The crisis engulfing IL&FS, or the Infrastructure Leasing and Financial Services Limited, has led to two phrases entering common usage in India. I do not recall “too big to fail” or “shadow bank” being used to describe the country’s financial affairs prior to the last two months.
“Too big to fail” became common parlance during the 2008 subprime crisis, with America’s treasury department and regulatory authorities, including the Federal Reserve and the Securities and Exchange Commission, employing it to justify bailing out sundry private investment entities. The underlying concept is simple: an entity has vast exposure across the financial ecosystem and, for whatever reason, it’s unable to meet its obligations; if it defaults, its creditors will also be unable to meet their obligations, leading to contagious defaults. So, rescue the sick entity.
Such a rescue is morally ambiguous. It usually involves forgiving the entity’s transgressions and places a financial burden on the rescuers, which generally means taxpayers and shareholders of other institutions being dragged into the mess. It may be the pragmatic thing to do, however, if indeed the entity is too big to fail.
“Shadow bank”, or shadow banking, is often used to describe informal or semiformal lenders in mainland China. Loosely, a shadow bank is an entity that offers financial services similar to a bank but without being part of the regulated banking system.
Shadow banks labour under one great disadvantage: they have a higher cost of funding. But the lack of regulatory oversight allows them to take on more risks than banks. So, they can cut corners and earn higher returns. They can also go bust more spectacularly.
In India until about a month ago, shadow banks were known as non-banking financial companies, or NBFCs. There are thousands of them and they come in all shapes and sizes. Some have specialised briefs and, often, a majority government shareholding. The Power Finance Corporation, for example, has the government as the majority shareholder and does what its name suggests. Ditto for the Rural Electrification Corporation. There’s HDFC, the premier and pioneering housing mortgage lender, and there are specialists in vehicle finance, hypothecating both commercial and personal vehicles. There are retail lenders offering easy monthly instalment schemes for people buying fridges, mobile phones, laptops, lawn mowers, doing house improvements. There are NBFCs lending against gold and NBFCs offering personal loans for varied purposes.
One key area of NBFC operations is infrastructure financing. There are inherent technical and historical reasons banks are wary of infrastructure. Most bank funding is short to medium term, consisting of demand deposits (savings accounts that can be liquidated anytime) and fixed deposits ranging from 30 days to about five years. Banks have sector exposure and company exposure limits, that is, they cannot lend more than a certain percentage of their resources to one sector, or to a single entity.
Infrastructure projects are long-gestation and high-risk. It takes years to lay a major road, build a port terminal, roll out a telecom network, begin a mining operation, or set up a power plant. They are capital-intensive, requiring vast sums of money, and the returns are zero until the project is up and running. There are political hurdles since land acquisition and regulatory clearances are always involved. The assets of an unfinished project – a half-built bridge, or a stalled power plant – are often worthless, so the lender can recover nothing by seizing assets. There are legal complications involved in seizing assets anyway. That is quite apart from the usual endemic contractual disputes.
Banks thus run high risks and face asset-liability mismatches in financing infrastructure since it requires them to borrow money for short durations, then lend for long durations. Indeed, banks have already lost vast sums by funding infrastructure, with power, road construction and telecom sectors accounting for the maximum losses.
Role of NBFCs in India’s economy
Enter NBFCs. They face asset-liability mismatches similar to banks but there are no Reserve Bank regulations preventing them taking such risks or limiting exposures. They borrow money and roll over loans while lending to high-risk infrastructure projects. They can make long-term returns that are well above the norm for banks. They can also go bust if a sufficiency of projects fails or goes into overruns and/or cannot refinance borrowings. The system depends on high credit ratings that allow NBFCs to continue borrowing. And, of course, it depends on projects not going sour.
IL&FS went bust because it lent to too many projects that went sour, one way or another. It was unable to refinance after it started defaulting and its credit ratings fell. The Centre is working on rescuing IL&FS because it has many former government officials embedded in its management structure. What is more, the Life Insurance Corporation and the State Bank of India – both state-owned – have large stakes in the troubled company as does the Central Bank of India, itself a bankrupt public sector bank. There are two big overseas shareholders, adding an embarrassing international dimension to the situation.
IL&FS is probably also too big to fail, although it has an opaque balance sheet with over 200 subsidiaries and special purpose vehicles. Continued defaults could lead to freezes across India’s bond market as the company’s creditors would find it hard to continue servicing their loans. The crisis, in fact, has already hit the debt mutual fund market.
It will take a while for the new board of IL&FS to make sense of what is going on. The company has a debt of Rs 1.2 lakh crore on its consolidated balance sheet. It also owns a lot of assets, some of which may be worthless but some may be undervalued. The Life Insurance Corporation estimates the assets to be worth about Rs 70,000 crore. Deleveraging by selling some assets could help meet current obligations and buy IL&FS some time.
Nervousness in the NBFC space has already translated into problems for other companies. When DSP Mutual Fund recently sold non-convertible debentures of the Dewan Housing Finance Corporation at a discount, the latter’s stock took a hammering. Debt market yields are up, which means bond prices are down and lenders want a higher return to bear the risk of lending cash.
How do other nations handle such asset-liability mismatch situations? Well, most developed economies have efficient liquid bond markets with a strong secondary activity. The difference between taking a loan and floating a bond is that a bond can easily be resold, at either a profit or a loss, on the financial exchanges whereas selling a loan requires over-the-table negotiations with potential buyers. A secondary market for bonds allows any entity to easily offset a risk by booking losses when they please. India does not have a secondary bond market to speak of, with most debt being government securities or unsecured commercial paper.
Other, more developed economies also have large pension funds, which can afford to lend for the long term unlike banks. In India, the Provident Fund is the only such actor and it is essentially a government body. Insurers can also invest for the long term but, again, there are problems with this in India. The Life Insurance Corporation has been used to rescue all sorts of financial lame ducks such as IL&Fs rather than make sound commercial decisions.
IL&FS will be rescued, one way or another. Shareholders will pony up for a rights issue. The company’s new government-appointed board will figure out ways to deleverage. But the long-term issues with shadow banking will not go away; they will surely crop up again.
In the short term too, given the timing, this could negatively affect both infrastructure financing and household consumption. The impending festive season, followed by the marriage season, is when most households purchase their consumer durables, new cars, bikes and suchlike. A large chunk of these transactions is driven by products bought through easy monthly instalments, usually provided by NBFCs. If there is nervousness across the NBFC space, it could drive down consumption.