September 15 marked the tenth anniversary of the collapse of Lehman Brothers, a century- old gold standard Wall Street investment bank. Its bankruptcy had a domino effect, playing a key role in causing the financial crisis in the US and Europe. It is now popularly referred to as the Global Financial Crisis, although strictly speaking it was the North Atlantic Financial Crisis. The economy took a heavy hit, as GDP growth became negative, unemployment rose to more than 11 per cent in the US, and even higher in Europe and bank lending froze. The economies of India and other Asian countries were not immune. In October and November of 2008, as liquidity conditions tightened in India, mutual funds faced huge redemption pressure. Investors wanted to encash their units (also called net asset value, NAV) as the stocks nosedived. For investor cash payouts, the mutual funds had to liquidate their own stock holdings, causing a further fall in stock and bond markets. This downward spiral can be virtually bottomless.
In a very unusual and unorthodox approach, the RBI, which is not the regulator for the mutual fund industry, stepped in to offer emergency liquidity. Investments in mutual funds are never “assured” in the same sense as a fixed deposit in a bank—the funds can face a liquidity crisis in case of large redemptions. Thus, support from the RBI was crucial and timely. Thanks to this, the actual redemption pressure was reduced, and even the NAVs stabilised. Subsequently, the stock market recovered. Unlike the US crisis, Indian banks did not have a mortgage loans problem. But the contagion effect could not be avoided. Financial markets are notoriously prone to herd behaviour and irrational panic, which can precipitate a crisis even in reasonably sound economies.
On the occasion of the Lehman anniversary, India is once again facing a mini-crisis of its own, caused by a non-banking financial company Infrastructure Financing and Leasing Services Ltd (IL&FS). The current situation, too, will call for unorthodox measures, and calming nervous investors. But first, let’s rewind a bit, and recall the problem of bad loans i.e. non-performing assets (NPA) of banks. The NPAs have risen three-fold in the past five years, from around `4 trillion to `12 trillion. The government is focused on solving this NPA problem; three fourths of banking anyway is under public-sector ownership. The steep rise in NPAs is mostly due to a belated recognition of older, serious problems. The RBI is enforcing recognition norms more strictly now. Indulgent forbearance is gone, and that’s a good thing.
Eleven banks are under “Prompt Corrective Action” of the RBI, which effectively means a freeze on fresh lending, unless prior bad loans are tackled. One side-effect of this has been that bank credit to industry has virtually stagnated. Since January 2015, the cumulative growth to industry has risen barely 1 or 2 per cent. In the current year, between April and August, the credit off-take by industry declined by 1.4 per cent. This was across micro, small and large industries. Of course, loan growth to other sectors like retail (personal) loans is relatively healthy.
But with the stagnation in bank credit to industry there has been a resurgence of NBFCs. There are thousands of NBFCs, of which a dozen or so have grown handsomely. Unlike banks, NBFCs do not accept public deposits and depend on continuous borrowing from banks or capital markets for funding. They are nimble. They provide loans to small and large industries, to housing and real estate and to infrastructure companies. And they also face less stringent regulation. They need to continuously borrow short term, to fund long-term assets. This is called maturity transformation between their liability side (funding) and their asset side (loans). As long as the assets that they are building are financially healthy, and repayments are steady, the NBFCs are able to attract fresh investors and funding, and can keep expanding their balance sheet. But the maturity mismatch (short-term borrowing funding long-term assets) normally doesn’t create a problem as the investors trust the health of the underlying business and the competence and integrity of the management.
India’s mini-crisis is unfolding in this scenario. A hitherto gold standard, IL&FS is facing a funds crunch and has defaulted on payments. IL&FS is a three-decade-old, AAA-rated lender that has financed projects worth more than 1 trillion rupees. It is the parent of a web of 169 companies, some of which are listed. Over one-third of IL&FS is foreign-owned and one-fourth by LIC. Many of the projects under the IL&FS umbrella have secure, ringfenced cash flows from government entities or through tolls. Yet one default has the potential to create a domino effect, and suddenly all the borrowers and investors are nervous. One prominent mutual fund sold an IL&FS bond at a discount, as if signalling it wanted to make a distress sale to get rid of that bond.
IL&FS entities have approached the National Company Law Tribunal to get protection from lenders. The RBI says that IL&FS balance sheet showed negative net-owned funds from at least two years ago. The rating agencies have downgraded the rating to junk within 45 days. In such a fast-paced scenario, panic can be self-fulfilling and can precipitate a full-blown crisis.
Since financial markets are interlinked, the stock market too is affected. In September, the mid-cap and small-cap indices fell sharply, reflecting bearishness. We need a calming assurance from the very top—from policy makers and the regulator—to ensure that the resolution of the IL&FS problem will be orderly. Just as in 2008, we should be prepared to use unorthodox means of liquidity and funding support to prevent a small problem from becoming a crisis. Otherwise in finance, panic feeds on itself. Emotion trumps economics. Sound companies can be demolished by irrational stampedes.
(Through The Billion Press)
Ajit Ranade
The writer is an economist and Senior Fellow, Takshashila Institution
Email: editor@thebillionpress.org