The great Indian credit squeeze, in six charts

A year after the collapse of the financial behemoth IL&FS created a crisis of confidence in India’s shadow banking sector, fresh skeletons have once again tumbled out of India’s beleaguered financial sector. Officials at PMC bank admitted in an explosive letter that they had cooked their books to avoid recognizing bad loans to one of their major clients, trouble-ridden real estate developer, HDIL Ltd.

Around the same time, the Yes Bank stock was hammered, primarily on account of concerns relating to its exposure to another troubled shadow bank or non-banking financial company (NBFC), Indiabulls Housing Finance Ltd. Concerns over asset quality have since then spread to other parts of the financial system. The RBL Bank’s stock price slumped to a record low last week amid concerns over its corporate loan book. IndusInd Bank has also faced tough questions on its loan-book from analysts after it declared a higher-than-anticipated jump in provisions for bad loans . Meanwhile, analysts have warned that the shadow banking crisis could mean a spike in bad loans for conventional banks which fund the shadow banks.

The crisis of confidence in India’s financial sector comes at a time when real credit flow (adjusted for inflation) has slowed down sharply, mirroring the slowdown in Asia’s third-largest economy.

But the credit squeeze has been long in the making. Following the effervescent lending of the boom years and the eventual bust, banks have become wary of lending even as firms have become reluctant to undertake new projects.

Data from corporate balance sheets suggest that year-on-year growth in borrowing from bank and non-bank sources has witnessed a secular decline since at least 2011-12.

To be sure, firms have tried to diversify their sources of funding in recent years, with some firms tapping the domestic corporate bond markets while others have relied on external funding.

Yet, as a share of total credit to the non-financial sector, bank credit remains the dominant form of credit still. Among the largest economies comprising the G-20 group, the share of bank lending to the non-financial sector is the highest for India, data from the Bank for International Settlements (BIS) show.

At the same time, the capital buffers of India’s banking system are among the lowest among the G-20 economies. The capital adequacy ratio (CAR), a metric that foretells a bank’s ability to absorb losses using its own capital, is much lower for India than it is for most large economies, data from the International Monetary Fund (IMF) show.

Given the primacy of banks in India’s economy, and their poor state of health today, it is little wonder that economic activity has been slowing down across the country.

The roots of the crisis lie in the credit boom in the years leading up to the great financial crash of 2008. The boom was halted briefly by the crash before it resumed again thanks to a combination of loose monetary policy and regulatory forbearance, which allowed lenders to delay classifying non performing loans as bad loans. But doubts over the true extent of the stress on bank and corporate balance sheets only grew, prompting the Reserve Bank of India (RBI) to finally launch a clean-up act in 2015, laying bare the rot in the banking sector. The RBI also put restrictions on fresh lending by some of the worst-affected lenders. Governance reforms in state-owned banks proposed by the PJ Nayak committee, which could have allowed the healthier banks to lend more freely were put on the back-burner by the government.

Constrained by new regulations and the weight of bad loans on their books, banks outsourced part of their lending activity to shadow banks. These non-banks played a key role in ensuring credit to risky sectors such as real estate even while ensuring that banks did not have to bear a direct exposure to such assets. However, these shadow banks were much more under-capitalized and under-regulated compared to the traditional banks. And at the slightest hint of trouble (the IL&FS implosion), the shadow banking sector came under a cloud, making it difficult for shadow banks to roll over debt. This created a liquidity squeeze in sectors such as real estate that were dependent on the shadow banks.

Now, the problems in the shadow banking industry threaten to spillover to the banking system. A 21 October note by Fitch Ratings warned that bank loans to shadow banks could turn sour in the coming months, and this could lead to a fresh spike in non-performing assets of banks. If 30% of the NBFC exposure turns non-performing, the ratio of non-performing assets could rise from an estimated 9.3% in fiscal year 2019 to 11.6% in fiscal year 2021, the note said.

How much of this would come to pass depends on how much of the shadow banking loan book turns sour. As was the case with the banking sector a few years ago, no one knows the true extent of the rot in the shadow banking system. An asset quality review of the sector similar to the one conducted for banks in 2015 might help bring clarity to the markets and improve trust overall but RBI does not seem to be interested.

The opacity around asset quality has led to a spike in the risk premium (the extra yield private borrowers in the bond market have to pay compared to the government, which borrows at the ‘risk-free’ rate), nullifying the effect of RBI’s successive rate cuts. The rise in risk premium on top-rated securities since the IL&FS crisis has outweighed the fall in the risk-free rate. This seems to have contributed to a decline in private debt issuances in recent months, drying up a key source of funding for both shadow banks and non-financial firms.

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The mess in India’s financial system lies at the heart of India’s slowdown today. Any solution that side-steps this problem is bound to fail.