Fault-lines

The rapid snowballing of debt defaults by IL&FS and its group entities into a system-wide liquidity crunch has exposed well-hidden fault-lines in the workings of both non-banking finance companies (NBFCs) and the Indian bond market. After failing to respond with alacrity to events, RBI and SEBI have attempted to calm frayed nerves by assuring liquidity support and talking up the market. But borrowing costs for NBFCs have shot up nevertheless, reflecting heightened risk perceptions for the sector. The Centre on its part seems undecided too. On Wednesday, IL&FS’ key shareholders LIC and SBI, belatedly told market participants that they wouldn’t ‘let IL&FS go down’. But the modalities of a bailout remain unclear.

The trigger to the crisis came from news reports that DSP Mutual Fund had sold its DHFL bond holdings at a discount to the market rate after failing to find immediate buyers. As the rumour mills went into overdrive about debt troubles at NBFCs, the stock markets resorted to fire sales of NBFC stocks, battering them by 15-50 per cent. Assurances from the affected NBFCs that they faced no debt problems fell on deaf ears. Meanwhile, as the bond market promptly bid up its asking rates for NBFCs, fears mounted that leading NBFCs who were due to refinance their short-term debt would face a sharp spike in costs or even a freeze in funding in coming months. This crisis has exposed three structural weaknesses in the bond market that have so far gone unaddressed. One, despite its burgeoning role in corporate lending, the Indian bond market remains a fair-weather friend, lacking appetite for lower-rated borrowers. This makes it possible for a single default (IL&FS in this case) to virtually dry up funding for an entire sector. For NBFCs, the risk was magnified by asset-liability mismatches aggravated by their chase for high growth in the last three years. Two, the corporate bond market remains woefully lacking in both liquidity and depth, leading to a severe mis-pricing of risks whenever there’s a sudden bout of risk aversion. Three, mutual funds becoming influential players have also added to the fragility of this market. With liquid and short-term debt funds subject to overnight redemption demands, any nervousness in corporate treasuries can trigger a selling spree by funds undermining an already jittery market.

These shifts in the bond market suggest that IL&FS-like episodes can very well recur unless the RBI and SEBI come up with permanent fixes to the liquidity issue in corporate bonds. As variable repos may not help non-bank participants, the RBI may have to consider a special repo window in corporate bonds to provide liquidity to such players. The IL&FS saga is also a reminder that shadow banks in India lack a formal mechanism for early detection and orderly resolution of defaults. Here, the Centre was wrong in shelving the Financial Resolution and Deposit Insurance (FRDI) Bill, because of objections to the unnecessary bail-in clause.