The Long Stinging Tail Of India’s Credit Crisis

The long tail of India’s credit crisis — now close to half a decade old — continues to bruise both lenders and bankers alike. The last twelve months have seen new vulnerabilities surface just as old fault lines were seeming to get addressed. These vulnerabilities now threaten to turn into a vicious cycle where an economic downturn feeds into financial sector weakness, which comes back to the hurt the economy and so on. An idea or a package to break this cycle remains elusive.

So What’s New?

The story probably sounds boringly familiar so far. You’ve heard it time and time again over the last five years. So what’s new? What’s new is the fact that just when there appeared to be an end in sight, the sector is facing a whiplash again.

The cycle started with a cleansing of the poor credit decisions taken in lending to large corporate groups. And so we first saw the so-called corporate lenders — almost all public sector banks and a handful of private banks — take the hit. At the time, it was believed that the new private sector banks who had focused on the emerging mid-corporate segment and on retail borrowers will hold strong.

It wasn’t to be. It turns out that even some of mid-sized private banks too had failed to keep risks in check as they chased high yield businesses. After Yes Bank, concerns have emerged over the quality of the corporate loan book of RBL Bank, albeit in a smaller way. Concerns have also been raised about the structured lending book of IndusInd Bank, which has gone slow on that high yield business.

Among the non-bank lenders, we have now seen some big casualties while a few others are facing rough weather.

Three non-bank lenders — IL&FS Financial Services, Religare Finvest and now Dewan Housing Finance Ltd. — have faced allegations of gross mis-governance. A fourth — Altico Capital — has gone into default. Others like Indiabulls Housing Finance continue to struggle to raise fresh funding from the debt markets. Even the blue-blooded KKR India Financial Services Pvt. Ltd. has seen its rating downgraded and its credit market head resign.

Meanwhile, the trouble, which, in the initial years, was coming from ten large industrial houses is now dispersed. A set of companies with over-leveraged promoters are seen as a risk. Small businesses with linkages to large enterprises facing trouble are expected to face pain due to payment delays. Developers, who are no longer getting the funding they were from NBFCs, are at risk. No visible trouble has surfaced in the retail lending side but if the economy remains weak and if there are job losses, some deterioration in asset quality there can’t be ruled out.

The result of all this is that expectations of a fall in bad loans in FY20 have started to turn. In a note dated Oct. 21, Fitch said that it expects the banking system's gross non performing loans ratio would rise to 11.6 percent by FY21 from 9.3 percent at FY19, compared with an earlier expectation of a decline to 8.2 percent.

Financial Sector Capacity

This dispersed set of problems has once again brought the problem of financial sector capacity to the fore.

Till about a year ago, there were two major demands – more capital for public sector banks and easier liquidity. The government coughed up the capital and the Reserve Bank of India yielded to demands for easier liquidity.

Despite that, money supply to the economy — as measured by M3 growth — has been weak. The money multiplier, which reflects how much money supply is created by one unit of central bank money, remains low essentially reflecting the inefficiencies of the financial system.

So while India’s Monetary Policy Committee is trying to stimulate the economy using interest rate cuts and the RBI is doing its bit by providing surplus liquidity, much of this is not getting transmitted to the broader economy.

If anything, the constrained flow of finance, part of which follows weakness in economic activity, is starting to lead to problems in itself. If Fitch Ratings is to be believed, this constrained flow of finance could pull down FY20 GDP growth to 5.5 percent, even lower than the RBI’s sharply revised forecast of 6.1 percent.

The Trust Factor

Amidst all the problems already being faced, a problem of trust in Indian banking is swirling around. Trust is intangible and any pronouncements of diminished trust in the banking system are impressions more than assessments.

Yet two recent instances are telling.

On Oct.1, the RBI issued a rare public statement saying that it “would like to assure the general public that Indian banking system is safe and stable...” The statement came in the wake of a fraud at PMC Bank, which prompted the regulator to impose restrictions on withdrawal of deposits.

On Oct. 21, the Odisha government issued an advisory to its departments asking them to exercise caution in deciding where to park deposits in light of “apprehensions” about the health of some banks. The order was later withdrawn after the RBI told the state government that such advisories could have unintended consequences for stability of the financial system.

Such statements should not be necessary, particularly in a banking sector still dominated by lenders owned by the sovereign. Yet, a need was felt for them and that is a signal in itself.

Breaking The Cycle

So what needs to be done to break the cycle? The answers are not easy. But perhaps a word of advice from a veteran central banker may help those in places of authority right now.

In June 2018, former RBI Governor YV Reddy gave a speech in Kohlapur titled ‘Keeping Banks Safe’. He dealt with issues ranging from bad loans emerging from lending to large corporations to capital, banking sector frauds to investigations and the RBI’s reputation. The issues, broadly, remain unchanged with few new problems thrown in.

Reddy concluded his speech by saying:

“...confidence, coherence, consistency and clarity should be maintained in official pronouncements on banking recognising that banks are special and deposits in banks are very special.”

Two of those four C’s are critical at this juncture. The need to instill confidence through words and actions. And the need to provide clarity on weak spots in the financial system and a plan to deal with them. Without that clarity, confidence may further get compromised.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.