The Indian Shadow Banking Crisis and its Implications for the Future of the Economy

Is the Shadow Banking Crisis the Indian Lehmann Moment?

For close to a year now, the Indian Shadow Banks and the assorted NBFCs (Non Banking Financial Companies) have been in a crisis mode.

Faced with souring loans and rising NPAs or Non Performing Assets, the likes of ILFS (Infrastructure Leasing and Finance Services, DHFL (Dewan Housing Finance Corporation), Indiabulls, and a host of smaller such firms have been under pressure to meet the payment deadlines on outstanding loans and to redeem the associated requests from Mutual Funds companies that have significant exposures to them.

Indeed, many commentators have dubbed this crisis as being similar to the Great Recession of 2008 and some have called the default by IL&FS as being “India’s Lehmann Moment”.

With the stakes so high, the government was forced to step in and bailout (partially and fully) of some of these firms lest they cause market panic and lead to a collapse of not only the Shadow Banks, but also the wider economy since in the present times, the various actors in the Indian Economy are so intertwined that a crisis affecting a few has the ability to turn systemic in no time.

What do the Shadow Banks and the NBFCs do in India?

Before we launch into a discussion of what went wrong and what this crisis means for the Indian Economy, a short explanation of these firms and why they have gained importance in recent years would set the context.

Shadow Banks are so called because they work almost like Banks except that they are not as broad based in their reach as the latter. For instance, both Shadow Banks and NBFCs take deposits and extend loans, though their area of focus is narrower than the traditional banks.

In addition, the Shadow Banks and NBFCs often lend to high risk borrowers with poor credit history as well to projects that are not as gilt edged as those that the traditional banks lend to.

In a way, the Indian Shadow Banking and NBFCs sector is akin to that of the High Risk Junk Bonds and Mortgage Sector in the United States where the spreads are higher due to the high risks and at the same time, the threat of defaults and crises hangs like a Sword of Damocles.

After all, when you lend to people and projects as well as to industrialists and other firms that are risky, you carry the threat of not being paid on time, if at all fully paid when due.

Why the Shadow Banks are so important in the Indian Context?

Having said that, one might very well ask if such firms are so risky, why have them and entertain them in the first place. The answer to this question lies in part to the fact that someone has to lend to those sectors that are not covered by the formal and traditional banking sector.

In addition, the Indian Economy is not sophisticated enough or trusted enough by large sections of society that many Indians with meagre savings and expectations of high and quick returns often turn to these firms.

Indeed, this is the reason why the NBFCs thrive as do the Shadow Banks since the penetration as well as the comfort level with the traditional banks is not yet reached a stage where ordinary Indians can invest or take loans from them.

Moreover, there is the added aspect of banks requiring extensive documentation for availing loans which reinforces the perception among many that they are not the places for them.

For instance, a conversation with my Handyman once turned to this topic and he said that he was asked to provide his Income Tax Returns and other documents for availing loans that the New Credit Policy of the Modi Government rolled out to help small entrepreneurs and businesspersons such as him.

The Indian Economy can’t do “With or Without” Them

Indeed, as can be seen from the last sentence, there is a dichotomy at the heart of the Indian Economy and that is despite governmental push to encourage more Indians to trust the Banks, due to various reasons discussed above, the results are disappointing.

Moreover, the present crisis has been caused mainly by the Government itself as following the Shock move to demonetize the cash in circulation, the resultant huge inflows into the Banking Sector found their way into the Shadow Banks and the NBFCs.

In addition, despite the RBIs (Reserve Bank of India’s) active regulation, the NBFCs and the Shadow Banks are thriving with the knowledge that the government would bail them out in case of trouble.

This is precisely the situation that the outspoken former RBI Governor, Raghuram Rajan, had warned about and it was during his tenure that there was a crackdown on these firms. Even his successor, Urjit Patel, followed up on some of the actions to regulate and it is unfortunate that he became the Victim rather than the Saviour.

Need to Move Beyond Knee Jerk Reactions and Regulate

Lastly, it is high time the Indian Government unveiled a comprehensive action plan to regulate the Shadow Banks and the NBFCs and not behave in a Knee Jerk fashion wherein it wakes up during crises and for the rest of the time, it is in deep slumber.

After all, the investors being the Lower Middle Classes and the Poor who constitute a significant vote bank, no government can ignore them either during their need or during the government’s need.

To conclude, to prevent recurrence of such crises, more powers must be given to the regulators in addition to certain independence to them to crack down on the errant firms.

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