Troubles stalking India’s shadow banking are getting worse

These institutions are getting some exposure these days for the wrong reasons

In India, crises move slowly. We’ve known for years that the state-controlled banks that dominate the financial sector were groaning under the weight of bad loans. For years, though, the government successfully kicked the can down the road.

All those assets haven’t been accounted for yet, the banks haven’t been fully recapitalised, the bankruptcy process isn’t working to schedule, yet somehow the banks are still chugging along.

India’s luck may be about to run out. The country’s shadow banking sector — dominated by what officials call “non-banking financial corporations” or NBFCs — faces something of a reckoning over the next month. Ever since a leading NBFC — Infrastructure Leasing & Financial Services Ltd, or IL&FS — defaulted on some of its debt recently, the entire sector has been starved of funds. The amount shadow banks managed to raise through the sale of commercial paper — short-term debt — fell by 65 per cent in October, according to Edelweiss.

IL&FS ran into trouble because it was borrowing short to lend long. Given that such behaviour is common throughout the sector, everyone is worried about whether shadow banks will be able to roll over their debt. The 50 largest NBFCs are looking for Rs700 billion (Dh35.48 billion) in just the current month.

For India and its government, this poses a real problem. While shadow banks account for at most 15 per cent of lending in India, they seemed like safe and attractive destinations for the savings of the middle-class.

They’ve also become central to infrastructure finance over the past few years. If a lack of funds slows down the real estate and infrastructure sectors blue-collar jobs, too, would be lost. This isn’t the sort of thing any government wants just months before an election.

Bad ideas

That’s why all sorts of bailout schemes are being planned. Most look like bad ideas.

For instance, India’s largest bank, the State Bank of India, has promised to buy Rs450 billion of shadow-banking assets and banks have been allowed to lend more to NBFCs. If people fear that banks aren’t being sufficiently discriminating when buying NBFC assets, they’d have even more reason to worry about the asset quality of those banks. In other words, bailouts could spread contagion.

What’s more problematic is the government’s insistence that the Reserve Bank of India open up a special window to lend money to the sector. The RBI is resisting; it doesn’t think there’s a systemic risk here.

The RBI seems convinced that shadow banks need to clean up their act — and they won’t if they get access to easy money now. If a firm or three end up going under, so be it.

That would be better than using public money to create a dozen more failures such as IL&FS over the next few years.

This is a genuinely brave — and praiseworthy — stand. One of the great wonders of Indian economic history is that so few firms are allowed to fail in an economy that constantly under-performs expectations. That’s one reason few sectors manage to rise above mediocrity: The market is never really allowed to work.

This crisis may be an opportunity to change that mindset. India needs a vibrant shadow banking sector; there are some things that regular banks just can’t or won’t do. But the country won’t get one by coddling institutions that are borrowing at the wrong tenures and lending to the wrong sectors.