MONTH AFTER MONTH, finance ministry and Reserve Bank of India (RBI) have been citing improved asset quality of banks, robust credit off-take and strong earnings growth as evidence that the economy is on the right trajectory. On the face of it, this may be true, but disaggregated data paints a different picture. Before getting into that, here is a brief backgrounder.

Recall how three big NBFCs, IL&FS, DHFL and HDIL, collapsed one after the other beginning 2018. This also led to collapse of Punjab And Maharashtra Cooperative Bank (in 2019) and Yes Bank (in 2020). The chain of events created panic in the economy as credit dried up and a fresh NPA crisis emerged. Central government asked SBI and LIC to pump in money to save IL&FS and Yes Bank. DHFL, HDIL and PMC went into bankruptcy.

What caused the collapse of NBFCs and banks together? Their finances were interlinked and all of them were done in by massive fraudulent activities involving mala fide loans and money laundering. Hundreds of shell companies, supposedly rooted out by government, also tumbled out, further demonstrating lax regulations. Since NBFCs source a big chunk of their funds from banks, lax regulation meant financial risks travelled to banks and the rest of the economy. RBI’s Financial Stability Report (FSR) of July 2020 pointed out that NBFCs’ bank borrowings went up from 23.1% in March 2017 to 28.9% in December 2019.

Since then, RBI has taken several measures to tighten oversight of NBFCs, but its ineffectiveness is all too evident.

Quantum Jump In Bank Credit To NBFCs

RBI’s October 2023 bulletin says NBFCs’ bank borrowings went up to 41% (of their total borrowings) at the end of March 2023 (FY23), a massive jump from 35.5% at end of March 2022 and 33% at end of March 2021. This data also confirms rise in credit to NBFCs as proportion of total credit to non-food sector from 8.3% in FY21 to 8.6% in FY22 and 9.7% in FY23. In September 2023, it stood at 9.4%. NBFCs are part of the services sector.

Recognising the financial risks, RBI Governor Shaktikanta Das warned in the bulletin: “Banks and NBFCs would be well advised to strengthen their internal surveillance mechanisms, address build-up of risks, if any, and institute suitable safeguards in their own interest. The need of the hour is robust risk management and stronger underwriting standards.”

However, it is RBI’s Centre for Advance Financial Research and Learning (CAFRAL) which has spelt out in detail how rise in bank lending to NBFCs is creating financial risks. Its November 2023 report, “India Finance Report 2023: Connecting the Last Mile,” takes into consideration data up to H1 of FY23, when bank lending to NBFCs had risen to 36% (as against 41% in full FY23). The report flags four points about financial health of NBFCs:

(i) Rise in bank borrowings by NBFCs raises concerns about “systemic contagion” and underscores the need for tighter preventive measures to mitigate potential systemic fallout; public sector banks are the largest lenders and most of it is “direct” lending (lending through debentures and commercial papers is a much smaller component).

(ii) On assets side, there is “a large fall in secured borrowings” and “a marginal increase in unsecured borrowings,” showing “increased exposure to riskier finance”; there is also a “significant fall in reserves and surplus,” indicating “buffers grow thinner.”

(iii) Capital market exposures, led by equity share ownership, increasing risk; this “risk-taking behaviour” is prompted by interest rate tightening.

(iv) There are concerns about “spillover of losses” from online lending to traditional banking; the stronger the linkages between traditional lending and online lending, the larger the spillover; hence, digitalisation needs to be “accompanied by quick and nimble regulation.”

The question that must strike is — why are banks lending more to NBFCs despite knowing the risks? The answer is that banks are either developing risk aversion (for lending directly) or not finding enough takers as it happened during 2017-19. Banks had cut down lending drastically after the collapse of NBFCs. Finance ministry and RBI know the reality but robust growth in overall credit outflow to non-food sector from 5.5% in FY21 (pandemic fiscal) to 15.4% in FY23 has provided a convenient cover for ignoring it. There is enough evidence of banks’ aversion or no takers for their loans because the economy is slowing down.

Risk Aversion Or No Takers?

RBI recently recast its data system, removing details of credit outflows in pre-January 2019 period. Even then, the disaggregated data between January 2019 and September 2023 show that within the credit outflow to non-food sector, share of personal loans went from 24% (of non-food off-take) in January 2019 to 31.9% in September 2023.

Of this, gold loans went up from 0.3% to 0.6%. Credit to NBFCs went up from 7.2% to 9.4%. Credit to large industry went down from 24.2% to 17%, to ‘industry’ as a whole from 29.3% to 22.9%. Credit to MSMEs rose from 5.1% to 5.9%. Credit to services went up from 23.7% to 26.6% and to agriculture from 11.7% to 12%. The rise in credit to services is driven by NBFCs.

The above points reflect double inversion in credit outflow — personal loans and services overtaking ‘industry’ and ‘large industry’ in quantum. It must be kept in mind that loans to industry and services reflect the need for working capital and investment to produce more goods and services. Personal loans, on the other hand, are meant only for consumption expenditure in which NBFCs provide the last-mile connectivity. Hence, rise of credit to services should count as rise in personal or consumption loans.

That there are fewer takers for bank loans in industry is also evident in (a) eight-month fall in PMI in October 2023, and (b) three-month fall in growth of industrial production.

Balance sheets of banks and NBFCs are surely better now than during 2017-19 but it shouldn’t be forgotten that this happened more because of (a) massive NPA write-offs (₹14.5 lakh crore since FY15) and recapitalisation (₹3.12 lakh crore) of banks (b) recapitalisation of NBFCs by SBI and LIC (mentioned earlier) and (c) removal of collapsed NBFCs and banks (those that went into bankruptcy).

Days after RBI’s October bulletin and CAFRAL report, RBI realised the gravity of the situation and raised capital to risk-weighted asset ratio of banks and NBFCs on November 16 by 25 percentage points to 125%, back to the 2019 level, to cover unsecured loans (personal loans, excluding housing loans, education loans, vehicle loans and loans secured by gold and gold jewellery, but including credit to NBFCs) which, industry estimate shows, will cost banks ₹84,000 crore in excess capital, raising borrowing costs for consumer loans.

That the improvement is not because of better governance, regulatory oversight or credit culture of corporations is also evident.

Willful Defaults And Bank Frauds Grow

As per the RBI-registered Transunion CIBIL database, willful defaults (of over ₹25 lakh) jumped from ₹3.04 lakh crore in FY22 to ₹3.55 lakh crore in FY23, a rise of ₹50,000 crore. Number of willful defaulters went up by 2,002 during the period. Perhaps that is what prompted RBI to issue “Framework For Compromise Settlements and Technical Write-offs” on June 8, 2023, handing over power to bank boards (i) to go for ‘compromise settlements’ with willful defaulters and (ii) give fresh loans to willful defaulters after 12 months of such settlements. The earlier 2019 framework didn’t allow such “restructuring” or “evergreening” of loans.

Fortune India had then pointed out that this was an invitation to more willful defaults and banking frauds. As per RBI, willful defaulters are ones who have the ability to pay but don’t and divert loans for other purposes. A compromise settlement involves a sharp haircut. The number of willful defaulters (CIBIL) was rising even before RBI’s 2023 framework for compromise settlement. Giving willful defaulters access to fresh loans points to the probability of further spike in such cases.

Along with willful defaults, banking frauds have also risen in recent years, both in and after 2018. Their number jumped 17 times during FY15-23 to 5,88,744 from 34,198 during FY04-14. The amount involved nearly doubled (1.9 times) to ₹65,812 crore during FY15-23 as against ₹34,904 crore during FY06-14, as per the RBI data. That is not all.

Credit Culture, Respect For Governance

On November 9, 2023, Supreme Court upheld the constitutionality of the IBC provision (introduced in 2019) expanding insolvency proceedings against personal guarantors. This judgement shows two bad corporate governance practices: (i) it wasn’t part of the IBC of 2016 but inserted three years later in 2019 and (ii) more than 200 petitions were filed before the court to challenge it. Isn’t personal guarantee meant to recover the outstanding if the one taking the loan defaults or fails altogether?

Also, on May 3, the Supreme Court upheld a provision in the Companies Act of 2013 which allowed a five-year ban on auditors found guilty of indulging in corporate frauds. It was challenged by auditors of IL&FS Financial Services Ltd — BSR & Associate, a KPMG affiliate and Deloitte — in the same case mentioned at the beginning. The auditors took the plea that since they had resigned from the firm — even though it was post facto and their collusion in the banking fraud had been proved by then — they shouldn’t be prosecuted or banned.

The last two instances show scant respect by corporations for both good corporate governance practices and law of the land.

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