Shadow banking crisis to continue to haunt India’s financial system

Dubai: The euphoria on Indian stock markets following the land slide election win of the National Democratic Alliance (NDA) could be short lived if the government and the Reserve Bank of India (RBI) do not urgently address crisis brewing in the non-banking financial services sector (NBFCs), according to analysts.

NBFCs are plagued by a credit squeeze, over-leveraging, excessive concentration, and massive mismatch between assets and liabilities. A crisis-like situation began to emerge in second half of 2018 when the Mumbai-based Infrastructure Leasing & Financial Services (IL&FS) ran out of money. The government had to step in and supersede the board to avert a total collapse. At the time, it appeared that near-term risk from shadow banks were contained as some funding sources remained available and policy support was put in place.

However, the funding trends in the industry shows, despite the government intervention in IL&FS, the sector continues to face a crisis of confidence and liquidity crunch. Analysts say, if left unchecked, the crisis could lead to massive credit defaults with wide ranging ramifications for the financial service sector and the economy.

Shadow banks are under pressure to deleverage and are scaling back lending significantly. We think tightening financial conditions will weigh on growth this year.

- Sergi Lanan, Deputy Chief Economist of Institute of International Finance

“The funding situation remains relatively stable, with comfortable bond rollover rates and ample support from commercial banks. However, shadow banks are under pressure to deleverage and are scaling back lending significantly. We think tightening financial conditions will weigh on growth this year,” said Sergi Lanan, Deputy Chief Economist of Institute of International Finance (IIF).

Shadow banking assets as a percentage of total financial assets within the country were at 14.3 per cent, in line with the global percentage of 13.7 per cent, according to recent report by credit rating agency Fitch.

The figures assume significance as Indian shadow banking’s rapid growth and reliance on short-term funding sources bubbled over in 2018. “Despite these modest indicators, the Indian shadow banking system has grown rapidly over the last decade, with a particular spike in 2017 driven by finance companies providing asset finance and home loans and funds investing in infrastructure loans,” Fitch said in a recent report.

“Non-bank growth has been fuelled by accommodative funding markets following demonetisation, which saw liquidity flow to money market funds and banks, while many Indian public-sector banks were capital-constrained due to their own asset quality issues,” it added.

Flawed funding

At the core of NBFC crisis in India is the funding model these institutions follow. Their mains source of funding is commercial papers (CPs), with which they borrow short term funds and lend long term on mortgages, vehicle finance and infrastructure projects, creating a structural mismatch in assets and liabilities on their balance sheets.

To keep the funding cycle going, these companies are forced keep on issuing and rolling over CPs. With the signs of economy slowing and visible deterioration in the asset qualities of NBFCs, the funding sources of these institutions are drying up and many are forced to retrench or deleverage.

Analysts say the credit crunch in the industry has been accentuated by the IL&FS crisis followed by a number of credit rating downgrades on leading NBFCs.

According to industry estimates, Indian NBFCs have more than $15 billion (Dh55 billion) commercial papers (CPs) coming up for redemption in next three months. If commercial banks, private investors and mutual funds are not willing to buy the CPs issued by NBFC’s these institutions could head into a liquidity crisis leading to defaults of their obligations, rise in non-performing loans of banks and investment losses to those with exposures to these instruments.