The problems in India's financial systems started showing up in 2015, shortly after the then RBI governor Raghuram Rajan forced banks to go for the Asset Quality Recognition exercise. The bad loans given by banks, which were hidden by the process of ever-greening till then, came to the fore. It was found that many public sector banks did not even have enough capital to continue lending.
The government hoped the problem would be fixed by the Insolvency and Bankruptcy Code, which allowed lenders to take the defaulting borrowers to the National Company Law Tribunal and sell them off to recover money in a time-bound manner. In practice, it turned out that the banks had to take a huge haircut in the process - they had to write off 90 per cent or more of the money they were owed in many cases. Nor are all cases resolved quickly.
Meanwhile, bank frauds were on the rise. While the Nirav Modi-Mehul Choksi and PNB fraud grabbed headlines, RBI data shows that bank frauds touched an unprecedented Rs 71,500 crore in 2018/19. Over 6,500 cases of fraud were detected/recorded that year by banks. The higher cases are because of forensic audits ordered by banks in all the NPA cases pertaining to past years.
Even while the regulator and finance ministry were grappling with these problems, the IL&FS scandal erupted. For years, IL&FS was considered a quasi-government body that lent to the critical infrastructure sector. LIC was its single-largest shareholder with over 25 per cent of the shares under its belt, while SBI, HDFC and Central Bank were significant shareholders as well. It turned out that the senior management had been fudging figures and hiding the problems for a long time until it could be hidden no longer.
The IL&FS crisis triggered off an avalanche in the shadow banking or non-banking financial companies (NBFCs) sector. NBFCs have been as crucial for the Indian economy as the banking system - they lend to those who do not get bank loans easily. Real estate projects, commercial vehicle buyers, home buyers in smaller cities, infrastructure projects, small- and medium-scale enterprises, and even consumer durables and automobile sectors have depended crucially on the NBFC sector for loans.
The problem was that many NBFCs had an asset liability mismatch - they would raise money through short-term borrowings from companies, mutual funds and banks and lend money for a longer period. This was not a problem as long as they could roll over their loans. But the IL&FS crisis created a scare in the financial markets and short-term borrowings started drying up. This is threatening to turn into a contagion, with many NBFCs facing a liquidity crisis. One of the biggest names in housing finance - Dewan Housing - is now being seen as a defaulter and no one knows what is next.
Now it is clear that the time for band-aid solutions to the financial sector crisis is over. The RBI and finance ministry need to work together to fix the problem properly. Otherwise, India's economic prospects will take an unimaginable hit.