What Explains India's Shadow Banking Crisis, and What Can Be Done Now?

Instead of encouraging public sector banks to increase lending to shadow banks, the strategy should be to ring-fence the current liquidity crisis in the shadow banking sector.

The ongoing liquidity crisis in India’s shadow banking sector is intensifying. The troubles that started with defaults by Infrastructure Leasing & Financial Services Limited (IL&FS) last year are far from over, as the sector continues to face a severe liquidity crisis. If tight liquidity conditions persist in the next financial year, it may turn into a solvency issue for several shadow banks.

After the IL&FS collapse, the entire sector is facing a crisis of confidence. Investors are shying away from investing in securities issued by shadow banks. Several shadow banks are finding it difficult to raise money from banks, mutual funds and the rest of the financial system for either funding their growth or rollover of existing short-term debt. Some are resorting to asset monetisation to meet their immediate repayment obligations.

Leave aside those shadow banks that have weak financial profiles; even financially sound and better-governed entities are facing a liquidity squeeze. Most shadow banks have reduced disbursement of loans to preserve liquidity.

After growing aggressively in the last three years, the credit disbursals by shadow banks have fallen by almost a third this year. Consequently, lending to housing, automobile, consumer durables and small businesses has substantially reduced. In sectors such as housing and automobile, shadow banks play a vital role in loan financing. The reduced availability of funding has contributed to the slowdown in these sectors.

Also read: How a Shadow Banking Crisis Sent India’s Autos Sector Into a Tailspin

In particular, the automobile sector has been badly hit by the ongoing liquidity crisis as shadow banks were the leading financiers of commercial vehicles, passenger cars and two-wheelers in India. Before the onset of the liquidity crisis, close to 40% of new auto loans were issued by shadow banks. According to the Society of Indian Automobile Manufacturers, passenger car sales declined by 26% in April-July 2019 over the same period last year. Close to 300 dealer showrooms of passenger vehicles have shut down across India in the last one year as shadow banks have stopped financing vehicle purchase, while automakers have either cut production or shut production plants temporarily to keep inventory in check. Analysts estimate that tens of thousands of jobs in India’s auto sector are at risk if the slump in the automobile sector continues.

Since commercial banks are still struggling with high levels of non-performing assets, they are not rushing in to fill the void left by the shadow banks. Rather, commercial banks may also like to reduce their exposure to stressed sectors such as automobile and housing to improve their balance sheets. All these developments in the financial sector will have serious ramifications on the overall economy as the bulk of India’s economic growth is driven by domestic demand.

DHFL: The new poster boy of the liquidity crisis

Since September 2018, hardly a week passes without more bad news about the cash-strapped Dewan Housing Finance Corporation Ltd (DHFL). On August 16, DHFL again defaulted on its repayment obligations worth Rs 15.7 billion on non-convertible debentures and commercial papers. Nothing new as the company has not been able to meet most of its debt repayment obligations since June 2019, but this was the largest default by the DHFL till date.

DHFL has a total debt liability of Rs 850 billion as of June 2019, out of which secured loans stood at Rs 749 billion while the rest is unsecured. The company posted a net loss of Rs 22 billion in the fourth quarter of 2018-2019.

The company’s lending business has virtually come to a standstill, with no fresh disbursements of loans in the last six months. The series of defaults have made it almost impossible for the company to raise new money from the financial markets.

In July, while announcing the fourth-quarter financial results, the company admitted that it is “undergoing substantial financial stress” and its ability to raise funds was “substantially impaired and the business has been brought to a standstill with there being minimal/virtually no disbursements… These developments may raise a significant doubt on the ability of the company to continue as a going concern.”

Also read: How Should India Resolve the Fault Lines in its Shadow Banking System?

Of late, DHFL sold its stake in non-core businesses to meet some of its repayment obligations, but it has not been able to find suitable buyers for a majority equity stake in the company. So far, investors have only shown interest in buying portions of its asset portfolio.

Earlier this month, the company approached the consortium of lenders with a resolution plan that includes conversion of debt to equity, a moratorium on repayments, and new credit lines to start fresh lending. The bankers are now discussing the resolution plan. Currently, the Wadhawan family controls DHFL, with a 39.21% stake in the company. If the lenders accept the resolution plan, they may also demand to replace the company’s management because in January, online news portal CobraPost raised allegations that DHFL created shell companies to divert funds worth Rs 31 billion.

After the IL&FS collapse, DHFL is the second large-sized shadow bank on the verge of bankruptcy. With so much public money at stake, banks, mutual funds, pension funds and insurance companies are all keen to avoid bankruptcy at DHFL.

A belated regulatory response

In the past two months, several regulatory measures have been announced by the Ministry of Finance and the Reserve Bank of India. Some of the regulatory measures were long overdue. For instance, returning the regulatory authority over the housing finance sector from National Housing Bank to the RBI is a welcome move, provided the staff strength of RBI is suitably increased to undertake both onsite inspections and off-site surveillance of housing finance companies that constitute a major segment of India’s shadow banking sector.

Another notable development is that the RBI is now empowered to remove any director and supersede the board of directors of shadow banks “in the public interest or to prevent the affairs of a nonbanking financial company being conducted in a manner detrimental to the interest of the depositors or creditors, or financial stability or for securing the proper management of such company.”

Besides, the RBI has been given powers to remove or debar auditors if they fail to conduct their role correctly. The financial penalties are also enhanced if the shadow banks don’t implement the regulatory measures.

The RBI has recently cancelled registrations of 1,851 shadow banks that could not raise even Rs 20 million to meet the minimum regulatory requirements. One wonders why such entities were permitted to run a shadow bank in the first place?

What about carrots?

Both the finance ministry and the RBI have announced several policy measures to ease liquidity pressure in the shadow banking sector. However, the effectiveness of these measures remains to be seen. These include an increase in any bank’s single-exposure limit to a single shadow bank from the existing 15% to 20% of tier-1 capital; priority sector lending status for credit to shadow banks for on-lending to agriculture, SMEs and housing; and reduced risk-weights for consumer loans.

In her Union Budget speech on July 5, the finance minister provided a one-time six months’ partial credit guarantee to public sector banks for the first loss of up to 10% to purchase high-rated pooled assets from financially sound shadow banks amounting to Rs 1 trillion. It is too early to assess the impact of this measure as its operational guidelines have been issued on August 13, but the fact remains that this one-time facility is only meant for “financially sound” shadow banks. In other words, the least risky shadow banks (such as HDFC and LIC Housing Finance) will benefit from this facility, not the cash-starved weaker entities such as DHFL and Reliance Capital.

On August 23, Nirmala Sitharaman announced additional liquidity support of Rs 200 billion to housing finance companies to be provided by the National Housing Bank, as part of a stimulus package. The minister also announced that public sector banks (PSBs) would fast track collaborations with shadow banks for loans to SMEs, small traders and microfinance institutions under the co-origination scheme introduced in last August by the RBI. Under this scheme, shadow banks will take a minimum of 20% of the credit risk by way of direct exposure while the co-originating PSB will take the rest of the credit risk.

Finance minister Nirmala Sitharaman arrives at parliament to present the Union Budget 2019-20 in New Delhi, July 05, 2019. Photo: PTI

This scheme allows shadow banks to expand their business and thereby book profits with little investments while the PSBs can meet their priority sector targets of lending to such sectors, albeit with higher credit risks. At the time of writing, there is no information available about the volume of loans disbursed under the co-origination scheme. As there are better and safer options available to the PSBs to achieve priority sector lending targets, they may not be willing to collaborate with ailing shadow banks unless they are forced to do so by New Delhi.

More importantly, it raises a pertinent question: why encourage public sector banks to increase lending to shadow banks? And particularly at a time when the capital-constrained PSBs already have considerable exposure to troubled shadow banks (such as DHFL and Reliance Capital) and are currently struggling to repair their balance sheets from the NPA crisis? Such policy moves would make public sector banks more vulnerable as the potential risks in the shadow banks will spillover to banks. PSBs account for nearly 70% of India’s banking sector and therefore raise potential financial stability concerns.

Rather, the strategy should be to ring-fence the current liquidity crisis in the shadow banking sector and thereby prevent the problems spilling over into the Indian banking sector.

In China and elsewhere, the authorities are trying to break the interlinkages between the shadow banks and banks to ensure the contagion risks arising out of a failure of large shadow banks in the banking sector are contained, and overall financial stability is preserved.

To restore the investors’ confidence, the RBI should undertake the asset quality review of India’s shadow banks to bring all problems to the fore, similar to what the RBI conducted for commercial banks in 2015.

An inherent problem with the business model of shadow banks is their over-reliance on short-term funding to fund longer-term assets. To finance infrastructure and long-term industrial projects, New Delhi should set up specialised development finance institutions with explicit public policy mandates and higher standards of transparency and accountability.

Kavaljit Singh works with Madhyam, New Delhi.