Indiaʼs banking

system is flirting
with a Lehman
moment
The collapse of a shadow
bank has sparked fear
and financial contagion
Nov 8th 2018

The collapse of a shadow

bank has sparked fear and
financial contagion

WHEN NARENDRA MODI was

elected prime minister of India
in 2014, his plan was to revive
its GDP growth rate back to the
near-double-digit figures seen
in the mid-2000s. Few would
have guessed that the biggest
threat to that goal was the
financial industry. 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 Indiaʼs 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.

Indiaʼs 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 Asiaʼs 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 banksʼ
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 Indiaʼs
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 Indiaʼs 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 formerʼs
core capital. Among private
lenders the mood is already
jittery: ICICIʼs 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 Indiaʼs 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
governmentʼs 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.