• Hindu College Gazette Web Team

Shadow Banking in India

The cataclysmic collapse of IL&FS, Dewan Housing and the fall of 6 debt funds by Franklin Templeton, all exemplify the feeble structure on which India’s shadow banking system rests. Shadow banking is the umbrella term which refers to the activities done by Non-Banking Finance Companies (NBFCs). This involves lending to both secured and unsecured projects, more often than not, at a higher interest rate.

NBFCs do not give out credit cards, do not accept deposits and are under-regulated by the financial regulators of the country. Its prominence is seen mostly in hedge funds, investment banks, real estate projects and so on. The shadow banking system has a large exposure to insufficiently collateralized loans, and most of them are done without adequate KYC or default risk analysis. Hence, due to its risk exposed structure, and large lending capacities, often without sufficient liquidity to account for large amounts of bad debt, the shadow banking system stands as a threat to global financial stability. It is often blamed for the financial crisis of 2008, as it was the primary source of subprime mortgage lending in the early 2000s, and the eventual downfall of mortgage-backed securities made all their debt worthless.

A similar story is that of Indian NBFCs since 2018, which had lent out to large infrastructure projects that were ultimately shut down due to different causesMutual Fund schemes were badly hit by defaults in payments worth $60 million by IL&FS, followed by a later default on short term commercial paper. A series of such events involving IL&FS and Dewan Housing Finance Limited defaulting on payments led to risk aversion from commercial banks and private investors, which led to many debt funds shutting down, including 6 debt funds managed by Franklin Templeton worth around $4.1 billion.

The government had to take over operations at IL&FS after its crumbling financial situation. The reason cited for this government intervention was that the insolvency of one of the biggest shadow banks would send shockwaves through the financial system akin to those of a large commercial bank’s fall, that would lead to a domino effect, endangering the whole financial system. In a developing economy such as India’s, shadow banks are responsible for a large chunk of lending for rural development projects. A shutdown of any major shadow bank drastically affects rural development, and cuts off sources of funding for existing projects. It also sends a ripple effect into the economy through its involvement in financial markets, which is explained through Figures 1 and 2.

Another major event that highlighted the cash flow problem of shadow banks was the project undertaken by Jaypee Infratech, a real estate developer. Potential homeowners were lured into buying plots in what was to be a mega project of over 30,000 apartments on the Noida-Greater Noida expressway. Most invested in the early stages, as any mindful real estate investor would, and took loans or used up a large chunk of their savings to book a plot in the upcoming project. As promising as it sounded, the project has been under development for over 12 years and hardly a large chunk of plots have not been delivered.

Since real estate developers take large loans, they prefer approaching NBFCs to go through less scrutiny of the turnover of their projects. While commercial banks became risk averse, shadow banks dipped their toes further into real estate projects, with funding directed towards them increased by 46% in the period of 2015-2019. After defaults on their delivery commitments by builders, defaults also began piling up by individuals who took loans for buying the plots in the failed projects.

These are the simplified balance sheets of a shadow bank, containing only the relevant line items needed to understand the impact of failed loans on shadow banks and consequently debt funds worth billions of dollars.

A shadow bank has assets as loans and debt bonds, i.e., they are going to receive interest and loan payments, and have also bought debt bonds. These debt bonds are rated according to rating standards of agencies such as Moody’s and Fitch ratings, which depicts the value and risk factor of the debt, with ‘AAA’ rated bonds being the safest. These bonds are taken as collateral and asset backed commercial paper (ABCP) is issued against it, which is then taken on by Mutual funds such as those run by Franklin Templeton. Against the ABCP, the Mutual Fund takes money from investors, using a Net Asset Value (NAV), which is derived from the underlying asset’s value (i.e., the ABCP). The money invested by individuals is put in deposit like tranches.

If loans begin to default, and debt bonds become illiquid, this reduces the value of the ABCP issued against it, and consequently the NAV falls, which is bought by retail investors. This structure of the debt market explains the fall in value of the debt funds handled by Franklin Templeton after large defaults by real estate developers such as JP Infratech.

In 2018, Indian Public Sector Banks (PSBs) were coming under pressure after they collectively reported stressed assets of around $120 billion, and 11 PSBs came under the RBI’s Prompt Corrective Action (PCA) framework, which restricts lending of these banks to a certain limit. A solvency risk was also seen in PSBs as their Credit-Deposit ratio increased significantly, indicating that they were lending a very large portion of their deposits. In case of a financial emergency, a run on the bank would threaten insolvency of large public banks.

This phenomenon is also known as the ‘survival constraint’, famously penned down by Hyman Minsky, who talked about excessive liquidity risks taken on by financial institutions during economic booms owing to over-optimism and adverse selection. The survival constraint is about managing and timing payments and receivables, in a way that cash inflows exceed cash outflows.

This liquidity crisis can be best understood in terms of real numbers. After the first default by IL&FS in August 2018, Franklin Templeton lost Rs.16,000 crore over the next 18 months as the debt lost value and IL&FS faced downgrade after downgrade by credit rating agencies. The retail investors who had invested their hard-earned money in Templeton’s debt fund started getting twitchy, as they should. Just when the liquidity crisis began to ease itself and the shadow banking system began to find its feet in March 2020, the Covid-19 pandemic hit, and made matters worse. The mismanagement in the timing of maturities of the instruments held by Templeton worsened the situation, with large percentages maturing at the same time. This is bad for the fund as current illiquid scenarios in the commercial paper market as well as the bond market would mean that the returns would take a serious hit. This is one of the aspects emphasised upon by Minsky with reference to the survival constraint; i.e., there should be an alignment of inflows and outflows such that there remains a positive cash reserve.

The shadow banking system, despite its risks, stands to be an important source of credit in economies, especially developing ones. The limited reach of public and private sector banks, and their relatively stronger due diligence procedures are the reason why NBFCs are the ones who take higher risks by lending freely at higher rates in search of profits which are sometimes not there.

By Arjun Tandon

Arjun is a budding economist, with primary focus on monetary and public economics. He can usually be found driving karts, doing research, reading philosophy or playing football.

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