Financial sector problems will slow down real economy’s recovery

More problems have emerged at Dewan Housing Finance Corp. Ltd (DHFL). A media report said that unsecured fixed deposit holders now run the risk of having their money stuck for a while as a forensic audit revealed the possibility of fraud. Consequently, if a probe is initiated by the Serious Fraud Investigation Office (SFIO), repayments of depositrs could be frozen.

The problems at DHFL, when viewed alongside a year’s negative developments in India’s shadow banking sector, signals a gloomy outlook for the financial sector. The situation is unlikely to improve meaningfully in the next 12 months.

India’s shadow banks are the ubiquitous NBFCs. At the end of March 2019, there were 9,659 NBFCs registered with RBI, of which only 88 were deposit taking firms.

The shadow banking problems and the risks they pose to financial stability come from their linkages to banks.

The consolidated balance sheet size of NBFCs at the end of March 2019 was Rs 28.8 trillion, or about 15% of the size of the economy as measured by GDP. In the recent past, the balance sheet size of NBFCs as a group has been growing faster than nominal GDP.

The financial stability risks and attendant negative impact on the wider economy come from two factors.

One, about 70% of total liabilities of NBFCs is from public funds, particularly through borrowings from banks and debentures. Bank exposure in NBFC liabilities has increased by about 8 percentage points in the last two years to 29.2%.

Therefore, problems in NBFCs influence banks, both in financial and behavioural terms.

Linked to the problem mentioned above is the uncertainty about the true state of affairs in shadow banks. How serious are their liquidity problems?

In this context, a story on DHFL in Mint quoted a deposit holder who observed that the company had AAA rating and a 25-year history.

How many lenders are today wondering if the credit rating and audited accounts are reliable indicators?

The combination of these factors will in all probability gum up the flow of money. Shadow banks, to begin with, undertake liquidity transformation by investing in illiquid assets by sourcing liquid funding. In the process, they run the risk of defaults if the funding sources begin to dry up in the backdrop of distrust.

Another fallout will be that the risk premium on loans will increase. In other words, an increase in risk premium works against RBI’s attempt to lower the interest rate level in the economy.

The real economy’s performance the next year will be adversely affected by the financial sector problems.

DISCLAIMER : Views expressed above are the author’s own.

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