India’s Banking System is flirting with a Lehman moment

For several years state-run banks have failed to get to grips with a $100bn mountain of dud loans. Now panic has seized parts of the privately run system. One bank boss says the situation is as bad as the Asian crisis of 1998 or the global crash of 2008.

In September IL&FS, a financial firm that owns and finances roads and power plants, defaulted on some of its $13bn of debt. The contagion has struck India’s shadow banks, which rely on $250bn-300bn of borrowing to fund themselves. Their market value has collapsed by a median of 40% this year.

A bitter row about how to respond has erupted between the government and the Reserve Bank of India (RBI), the largely independent central bank.

Over a billion people depend on an emergency being avoided. India’s financial system has both Chinese and American characteristics; it faces a blend of a slow-motion banking crisis at government-run lenders, plus a high-speed liquidity run of the kind that hit Wall Street in 2008.

That the industry has taken on a hybrid character over time reflects the conflicting aims of the forces that shaped it.

The state wants pliant banks, ready to lend to the rural poor and to infrastructure projects, and that will buy government bonds. The RBI emphasises stability, so is paranoid about wheeler-dealers taking risks or ripping off the vulnerable.

Entrepreneurs want capital and to start financial-services firms themselves. And consumers want loans and whizzy new banking technologies.About half the system, measured by loans, consists of state-run banks. They are usually listed but the government appoints their top brass and often influences them to disastrous effect.

Another 25% comes from private banks; some of which are among Asia’s best-run lenders—HDFC Bank and Kotak trade on about four times their book value, compared with below one times for the zombie state banks.

The other quarter is from a motley crew of 50-odd shadow banks that have expanded quickly. They are less heavily regulated and lend in particular areas such as housing. They are usually prohibited from taking deposits so fund themselves with debt.

Last, there are innovative digital firms, such as Paytm, a mobile-payments firm. Overall, the system straddles the 19th and 21st centuries, featuring subsiding bank branches protected from the monsoon by tarpaulins, but also virtual mobile chatbots.The present troubles have their roots in 2005-12, when state banks went on a lending bender, extending credit to dubious tycoons and to infrastructure projects. Net bad debts are 9% of state banks’ loan books.

The government has not properly recapitalised these zombies and the flow of credit from them has slowed. Accidents keep happening.

In February PNB, the second-biggest state lender, disclosed a $2bn fraud involving diamond merchants. A second phase began after 2012. Between 2012 and 2017 more capital flowed into India than flowed out.

In 2015 interest rates began to fall and in November 2016 the government replaced the stock of bank notes overnight, leading savers to switch from physical money into deposits with banks, and into debt mutual funds. Flush with cash, and with rates low, they looked for ways to lend the money out again and part of the answer was to fund the shadow banks, which went on a binge—the top 50 have doubled their debts and assets in the past five years. Perhaps as much as $50bn-100bn of their debts comes due within 12 months. Borrowing short and lending long is a high-stakes game.

After the IL&FS collapse, confidence has evaporated. The group has 348 opaque subsidiaries, including India’s longest tunnel. It has now been taken over by the government, which indirectly owned 40% of it.

Mutual funds and banks are reluctant to lend to other shadow banks—most report solid capital ratios, but can anyone be sure they do not have time-bombs buried in their balance-sheets? For weeks the shadow banks have faced a liquidity crunch. They are big enough to damage India’s entire financial system. Mutual funds, which are sold to the public, have $55bn of exposure to them, or 11% of total assets under management.

Conventional banks have loaned $70bn to shadow banks, the equivalent of two-fifths of the former’s core capital. Among private lenders the mood is already jittery: ICICI’s boss has just departed after claims of conflicts of interest (which she denies).

Yes Bank is replacing its boss after the RBI refused to approve an extension of his term. Even if a full crisis does not erupt shadow banks may be forced to shrink. When combined with the rotten state banks, that would mean that 75% of India’s financial system is on crutches. Bazooka time A sell-off in global markets could easily trigger a new wave of panic.

The government, facing a general election next year, wants the central bank to lend more freely to the shadow banks. But the RBI does not want to reward failure and has so far injected liquidity only indirectly, by buying government bonds and allowing banks to guarantee some new bonds issued by shadow banks. It blames the government for its endless meddling in state-run lenders and for its failure to recapitalise them, despite years of warning signs.

In the short term the government is right—unless the liquidity squeeze abates soon, the central bank will need to set aside its natural reluctance and act boldly. In the long term the RBI is right. A “big bang” reform is needed to privatise the state banks and extract them from the government’s tight grip. India also must end the regulatory arbitrage that allows shadow banks to raise most of their funds from retail investors and deposit-taking banks.

Either shadow lenders should come out of the dark and be turned into banks, or a firewall will have to be erected around them to protect the rest of banking. And if India does not get its financial system back on its feet, the economy will not grow fast. It is that simple.

Source: The Economist

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