Mains Paper: 3 | Economy
Prelims level: NBFCs crisis
Mains level: Policymakers must address the structural problems behind the NBFCs crisis
• The default of Infrastructure Leasing & Financial Services (IL&FS) on several of its debt obligations over the last couple of months has raised serious questions about how regulators missed the growing debt pile of a systemically important financial institution.
• The IL&FS saga has also exposed the underlying weaknesses in the non-banking financial company (NBFC) sector as a whole which has depended heavily on low-cost, short-term debt financing to sustain its shaky business model.
• As both international and domestic interest rates continue to rise, the stocks of NBFCs have been punished as investors expect the profit margins of these companies to come under pressure as their borrowing costs rise.
• NBFCs being unable to roll over their short-term debt in case of a severe credit crunch in the aftermath of the IL&FS saga.
• It is worth noting that the rise of NBFCs was fuelled primarily by the demise of traditional banks which have been unable to lend as they were bogged down by non-performing loans.
Analysing the crisis
• The response of policymakers to the ongoing crisis, which seems warranted if its purpose is to prevent a wider systemic crisis, is fraught with other risks.
• The Reserve Bank of India, the National Housing Bank and the State Bank of India last week decided to increase the supply of liquidity in the market to keep interest rates under control.
• The RBI has also urged NBFCs to make use of equity rather than debt to finance their operations. This is apart from the government’s decision to replace IL&FS’s management and commitment to providing the company with sufficient liquidity.
• While offering easy money may be a welcome measure in the midst of the ongoing liquidity crisis.
• The prolonged supply of low-cost funds to the NBFC sector also creates the risk of building an unsustainable bubble in various sectors of the economy.
• Defaults associated with any such bubbles will eventually only affect the loan books of lenders.
• State bailouts could also fuel the problem of moral hazard as other financial institutions may expect a similar lifeline in the future.
• Policymakers should thus try to focus on taking steps to address structural problems that contributed to the crisis.
• This includes steps necessary to widen the borrower base of NBFCs which have been banned from accepting deposits.
• This would allow NBFCs to tap into more reliable sources of funding and avoid similar liquidity crises in the future.