Financial sector stress
It is not obvious how the system will come out of it
The latest Monetary Policy Report of the Reserve Bank of India (RBI) shows that the flow of funds to the commercial sector has virtually collapsed. Between April and mid-september, the flow declined to ~90,995 crore against ~7,36,087 crore in the same period last year. The decline is an indication of stress in both the financial and industrial sectors. This indicates that a lot of businesses are in the process of deleveraging or reducing debt, while the financial sector is not looking to expand its balance sheet. Although this process may reduce balance sheet stress over time in the system, it would affect economic activity in the interim and potentially prolong the slowdown.
Incremental financing to a large extent in the above-mentioned period came through issuing securities and a flow of funds from abroad. While stressed corporate balance sheets have been a problem in recent years, perhaps the bigger worry for policymakers at the moment is the renewed weakness in the financial sector. At a time when the banking system was witnessing early signs of a turnaround, stress has spread to the non-banking financial companies (NBFCS). According to the June edition of the Financial Stability Report of RBI, the gross non-performing asset ratio for commercial banks is expected to decline to 9 per cent by the end of the current financial year compared to 9.3 per cent in March 2019. The provision coverage ratio has also risen for commercial banks. But problems in the NBFC sector can now spill over to the banking system. The trouble in the NBFC sector started to emerge in a big way with the collapse of the IL&FS group. The government-appointed management committee has said that half the group’s debt will be resolved, which would still mean that the system will need to write off about ~50,000 crore worth of assets. The collapse of the IL&FS group also froze the credit market, which created liquidity issues for other NBFCS. Banks and mutual funds that used to lend to NBFCS are not willing to do so in the same way, largely because of asset quality issues. NBFCS dealing with the real estate sector are particularly in a difficult spot because of a variety of issues afflicting it.
Although problems plaguing the financial sector are largely known, it is not obvious how the system will emerge out of this difficult situation. One of the biggest problems is that the economic slowdown could affect the repayment capacity of borrowers and increase defaults. Things for non-banking lenders could become worse because, on the one hand, they are finding it difficult to raise funds and, on the other, their asset quality could deteriorate further.
The government is working towards improving the flow of funds from banks to NBFCS, but it may not solve all the problems. What is needed is a faster resolution of stressed firms so that trust can be established in the financial system, which will help restart the flow of credit. It has been reported that the government is contemplating the idea of bringing NBFCS within the scope of the Insolvency and Bankruptcy Code. The other option could be to allow specialised funds that can buy bad assets at a reasonable discount. It is important to resolve the problems in the financial sector to avoid a vicious cycle of slow growth and increasing vulnerability of the financial system.