The failures of IL&FS, PMB and Yes Bank have left the Indian financial sector in shambles. How can reforms change the landscape of our economy?
Blues in the financial world
In 2018, India’s largest non-banking financial company (NBFC), Infrastructure Leasing & Financial Services Limited (IL&FS), defaulted on its payment, sending shockwaves across the economic sphere. This crisis was later termed as ‘India’s Lehman moment’ due to its widespread impact. A few months later, Dewan Housing Finance Limited (DHFL) also defaulted on its ₹1000 crore payment. Then came the collapse of the Punjab and Maharashtra Co-op Bank, where the Reserve Bank of India (RBI) imposed a withdrawal limit of ₹1000 for six months, which was later extended to ₹40,000. Similarly last week, Yes Bank, which financed DHFL with ₹4,735 crores, was imposed with a moratorium while the RBI and the Government explored ways to keep it afloat.
Raghuram Rajan, the Governor of Reserve Bank of India (RBI) from 2013, directed the banks to clean-up their bad balances and this led to the discovery of many non-performing assets (NPAs) that were crippling the Indian financial sector. NPA’s peaked at 11.2 percent of total assets in 2017-18. While this decreased to 9.05percent in 2019, it is highest amongst the economies that are of India's size. Since then, commercial credit by banks dried up as banks became wary of falling into the NPA trap. In 2020, it is expected that commercial credit is likely to increase only by 6 to 7 percent, making it the lowest in 58 years.
India’s financial journey from the 2000s boom to the present
From 2006 to 2008 the country was experiencing a boom period, which is generally characterised by significant economic growth and productivity. Many Banks decided to ride with the tide and lend indiscriminately, which further increased the GDP growth rate. However in 2008, during the global financial crisis, came the threat of recession. Banks were asked to lend more to spur growth, which led to higher NPAs as the economy failed to take off. Moreover, the majority of these loans were given out to infrastructure companies whose projects were expected to be completed, but remain incomplete due to costs incurred from delays in approvals from multiple regulatory bodies. This was the first stage of the problem; Aravind Subramanium (Ex-Chief Economic Advisor) termed it as the “Twin Balance Sheet” problem, where banks had bad loans (NPAs), and companies had bad debts.
After demonetisation, banks remained cautious in their lending despite having the liquitty to offer credit. Shadow banks like IL&FS borrowed short and lent it long for infrastructure and real estate companies. This gap was known as asset liability mismatch, where bank loans given to NBFCs were maturing faster than the loans given by the NBFCs. Since all NBFCs fund their credit operations by borrowing from banks, it led to another pile-up of NPAs for the banks.
Real estate or infrastructure companies, the prime borrowers, were performing poorly in the slowing economy in 2018. This led to the second stage or the “Four Balance sheet” problem where the banks, infrastructure companies, NBFCs and real estate companies had poor balance sheets, unable to meet their liabilities.
Many alleged corruption cases also came to light during this period, for example, the Nirav Modi scam, Chandha Kochar scandal and currently the Rana Kapoor scam. There was a lapse of judgement and clear mismanagement in terms of governance by the bank boards.
Bonds, Repo rate and more: What needs to be done next?
We can feel the pinch in our economy from the disheartened investors and the slowing credit from banks. The government and RBI have taken some key steps to help the financial markets. While some of these measures have been a hit, others have yet to show clear effects. Recapitalising banks with ₹2 lakh crores in 2017 helped them clean their balance sheet and start afresh, but this remains incomplete as many banks are still uncovering NPAs. The Insolvency and Bankruptcy Code of 2016 helped streamline the process of recovering assets from companies that no longer make any profit but owe a lot to banks. This process has only helped recover money from straightforward cases but has failed to recover from larger companies.
RBI has been cutting interest rates since April 2019; the move aimed to improve the lending behaviour of banks. This has not led to any immediate improvement in lending behaviour because banks have chosen to raise more money by increasing the risk premia.
Banks are running out of time because depositors need to be paid their interests, and lack of lending has resulted in poor revenue. If profit rates of companies are lower than the lending rates of banks, then companies will refuse to take risks, this causes a slowdown in the economy.
The government needs to step-up and introduce other reforms. Building infrastructure for a Bond market in India would help infrastructure and real estate companies as their borrowing habits are better suited for long-term credit. RBI and the Government need to simplify the regulation process, while also making it more efficient to prevent future scams. Increased competition needs to be encouraged between banks that could incentivise them to better assess the loans they are lending. The government also needs to set up a resolution mechanism for banks if they go under, the lack thereof forces the government to follow a cumbersome, ad-hoc relief package every time a bank under.
Financial Institutions are coming under increased stress as many companies are failing to pay their debt. Poor lending of banks has led to decreased earnings and caused stress. With a recession looming on the horizon, the entire financial system is confronting its most serious challenge. A proactive regulatory effort and resuscitation package with close monitoring of its efficacy by the state is the dire need of the moment.
Due to the poorly timed supreme court verdict on the AGR issue and slowdown in the economy, large companies like Vodafone and Anil Ambani’s Reliance are unlikely to meet their loan repayment schedules. The clock is, therefore, ticking for many more banks that have exposures to these companies.
Presently the government is looking forward to quicker resolution for banks and have already opened up an account to help rescue Yes Bank. Stricter and simpler regulations, with steps to increase competition, and a strong Bond market would go miles in helping the financial markets bounce back.