What’s up with India’s $1.7 trillion financial system? In the space of a couple of years, four major finance companies have been seized by authorities and the central bank has had to reassure the public multiple times. It’s a stark turnaround since the country emerged largely unscathed from the 2008 global financial crisis. Policy makers are grappling with a chicken-and-egg situation: Should they spur credit to boost economic growth or focus instead on cleaning up a banking system with the world’s worst bad-loan ratio?

1. How did it come to this?

The seeds were sown in a debt-fueled economic boom between 2007 and 2012, when banks increased loans by 400%. When the economy began slowing, many companies struggled to repay, making banks reluctant to lend more. That crimped the availability of credit and added a further drag on the economy, heaping pressure on indebted businesses. Some of the slack was picked up by non-bank lenders, or shadow banks, but one of the most prominent -- Infrastructure Leasing & Financial Services Ltd. -- became the first major blowup in 2018 in what became known as India’s mini-Lehman moment.

2. What’s happened since?

The collapse of IL&FS triggered something of a credit crunch and the Reserve Bank of India stepped in to take control of another shadow lender, Dewan Housing Finance Corp., to contain the fallout. A smaller lender also failed in 2019 after allegedly duping investors about its exposure to a property developer. Then, in March 2020, the central bank seized Yes Bank Ltd. in India’s biggest bank rescue, and in November it orchestrated the takeover of struggling Lakshmi Vilas Bank Ltd. by Singapore’s DBS Group Holdings Ltd., the first such move involving a foreign bank.

3. What went wrong?

Yes Bank’s troubles were rooted in the rapid expansion under its former Chief Executive Officer and co-founder Rana Kapoor. In his last full year in charge through March 2018, Yes Bank had the fastest loan growth of any bank in India. Credit Suisse had noted in a 2019 report the company had the biggest proportion of outstanding loans to large stressed borrowers. Authorities are investigating Kapoor for alleged lending impropriety. He denies wrongdoing.

Lakshmi Vilas suffered numerous setbacks in the recent past, including the ouster of its CEO by stakeholders. In 2019, the bank had planned to merge with shadow lender Indiabulls Housing Finance Ltd., only for the regulator to veto the move. The RBI had placed Lakshmi Vilas under watch in September of that year, months after the breach of key thresholds.

4. So it’s not just the economy?

No. India’s bad-loan problem has multiple roots, including government policies. Some borrowers found life harder when authorities suddenly tightened regulations; the courts canceled coal-mining licenses or ordered payment of telecom fees; natural gas supplies dwindled; real-estate prices fell and interest rates rose. Prime Minister Narendra Modi’s unprecedented decision in 2016 overnight to invalidate almost all of the nation’s physical currency devastated supply chains and created dangerous imbalances in the financial system, as Indians rushed to deposit their bills. Making matters worse, there was long a belief among some corporate executives that they could walk away from debts without facing consequences. Regulators allege that some bank chiefs handed out to their cronies many loans that ended up in default.

5. What are authorities doing and is it working?

The central bank in 2015 began assessing the bad loans, bringing to light the full scope of the problem. Gross non-performing assets across the banking sector surged from about 3% to more than 9%, then breached 10% -- the highest in the world. The government has created a new bankruptcy law to aid loan-recoveries but, as the economic growth slows, authorities are taking steps to spur fresh credit and show more lenience toward certain borrowers and small businesses. The central bank warned in July that India’s bad-loan clean-up is set to reverse, with soured debt forecast at 12.5% of total credit by March 2021, the highest level in more than two decades.

6. Are there more difficulties ahead?

Almost certainly. Fitch Ratings warned in July that capital fund-raising plans by Indian state-owned banks from private sources won’t be sufficient to mitigate anticipated risks without additional support from the state. Modi’s government is struggling to find cash to support the state-run lenders that hold most of the nation’s bad debt, and to spur credit. India entered an unprecedented technical recession in 2020 and the central bank said risks are piling up on household and corporate balance sheets that could spill into the financial sector.

7. Any silver lining?

The health of India’s shadow banking sector has improved, albeit from a shaky position. The central bank had been concerned about 10 companies on a list of 50, but is now just focused on four. Healthier shadow lenders could revive credit for consumers buying cars or vacations, potentially giving a shot in the arm to the economy.

For more articles like this, please visit us at bloomberg.com

©2020 Bloomberg L.P.