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Shadow banking emerges as the “Iron Man” of India’s financial services

(ATF) India’s troubled shadow banking sector may not be firing on all cylinders yet, but it is riding out its worst crises, and even impressing experts with its resilience. However, concern remains with the smaller shadow lenders who continue to face funding challenges and may need hand-holding for a while longer.

According to a Bloomberg review of the sector, India’s shadow banks remained resilient in August, suggesting that record stimulus steps by the Reserve Bank of India and government are helping the crisis-hit sector ride out the pandemic.

Tracking the index of AAA rated five-year notes, Bloomberg noted that with premiums on shadow lenders’ bonds falling to a two-year low, the sector is increasingly gaining the confidence of its fund providers. Besides, others important indicators like liquidity and share performance remain steady from the previous month, also showing that the sector’s financial strength is improving.

“The most significant development lately has been that (loan) recoveries have improved significantly over the past few months reaching a level of roughly 85% as of August,” Raman Aggarwal, president of Delhi Hire Purchase & Leasing Companies Association, told ATF.

Aggarwal who was recently an executive at one of the largest shadow banks in India added: “Overcoming the pandemic, which was its worst ever crisis in decades, also shows with every crisis the sector has emerged stronger – they are the Iron Man of India’s banking and financial services industry (BFSI).”

Stimulus-aided recovery

Shadow banking or shadow lending refers to high-yield lending by non-banking financial companies (NBFCs). They are so called because they operate outside the regular banking sector, which is subject to strict regulations and rules of the central bank.

Their reach extends into many corners of the economy, as they lend to a wide range of businesses from road-side teashops to tycoons. They are often the only source of credit for two-thirds of India’s 1.3 billion people living in the countryside and hence, are also integral to the country’s economy.

Shadow lenders borrow from cheap short-term lending windows on the bonds market and from mutual funds, institutional and corporate investors, then lending it on to long-term borrowers at higher rates of interest.

In a booming economy when money flows uninterrupted, this model works well as older short-term debts are rolled over by raising fresh loans, but when the liquidity sluice gates start to close their business model breaks down. Such a crisis hit in 2018 when two large NBFCs unexpectedly defaulted on repayments on loans they took from banks and mutual funds.

That stunned investors including the mutual funds, who were generously investing in debts floated by the shadow banks. The episode also caught out the credit rating agencies that had given the shadow banks their highest ratings just months earlier.

READ MORE: China must guard against rebound in shadow lending: CBIRC

Consequently, the series of rating downgrades that followed triggered a fund exodus as hordes of anxious corporate and retail investors started pulling money from the shadow banks and the mutual funds that had invested in the debts.

Aggarwal said the crisis triggered by the coronavirus pandemic has been worse because “the NBFCs simply had to close shop and sit tight during the months of lockdown”.

To avoid another 2018-like shadow banking crisis and to ensure the sector’s stability, the RBI last month announced a $1.36bn liquidity prop. That followed a $10.3bn special credit line provided to non-bank financiers by the government in May.

Stress still visible, though

Despite signs of recovery amid recent stimulus measures designed to stem the impact of the outbreak, shadow lending is not out of the woods yet.

According to the RBI’s financial stability report in July “smaller and mid-sized, and lower-rated or unrated NBFCs are still shunned by both banks and markets, accentuating their liquidity challenges”.

“Post-Covid 19, while the liquidity of the sector has improved significantly for the bigger lenders, a very large number of NBFCs are still facing challenges because the funds are reaching only those with high credit rating,” Siddharth Purohit, research analyst at Mumbai-based SMC Investments and Advisors told ATF. “The smaller ones are not rated so they are not getting funds.” 

The industry estimates that out of more than 9,500 NBFCs registered with the RBI, just about 90 of them have the top rating.

However, according Ajay Tyagi, a BFSI expert at the largest asset management company in India, Indian shadow lenders are of two types; “the well-managed and the me-too types.”

“While the me-too shadow lenders will continue to face challenges, well-managed shadow banks are clearly coming out of the woods,” Tyagi told ATF.

  • With reporting by Bloomberg.

READ MORE: Indian bad debts could top 12.5% by March

Indrajit Basu

Indrajit Basu is an India-based correspondent for Asia Financial and wears two hats: journalist and researcher (equity). Before joining AF he reported on business, finance, technology, wealth management, and current affairs for China Daily, SCMP, UPI, India Today Group, Indian Express Group, and many more. He is also an award-winning researcher. If he didn't have to pay bills, he would be a wanderer.


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