Suspended Loans and the Rolling Indian Banking Crisis

Indian banks sit on the largest book of suspended loans in the world.

Jun 24, 2020

Marc Rubinstein’s popular essay profiling Jamie Dimon attracted a reply from the CEO himself. Today, Marc is back with a briefing on the looming banking crisis in India.

All over the world loans are going unpaid.

In the UK, a sixth of all mortgages are currently on ‘payment holiday’.In the US one in twelve are. It’s the same across all loan categories. Whether it’s credit cards (4% in the US), auto (12% in the US) or – most striking of all – small businesses (over 20% in the US) whole loan books have been placed in suspended animation.

While the details vary by country, the broad picture is similar across the world. In some countries debt moratoriums have been imposed from on high. In Hungary borrowers only have to make payments on loans this year if they want to. Unsurprisingly over half of them have chosen not to.

In other countries, policymakers have provided guidelines and in yet others lenders have developed their own schemes. In most countries schemes require borrowers formally to seek approval for loan payments to be suspended. Such schemes are not without risk to the borrower. Even though payments are not being made, interest is still accruing and in some cases interest is compounding on the interest. When the UK extended its mortgage deferral scheme to the end of October, the industry body UK Finance warned that borrowers’ overall debt costs would end up higher if they extended unnecessarily.

The degree to which borrowers have embraced deferral schemes depends on the economic shock they face in their respective markets and the bureaucracy involved in deferring. In the US and the UK it looks like deferral applications peaked with Covid cases. In the last week of May a net 35,000 new US mortgage borrowers were given a pass on loan payments. That compares with 50,000 the week before and 100,000 the week before that. Most deferrals in the US and the UK were granted at the back end of March and the first few weeks of April. In contrast, in some markets like Spain, Thailand and Indonesia, they’re still processing a backlog.

Regardless of the specifics, banks across all these markets are united in a single question: How will these suspended loans perform once their deferral periods end? It’s a critical question not just for banks but for all participants in the economy since consumer strength hangs on it.

The problem is that no-one knows the core reason why borrowers are deferring loans. If it’s to conserve liquidity, that’s fine. If it’s because of genuine financial distress, that’s a problem for the banking system. But if it’s because borrowers simply don’t want to pay, then that’s a problem for the whole system inasmuch as it reflects a moral hazard.

In the aftermath of the financial crisis, The Greek government there introduced a foreclosure moratorium on properties in June 2010. Shielded from the penalty of losing their homes, many borrowers chose not to pay. Estimates suggest that by the end of 2013, 28% of defaults consisted of so-called ‘strategic defaulters’. (Sadly, the highest concentrations of strategic defaulters were found “in the industries of law and finance”.)

The Rolling Indian Banking Crisis

All of which brings us to India. Nowhere is the question of how borrowers will emerge from debt suspensions more critical than it is in India.

In May, the Reserve Bank of India extended a loan moratorium that had been in place since the beginning of March through to the end of August. During this six month period, borrowers do not have to make loan repayments; meanwhile their interest compounds. A few keystrokes of a standard issue financial calculator shows that a six month holiday now, with interest compounded, means more than six months of installments need to be added to the overall repayment amount. Not sure that this is fair, The Supreme Court has turned its attention to the issue and will make a ruling next week.

So far, banks and other financial institutions in India have granted moratoriums on between a quarter and three-quarters (yes, three-quarters) of their loan books. Indian banks sit on the largest book of suspended loans in the world.

And if there is a financial system that was ill-prepared coming into this situation it was India.

There are many ways a bank can court disaster:
it can attract fraud (which risk managers call ‘operational risk’);
it can lose access to cash (which risk managers call ‘liquidity risk’) and
it can make bad loans (risk managers call this ‘credit risk’).

In the past two years the Indian financial system has experienced all three.

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Fraud: Punjab National Bank vs Nirav Modi

Nirav Modi was once one of the richest men in India, worth an estimated US$1.75 billion. Born into a diamond trading dynasty, he launched an eponymous retail brand in 2010 and opened stores across the world. But his business was built on a fraud. Over the next eight years Modi colluded with bank officials at a branch of Punjab National Bank in Mumbai to obtain letters of undertaking for making payments to overseas suppliers. By the time it was uncovered in 2018 the fraud had cost the bank a staggering INR 143.57 billion (US$2.23 billion).

Modi (no relation to the Indian Prime Minister Narendra Modi) was arrested in March last year and currently sits in a London jail cell awaiting an extradition hearing. Yet, Punjab National Bank does not seem to have learned. Since the Modi case, it has gone on to uncover two further material incidents of fraud. Without the financial capacity to absorb the losses, it received dispensation to defer the costs and its most recent balance sheet reports a INR 15.8 billion build up of fraud-related charges.

If one fraud is a misfortune, and two is careless, three is systemic.

Punjab National Bank may be the most impacted, but it is not alone. Bank fraud has been rising in India for the past several years. What makes India different from other markets is the role its state banks play. In developing countries, state banks generally make up the minority rather than the majority of market share, typically around 20%. In India they make up 70%. As an extension of the public sector, governance practices in these banks can be quite poor. Boards lack an understanding of risk, the banks are under-resourced in expertise and relevant monitoring technology, and employees are not offered sufficient incentives to prevent or detect fraud early. It is no coincidence that state banks comprise over 90% of bank frauds by value.

Liquidity risk: A classic balance sheet mismatch

In the aftermath of the financial crisis, when Indian banks retrenched to mend their balance sheets, shadow banks emerged to finance the Indian economy. These shadow banks, or Non-Banking Financial Companies (NBFCs), borrowed short-term from banks and mutual funds and lent long-term on real estate and other assets. In the ten years following the financial crisis they provided ~35% of financial resources to the commercial economy with rising market shares throughout.

Problems came to a head in 2018 when one of the shadow banks – IL&FS – defaulted, leading to a liquidity squeeze on them all. Since then, regulators have closed some of the loopholes that gave shadow banks advantages and funding markets welcomed them back. But because capital markets are not as developed in India as they are in the US, shadow banks remain reliant on banks for funding. Currently banks provide around a quarter of Non-Banking Financial Company funding.

Such interconnectedness injects risk into the system. India’s was once the second most intertwined financial system in the world. It has untangled itself since then but there are fears that the current environment is exposing remaining linkages. In times of stress any lending that shadow banks have done can reverse back into those banks that lent to them. Like in many corners of financial markets, there’s an asymmetry here: in good times the shadow bank wins, in bad times the entity behind the shadow bank loses.

Credit Risk: A rolling crisis

Indian banks came into the year with one of the highest rates of non-performing loans in the world.Not as high as Greece, but higher than Portugal, Italy and even Argentina. Even before Covid emerged, the Reserve Bank of India warned that bad debts could rise to 9.9% of total credit by September 2020, up from the 9.0% it had predicted six months earlier.

Originally, a lot of the credit risk sat with the public sector banks. However, it went on to circulate around the entire system. When the public sector banks pulled back on credit around five years ago, shadow banks picked up the baton. And when they hit liquidity issues, private sector banks took over.

The newest, most aggressive private bank was Yes Bank. It grew its loan book by 2.7x over the three years to March 2018. When economic growth began to slow, its loans started to go bad. Unable to raise enough capital, Yes Bank was rescued in March by State Bank of India. A fifth of its loan book is now marked as bad.

Ironically the credit issues faced by the system didn’t emerge from too much lending. India’s credit-to-GDP rate is 51%, which is low by global standards, even while its gross domestic savings rate is in line with peer countries. The credit-to-GDP ‘gap’ is one of the indicators global regulators use to assess vulnerability and India looks OK. Rather, credit issues emerged from the wrong kind of lending.

Unfortunately the Indian credit cycle is turning before any of the vulnerabilities to fraud, liquidity risk and credit risk have been fully resolved.India is suffering particularly acutely from coronavirus with no peak in sight and so the moratorium relief may be necessary to ease the burden while the health emergency is being addressed. But once it is over India may have a financial emergency to deal with.

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