Fragile financial markets need calm assurance

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Published: Tuesday, 02nd October 2018

September 15 this year marked the tenth anniversary of the collapse of Lehman Brothers, a century old gold standard investment bank of Wall Street. Its bankruptcy had a domino effect, leading to a deep financial crisis across United States and Europe. It is now popularly referred to as the Global Financial Crisis, although strictly speaking it was the North Atlantic Financial Crisis (NAFC). It led to an economic crisis, as GDP growth became negative, unemployment rose to more than 11 per cent in the United States itself and more in Europe, and bank lending froze. In a globalised world, India and other Asian economies did not remain immune. In October and November of 2008, as liquidity conditions became tight in India, mutual funds faced huge redemption pressure. Investors wanted to encash their units (also called net asset value, NAV) as the stock market was crashing. In order to pay out cash to their investors, the mutual funds had to liquidate their own stock holdings, causing a further fall in the stock and bond markets. This downward spiral can be bottomless. 

This crisis in India’s financial sector was ironic, because unlike the United States, where the crisis originated as mortgages given to zero income borrowers (the so called “subprime crisis”), Indian banks did not have a mortgage loans problem.   Even then, the contagion effect and investor panic in India could not be avoided. Financial markets are notoriously prone to herd behaviour and irrational panic, which can precipitate a crisis even in reasonably sound economies.

In a very unusual and unorthodox approach, the Reserve Bank of India, which is not the regulator for the mutual fund industry, stepped in to offer emergency liquidity support. Investments in mutual funds are never “assured” in the same sense as a fixed deposit in a bank. Yet the funds can face a liquidity crisis, in case of massive redemptions. Thus, support and assurance from the RBI was crucial and timely. Thanks to this, the actual redemption pressure waned, and even the NAVs stabilised. Subsequently, the stock market recovered, and investor confidence was restored.  This crisis in India’s financial sector was ironic, because unlike the United States, where the crisis originated as mortgages given to zero income borrowers (the so called “subprime crisis”), Indian banks did not have a mortgage loans problem.   Even then, the contagion effect and investor panic in India could not be avoided. Financial markets are notoriously prone to herd behaviour and irrational panic, which can precipitate a crisis even in reasonably sound economies.

On the occasion of the Lehman anniversary, India is once again facing a mini-crisis of its own, caused by a non-bank finance company called IL&FS. The current situation, too, will call for unorthodox measures, and fundamentally calming nervous and panicky investors. But first let’s rewind a bit, and recall the problem of bad loans i.e. non-performing assets of banks. The NPAs have risen three-fold in the past five years, from around rupees 4 trillion to rupees 12 trillion. The government is focused on solving this hard NPA problem. Three fourths of banking anyway is under public sector ownership. The steep rise in NPAs is mostly due to a belated recognition of the older, serious problems. The Reserve Bank of India is enforcing recognition norms more strictly now. Indulgent forbearance is gone, and that’s a good thing. 

Many of the projects under the ILFS umbrella have secure and ringfenced cash flows coming in from government entities or through tolls. Yet one default has the potential to cause a domino effect. Suddenly all the borrowers and investors are nervous. One prominent mutual fund sold an ILFS bond at a discount, as if signalling it wanted to make a distress sale to get rid of that bond.

Eleven banks are under “Prompt Corrective Action” of the RBI, which effectively means a freeze on fresh lending, unless prior bad loans are tackled. One side-effect of this has been that bank credit to industry has virtually stagnated. In the past four years since January 2015, the cumulative growth to industry has grown by barely 1 or 2 per cent. In the current year, between April and August, credit off-take by industry actually declined by 1.4 per cent. This was across micro, small and large industry. Of course, loan growth to other sectors, like retail (personal) loans or to services sector is growing relatively healthily.  

But bank credit to industry is stagnant. Into this space vacated by bank loans has been the resurgence of Non-Bank Finance Companies, or NBFCs. There are thousands of NBFCs, of which a dozen or so have grown handsomely. Unlike banks, NBFCs do not accept public deposits, and depend on continuous borrowing from banks or capital markets for their funding. They are nimble. They provide loans to small and large industries, to housing and real estate as also to infrastructure. And they also have lighter regulation. They need to continuously borrow short term, to fund long term assets. This is called “maturity transformation” between their liability side (funding) and their asset side (loans). So long as the assets that they are building are financially healthy, and repayments are steady, the NBFCs are able to attract fresh investors and funding, and can keep expanding their balance sheet. But the maturity mismatch (short term borrowing funding long term assets) normally doesn’t create a problem because the investors (funders) trust the health of the underlying business, and the competence and integrity of the management.

Just as in 2008, we should be prepared to use unorthodox means of liquidity and funding support, to prevent a small problem from becoming a full-blown crisis. Otherwise in finance, panic feeds on itself. Psychology trumps economics. Sound companies can be demolished by irrational stampedes.

Into this scenario is India’s mini-crisis unfolding. A hitherto gold standard name in non-bank space called Infrastructure Finance and Leasing Services Company (ILFS) is facing a funds crunch, and has defaulted on payments. ILFS is three-decade old AAA rated lender which has financed projects worth more than 1 trillion rupees. It is the parent of a web of 169 companies, some of which are listed. One third of ILFS is foreign owned, and another one fourth is by LIC. Many of the projects under the ILFS umbrella have secure and ringfenced cash flows coming in from government entities or through tolls. Yet one default has the potential to cause a domino effect. Suddenly all the borrowers and investors are nervous. One prominent mutual fund sold an ILFS bond at a discount, as if signalling it wanted to make a distress sale to get rid of that bond. ILFS entities have moved the NCLT to get protection from lenders. The RBI says that ILFS balance sheet showed negative net owned funds since at least two years ago. The rating agencies have downgraded a AAA company to junk status within a span of 45 days. In such a fast-moving scenario, panic can be self-fulfilling, and can precipitate a full-blown crisis. 

Since financial markets are interlinked, the stock market too is affected. In the month of September, the mid cap and small cap indices have fallen sharply, reflecting investor bearishness. It is here that we need a calming assurance from the very top, i.e. from policy makers and the regulator, to ensure that the resolution of the ILFS problem will be orderly. Just as in 2008, we should be prepared to use unorthodox means of liquidity and funding support, to prevent a small problem from becoming a full-blown crisis. Otherwise in finance, panic feeds on itself. Psychology trumps economics. Sound companies can be demolished by irrational stampedes.

(The writer is an Economist and Senior Fellow, Takshashila Institution)