Is the crisis in IL&FS a sign that India has a shadow banking problem? The markets surely think so, as was evident in the panic selling on Friday and Monday. Several non-banking financial companies (NBFCs) were particular targets for selling, reflecting genuine questions about the expansion of lending by NBFCs in the past years that may have stressed their books. A series of defaults by IL&FS subsidiaries has caused questions to be asked as to whether the defaults will ripple through the NBFC sector. Baffled by the rapid downgrades of IL&FS debt paper — from triple-A to ‘D’ (or default) in less than two months — the Securities and Exchange Board of India has asked rating agencies to take cues from the market in evaluating bond issuers. The possibility of contagion would have been on many investors’ minds. After all, NBFCs have complex and obscure lending patterns. Yet, their parent companies are frequently given investment-grade credit ratings, and thus many investors, including mutual funds, have bought them extensively.
In order to deal with possible losses, these funds would have sought to shift allocations to safer, blue-chip stocks. This led to a jump in volatility in the market, which in itself caused concerns to spread further. The perception still is that the ongoing problems involving IL&FS and fears over the quality of the loan books of some NBFCs would freeze a large part of the credit markets. News that IL&FC and its 40 subsidiaries have petitioned the Mumbai Bench of the National Company Law Tribunal for debt restructuring would not make things better.
There are fundamental issues at work here. For one, NBFC lending in India might be subject to a serious asset-liability mismatch. Lending might have a longer tenure, as it is to the infrastructure sector, but this lending is financed by shorter-term debt. Clearly, this is a sector that requires closer regulatory scrutiny. While asset-liability mismatches are found sometimes in other fields of infrastructure finance, the shadow banking sector has an additional wrinkle: It is not clear exactly who has lent how much for what. An apparently sound financial company, because of its multiple subsidiaries, may have tendrils in all directions, and its collapse may hit the financing of hitherto unimpeachable enterprises. This fear is the breeding ground for a serious credit freeze-up. Concern about the effects of a credit freeze-up is also a major motivation behind some of the sell-off visible in the markets.
Can the government stand aside while this dynamic plays itself out? This might be a dangerous course of action. It is true that, while systemically important, IL&FS is, in the end, a private company. Yet the government has a duty to ensure that the financial arteries of the economy are not blocked. It also, however, has a duty towards taxpayers and clearly would have to justify any infusion of cash into IL&FS. A bailout by the Life Insurance Company of India would add to the impression that this government is treating LIC, and therefore Indian policyholders, as its piggy bank. Instead, the government needs to look at successful interventions from the past, such as its rescue of Satyam. Ideally, it should step in, appoint people to examine IL&FS’ working and its assets, who can then restore confidence, separate good assets from bad, and get the company — and the rest of the shadow banking sector — working again.
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