “in the ICU, if you want to save the patient, what is needed is not Paracetamol but full life support.”

But many regulators correctly doubt that’s the best strategy. Shadow banks have come to occupy a space in the Indian economy for which they weren’t built. Some of them gorged on money raised from the public - from state-owned banks or debt mutual funds - to lend to long-tenure projects, some of them in politically exposed sectors such as real estate or infrastructure.

NBFCs filled this niche by default: The government is short of money, there is no real corporate debt market in India, and the traditional banking system was burdened with bad loans.

Policymakers have responded cautiously thus far. The government has set aside a large amount of money to recapitalize India’s state-run banks, which many hope will mean they start lending again to liquidity-starved NBFCs.

(In some sense, that’s making a virtue out of a necessity: Basel requirements and their own bad-loans crisis meant banks needed the capital anyway). To encourage state-owned banks to help clean up the NBFCs’ balance sheets, the government has also announced that it will partially guarantee their purchase of securitized pools of NBFC assets.

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On the other hand, the restrictions on that guarantee are stringent enough for some analysts to declare it’s too weak. Fitch points out that that struggling shadow banks “may still have to fend for themselves.”

That’s how it should be. Let’s be clear: If the shadow-banking sector is to survive and be useful, more NBFCs will have to die. Indian regulators and politicians are generally terrified of anything shutting down, whether it’s a bank or an airline or a real estate company.

But, in this case, they will have to stand by as it happens - and, in some cases, administer the lethal injection themselves.

What’s important is to ensure those failures don’t bring down the entire financial sector. There’s reason to believe that’s possible. In China, for example, smaller banks and NBFCs fueled growth for years. As in India, the markets generally believed that regulators would never let them collapse.

But the Chinese authorities’ takeover of Baoshang Bank Co. in May this year shows that such systemic inconsistencies have a sell-by date. As Bloomberg News reported last week, that has led to a “wholesale repricing of risk for all but the largest Chinese lenders.”

This new granularity in how lenders are treated is exactly what India needs as well. Indian investors should not be led to believe that the government or the RBI stands as a backstop behind sectors indulging in risky lending; that would mean that finance isn’t doing its job of correctly measuring and pricing risk.

A few quarters of pain in sectors that depend upon shadow financing is a small price to pay to produce a sector that winds up doing its job efficiently and sustainably.

(The views, thoughts and opinions expressed in the article belong solely to the author)

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