How a potential $5 bn DHFL write-off can worsen the shadow bank crisis

India’s surprise seizure of a troubled shadow bank won’t end the woes of its lenders, faced with the risk of heavy write-offs if Dewan Housing Finance Corp. is declared a fraudulent account.

That’s because the Reserve Bank of India requires banks to provision fully for their entire exposure over four quarters if they decide a loan account involves fraud. The decision on Dewan will be based on a final report by the international accountancy firm KPMG on the firm’s lending practices, which is due to be submitted soon, according to bankers with knowledge of the matter, who asked not to be identified further.

An interim KPMG study of Dewan’s books earlier this year cited anomalies including 165 billion rupees of loans to entities connected to the company’s founders, equivalent to just under half of the banks’ total exposure of 380 billion rupees ($5.3 billion) to the shadow lender.

“If Dewan is tagged as a fraud account that will create significant additional provisioning requirement and will further dent the profits of banks,” said Mitul Budhbhatti, the head of financial institutions at CARE Ratings Ltd.

A total write-off would counter some of the optimism about efforts to contain the shadow banking crisis sparked by the Reserve Bank of India’s Wednesday move to remove Dewan’s management and initiate bankruptcy procedures. It would place an additional burden on Indian banks already struggling with $130 billion of bad loans, one of the highest levels in the world.

Only about 55 billion rupees of provisions would be required if the KPMG report absolves Dewan of irregular lending, Budhbhatti said.

Dewan has been struggling to repay its loans as the spreading shadow banking crisis has shut off new credit to the sector. The company’s shares are down more than 90% so far this year.

Lenders, headed by Union Bank of India, have formed a committee to discuss a debt resolution plan, which will have to be reviewed by a resolution professional once Dewan is admitted to the bankruptcy court. In February, they appointed KPMG to look into Dewan’s books following allegations by Indian website Cobrapost that the company had diverted funds to shell companies.

KPMG’s preliminary report, a summary of which was reviewed by Bloomberg News, said it was selected to look into Dewan’s accounts for the period between April 2015 and March 2019 to identify any “diversion of funds/misuse of funds outside the business/beyond the uses approved by lenders.”

It said Dewan disbursed loans and advances to “inter-connected entities” and “individuals having commonality with DHFL promoter entities” amounting to 197.5 billion rupees over the period of the study, with a total outstanding amount of 165 billion rupees on March 31, 2019.

The preliminary report said Dewan “could not provide a robust and well-defined tracking mechanism for end use monitoring of funds disbursed.” More than half of the connected entities had minimal operations, the report said, though it added that further research was needed as to whether they constituted related parties under the Indian Companies Act.

Representatives for Dewan and KPMG declined to comment.

One way of mitigating the fallout from Dewan, if irregularities are confirmed, is for banks to request special dispensation from the RBI to allow them to provide only for any amounts potentially earmarked as fraud, as opposed to the entire exposure. Banks reported 957.6 billion rupees of fraudulent accounts in the six months ended Sept. 30, according to India’s Finance Ministry.

And while other weak shadow banks would be hurt by the fallout from a total write-off at Dewan, the stronger ones might benefit, according to Gaurang Shah, vice president at Geojit Financial Services Ltd.

“It could also be an advantage for strong housing finance companies to garner larger market share and have better earnings,” Shah said.

Shadow banking crisis claims another victim; fin stocks a drag on Sensex

India’s unfolding shadow banking crisis has claimed another victim: the index-tracking funds investing in the nation’s stocks.

Financial stocks account for nearly half the value of benchmark S&P BSE Sensex and have been among the biggest drag on the gauge since it hit a peak in June. State Bank of India has been the biggest hindrance among stocks that have had the most negative influence, according to data compiled by Bloomberg.

“Most investors would welcome the idea of sector-specific caps,” said Gaurav Sinha, associate director for asset allocation at WisdomTree Investments in New York. “It’s a way to mitigate risks.” Wisdomtree’s $1.2 billion India Earnings Fund doesn’t allocate more than 30% to any one industry, he said.

Financials, whose weighting in the Sensex has more than doubled in the past decade, have seen sharp erosion in their share prices in wake of the yearlong crisis in India’s credit markets. Yes Bank Ltd. has slumped more than 70% this year, the worst performer on the gauge, and Indiabulls Housing Finance Ltd. was removed from the NSE Nifty 50 Index last month after the mortgage lender’s value more than halved.

Introducing a cap on sector weighting is an idea the National Stock Exchange of India Ltd. floated early this year, stirring a debate. Asia Index Pvt., a venture between BSE Ltd. and S&P Dow Jones Indices LLC, independently said sector-wise caps for benchmark gauges will hurt products linked to such indexes, in addition to increasing trading time and costs.

Shadow banking crisis claims another victim; fin stocks a drag on Sensex

To be sure, most benchmark indexes globally don’t limit the influence of industry groups. Curbs could stop the indexes from reflecting the dynamics of the underlying economy, said Hemant Kanawala, head of equity investment at Kotak Mahindra Life Insurance Co.

“The risk is there, but artificial constraints may not be the right answer,” said Kanawala. “One way could be to change the index methodology; that would be less distortive and would still allow the market to decide.”

SBI to ramp up small business lending as private banks, NBFCs grow cautious

India’s largest lender is hoping to capitalise on the country’s shadow banking crisis by building its mortgage and small business loan book as the non-banks are forced to pull back.

State Bank of India, which is slowly emerging from a period of massive provisioning on loans to large corporates like Essar Steel India Ltd., sees opportunities in taking business from the shadow banks without creating new asset quality problems, according to Chairman Rajnish Kumar.

“We are not shying away from any business but that does not in any manner mean that we are going to dilute our underwriting standard,” Kumar said in an interview. "And I believe there is sufficient business that meets our underwriting standards."

India’s shadow lenders have been under pressure since last year, when a series of defaults by Infrastructure Leasing & Financial Services forced the government to intervene and exposed weaknesses in the sector. The crisis has forced non-banking financial companies to sell assets and restrict new loans, giving state-owned lenders an opportunity to claw back market share they have lost over the past decade.

Kumar said SBI’s strong capital gives it the leeway to seek more mortgages and small business loans, which had been a focus for the NBFCs before the crisis erupted. That should help the bank attain its target of 11% loan growth for the year to March 2020, Kumar said, slightly lower than the 12% growth of the previous fiscal year.

Privately-owned banks are also showing greater caution, providing another opportunity for SBI, Kumar said. “In a situation where many private sector banks have become very, very cautious, it has opened up lot of headroom available for corporate credit growth for the bank,” he said.

Home loans and other consumer lending accounted for 6.48 trillion rupees ($93 billion), or 32.5%, of SBI’s total domestic lending as of March 31. Advances to companies in India accounted for another 43% of the book, while SME lending was 14.5%.

Government Measures

Despite seeing opportunities in the problems faced by shadow lenders, Kumar said the government needs to take steps -- such as providing partial credit guarantees to the NBFCs -- to prevent wider damage to the economy. The loans provided by India’s shadow banks can’t fully be substituted by the regular banks, he said.

SBI had outstanding loans to NBFCs of 1.87 trillion rupees at the end of March, the majority of which were backed or owned by the central and state governments or by large private sector institutions.

“We recognize that NBFCs were a good conduit for credit growth, and incremental lending has slowed down,” Kumar said. The banks are unlikely to resume lending to weak NBFCs unless the government provides backstop measures such as partial guarantees, he said.

If SBI or other banks are required to provide such loans “then probably lenders will be looking for some comfort from the government,” Kumar said.