The biggest challenge before the new govt

More than liquidity crisis, banks' risk aversion is at the root of the current problem. Despite two policy rate cuts, most banks have raised lending rates

A senior banker has recently said that traditionally the real sector affects the health of the financial sector but now, in the world’s fastest growing major economy, the financial sector woes are set to spill over to the real sector. My aunt agrees with the banker. Running the risk of being dubbed a Cassandra, she says it will be a big mess unless the new government and the Reserve Bank of India (RBI) act on this on a war footing.

Have the government and the banking regulator been in a denial mode? Not exactly. But, they need to act fast. Why? Let’s take a quick look at what’s happening in the Indian financial sector.

• The industry of non-banking finance companies (NBFCs), which have been growing at a much faster rate than the banks, is in a mess because of asset-liability mismatches. (For many, even the quality of assets is an issue.) The compounded annual growth rate of NBFCs in the past five years has been 17 per cent versus 9.4 per cent growth of the banking system; the housing finance companies have been growing at 20 per cent. The total credit market of the NBFCs till mid-last year was close to Rs 28.5 trillion, almost a third of the banking assets. It has started shrinking.

• Bank credit has been growing at around 12.3 per cent, much higher than around 8.4 per cent in the past two years but this does not reflect the true picture. In the past few years, there were credit substitutes, including loans given by the NBFCs. The relatively higher bank credit growth has not been able to cover that up. A closer look at the components of the bank credit bares all. Credit to large industry is growing at less than 8.2 per cent; micro and small industries 0.7 per cent; and medium industries 2.6 per cent. Where is the money going? The banking sector’s personal loan portfolio has been growing at around 18 per cent and housing loan at 19 per cent.

Illustration by Binay Sinha

• The Rs 23-trillion mutual fund industry is feeling the tremor of debt mutual funds’ exposure to various promoters of Indian corporations who have pledged their shares. The value of such shares has gone down, forcing the fund houses and the promoters themselves to sell shares in the market. Many NBFCs too have such an exposure.

• BSE data says the value of shares pledged by the promoters was Rs 2.25 trillion in the last week of April. More than 50 per cent of the promoters — 2,932 out of 5,126 BSE-listed companies — have raised money through this route. With many promoters rushing to pare their ownership, capitalism is being redefined in Asia’s third largest economy. 

• After the Infrastructure Leasing & Financial Services (IL&FS) fiasco, most raters are either scurrying for cover or aggressively downgrading companies. There are seven of them. Do all of them know how to assess risks? Of course, they are competent to read the balance sheets and the profit and loss accounts but they woefully lack market intelligence. This is why they always close the stable door after the horse bolts. Going by media reports, the rating agencies have rated around Rs 40,000 crore worth of debentures backed by promoter shares; these instruments have found place on the books of debt mutual funds and NBFCs. 

• For the record, the raters have put more companies under "rating watch" in recent times (after the IL&FS episode) than they had done at least in the last one decade. In fiscal year 2019, corporate bonds worth Rs 10 trillion were put under rating watch, about 10 per cent of the total corporate debt. The comparable figure for 2018 was Rs 2 trillion.

• If these are not enough to prompt the authorities for fast corrective action, there is a perceived liquidity crisis. Is the liquidity crisis grave? Many feel so. They say, it will jam the entire credit system and the $2 trillion economy will come to a grinding halt. While I agree with the gravity of the situation and the likely fallout, the perception on the liquidity crisis is exaggerated. At the root of the problem is not the lack of liquidity but the risk aversion of banks.

• The daily systemic liquidity deficit, which was Rs 1.3 trillion earlier this month, has come down to around Rs 30,000 crore. The RBI has been persistently addressing the issues generating around Rs 70,000 crore through $10 billion swaps in two tranches, selling bonds worth Rs 25,000 crore in May, and tweaking the so-called liquidity coverage ratio of banks to add liquidity to the system in April. But the banks are not willing to lend as they feel many NBFCs can go down under and they will not get back their money. Most of them have also not cut their loan rates despite two rate cuts by the RBI in the past few months. In fact, they have raised their loan rates.

When my aunt says it’s the Lehman moment for India, I don’t agree with her but we could head towards that if we don’t address the issues first.

What should be done? Parts of NBFCs, mutual funds and rating agencies have lost credibility. Quite a few banks are not in the best of heath. And the banking system has turned its back to credit-starved entities. They are giving money only to individuals for buying houses and personal consumption. Essentially, they are leveraging the India growth story. So far, the debate has been on joblessness and job cuts in the unorganised sectors but once the job cuts spill over to the organised sector, banks will see retail borrowers defaulting. That will be the proverbial last straw on the camel’s back.

Before the Lehman moment stares at us, we need to act. For the government and the Indian central bank, it’s time to shed the inhibitions and act decisively to avoid a systemic collapse. A few NBFCs may have to be put to sleep (the US did that to Wachovia — its forced merger with Wells Fargo), a few of them with impeccable track record may have to be made banks and kept under RBI glare (a la what the US Fed had done to Morgan Stanley and Goldman Sachs). We also need an Indian version of quantitative easing (QE) and a troubled asset relief programme (TARF). 

The RBI can take a close look at the troubled NBFCs and banks, force them to write down assets, arrive at the fair market value, and the government can pump in the money. If the structure is right, the government can reap rich dividends from the TARF once they get back to health.

The columnist, a consulting editor of Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd. His latest book, "HDFC Bank 2.0: From Dawn to Digital" will be released in July.

Twitter: @TamalBandyo