India’s financing arrangements are far more rudimentary than what Paul McCulley, formerly of Pacific Investment Management Co., had in mind when he warned of a “run on the shadow banking
system” at the 2007 Jackson Hole conference. McCulley was referring to the opaque Wall Street world of asset-backed commercial paper; structured investment vehicles; subprime residential mortgage-backed securities; and collateralized debt obligations.
The universe of more than 11,000 Indian shadow lenders draws its sustenance from formal banks, as well as from companies and individuals looking to deploy short-term surpluses. As yield-seeking capital comes into mutual funds, their managers buy commercial paper issued by operating finance companies (OpCo) as well as subscribe to bonds issued by the finance firms’ holding companies (HoldCo). The OpCo lends to home buyers, small businesses, and students as well as property developers, while the HoldCo brings in the funds borrowed from mutual funds as equity in OpCo. The minimum capital requirement of 15 percent of risk-weighted assets is easily met even as shadow lenders’ balance sheets expand by 20 per cent or more.
The shadow lenders, pumping out 30 per cent of all new credit over the past three years, are the reason why the Indian economy isn’t withering for lack of finance, despite a serious banking crisis: Eleven out of 21 state-run banks
are languishing in a regulatory prison. (The central bank wants them to boost their depleted equity before they can meaningfully expand their loan books again.) New skyscrapers are coming up, and small businesses are using loans against property to meet their working-capital needs. Traders are getting finance by pledging warehouse receipts.
This is where a comparison with China is useful. At 14 per cent of GDP, India’s shadow-banking universe is much smaller than the 70 per cent ratio in the People’s Republic, as Moody’s Investors Service notes. But while Beijing has successfully shrunk the industry from 87 per cent of GDP at the end of 2016 — a drop of 17 percentage points — New Delhi can’t afford the nonbank lenders to stumble even accidentally. If they retreat, capital-constrained local banks
won’t be able to take up the slack. Nor will an indebted Indian government be able to offset a resulting economic slowdown, the rating company said.
That’s why during the crisis of confidence triggered by IL&FS’s $12.8 billion bankruptcy, emergency liquidity support for shadow-banking became a contested issue between the government and the central bank, which wasn’t keen to deploy its balance sheet to take on private credit risk. The worst of the September stress has eased, but concerns about elevated funding costs remain. “Weaker balance sheets are going to fall off,” Saurabh Chawla, the outgoing chief financial officer of DLF Ltd., India’s largest listed property developer, told Bloomberg News.
Now that New Delhi has replaced an independent-minded technocrat at the Reserve Bank of India with a former finance-ministry bureaucrat, it’s reasonable to expect that shadow banks will be encouraged to expand again. The RBI is finicky about who gets a banking license, but even owners of bankrupt power firms are welcome to write home loans. Nor do the markets discriminate. Mutual funds are happy to lend based on inflated credit ratings, as became evident when IL&FS
blew up. As that crisis fades from memory, excesses will rebuild, and asset-quality will deteriorate.
Will New Delhi be prepared to pull the rug from under the nonbank lenders if they push things too far? On that count, hold no hope. China’s shadow banking
may be a lot bigger than India’s, but India’s is already too big to fail.