NBFC crisis: India’s next government has to defuse the ticking time bomb in its hands

At the heart of the ticking time bomb that is India’s financial market lies its shadow banking sector.

If the financial condition of these non-bank lenders deteriorates, it will spark an economic meltdown. However, the government and the banking regulator, which are keenly watching the situation, won’t let that happen, believe experts.

“There is an imminent crisis in the non-banking financial companies sector,” Injeti Srinivas, corporate affairs secretary told the Press Trust of India in an interview on May 12. “There is a credit squeeze, over-leveraging, excessive concentration, and massive mismatch between assets and liabilities, coupled with some misadventures by some very large entities, which is a perfect recipe for disaster.”

The first signs of this crisis were visible in the second half of 2018 when the Mumbai-based Infrastructure Leasing & Financial Services, a three-decade old lending giant, which claims to have helped finance projects worth $25 billion (Rs1.75 lakh crore) across the country, ran out of money. The situation became so dire that it was even compared to the 2008 Lehman Brothers crisis. The government had to step in and supersede the board to avert a blow up.

Since then, though, the cracks in the system have only become wider.

Here’s all that you need to know about this worrisome situation among over 11,000 non-banking financial companies in India:

What’s happening?

To put it simply, there are concerns that non-banking financial companies may run out of money, which will lead to defaults. Ever since the IL&FS crisis erupted, banks have been averse to lending to the sector, which has put them in a tight spot.

Amidst all this, there were downgrades by credit rating agencies. For instance, Reliance Capital-owned Reliance Commercial Finance and Reliance Home Finance were downgraded to “default,” implying they faced trouble paying their dues.

Other non-banking financial companies, such as Dewan Housing Finance were downgraded, while PNB Housing Finance was put on credit watch. This has made raising money to fund operations an uphill task for the shadow banks.

Now, what’s worrisome is that in the next three months, about Rs1 lakh crore of commercial papers raised by these shadow banks from investors will come up for redemption. Commercial Papers are debt instruments issued by companies to raise funds for a time period of up to one year.

As the non-banking financial companies are cash strapped, there is a looming fear that they will default on the Commercial Papers.

What led to it?

There is an inherent problem in the way these shadow banks function, believe experts.

They raise short-term loans of between three- and six-months duration, using Commercial Papers. On the other hand, the businesses they lend to (home loans, commercial purpose loans, vehicle loans and so on) are long-term ones. This is referred to as asset-liability mismatch.

To maintain their funding, they must keep issuing Commercial Papers at regular intervals and roll over earlier loans. When the economy runs smoothly, this cycle can be sustained without much trouble.

However, following the IL&FS crisis, neither banks nor mutual fund companies or other investors have been keen on betting their money on these non-banking financial companies. In the meantime, the cost of funds has also increased.

On the other hand, inflows into the mutual fund industry have slowed down, which has a bearing on funding by non-banking financial companies. “They [mutual fund managers] had a risk aversion towards the [NBFC] sector, but now there is a slow down in debt funds as well,” said Karthik Srinivasan, an analyst at credit rating firm Icra. “As a result, they are even more cagey about investing in these businesses.”

As a result, non-banking financial companies face an acute liquidity squeeze, hitting the overall financials of the company.

Who gets affected?

In case of a crisis, everyone.

That banks are a mainstay of the Indian economy is well known. As of March 31, they had loan outstanding (money they are yet to collect) of Rs92.1 lakh crore. In comparison, loans outstanding at shadow banks stood at Rs17.2 lakh crore, a fifth of the banks’.

If there is a default, then banks and mutual funds won’t be able to recover the money lent to non-banking financial companies. The overall market sentiment ends up taking a beating.

For businesses, raising money from non-banking financial companies is comparatively easier than from banks. Therefore, if the shadow banks fail, the funding tap will run dry for individuals and businesses seeking loans.

None of this augurs well for the Indian economy, already in the throes of a slowdown.

What has the government and RBI done?

The Narendra Modi-led government has assured the non-banking financial companies sector that if re-elected, it will figure out a way to ease the liquidity situation.

Meanwhile, the Reserve Bank of India has also been taking steps to improve the funding situation by pumping funds, which can be taken up by the banks to be lent to non-banking financial companies.

The government and the RBI are also looking at a better collection of data from non-banking financial companies. Even credit rating agencies have been asked to include “liquidity” as a separate parameter to stave off another IL&FS-like situation.

“[It] is very dynamic right now and no one knows if it can erupt into full-blown crisis in the coming months,” said Alpesh Mehta, analyst at Motilal Oswal, a domestic brokerage house. “One thing is certain, the government and the banking regulator needs to be more proactive and watchful.”

This article first appeared on Quartz.