Amazing rise and spectacular fall of shadow banking in India

Reasons behind the the real estate crisis and ghost cities of India

10 min readDec 1, 2020

Executive Summary

The roots of the current real estate crisis in India can be traced back to the economic liberalization policies of 1990s and 2000s. Just to be clear, liberalization did not cause the crisis. Liberalization led to the increase in financing and development activity leading to surge in stock market, increase in bond issuances and rise in consumer financing including mortgages. Shadow banks i.e., non banking finance companies (NBFCs) played a major role in this increase by raising funding from capital markets and providing funding to real estate developers. The result was that between 2009 and 2019, 5 million apartments were launched in India. In the 10 year period, the size of the housing loans quadrupled to $70 billion increasing the share of NBFCs in financing the economy.

And then the funding for housing projects from NBFCs came to a sudden stop. The result is the ghost cities.

Digression: It took 10 years for India with its huge capital base, large FDI and ample physical and human capital to launch 5 million houses. This is not to say PTI can’t deliver (i.e. not only launch but also complete) 5M houses in next 7.5 years assuming they win the next term. However, they should anticipate the resources that will be required/diverted from other sectors to deliver on this promise considering Pakistan’s much smaller capital stock and investment base.

This post is in three parts. First part chronicles the rise of NBFCs. Second part talks about how the crisis unfolded. Last part is steps being taken to resuscitate the sector. In the end, I have added the links I used. As this is a result of few hours of googling, and then a few hours of copy-paste and editing, this post should not be deemed as an exhaustive or correct analysis or an original piece of research.

Part I: Rise of NBFCs

Commercial banks and state run banks are the primary lenders to real estate and infrastructure projects in India. After the global financial crisis of 2008, commercial banks ended up with large number of bad loans on their books which began rising rapidly in 2012.

Real estate projects are almost always over budget and behind schedule due to delays in getting approvals/permits from government and local authorities. In addition, when large number of projects are launched simulaneously, it results in shortage of skilled manpower/ construction equipment further delaying the projects. This makes it harder for real estate developers to service their debt due to matters beyond their control. Consequently, banks which already had huge NPAs on their books from existing corporate and infrastructure projects, decided to curtail their exposure to real estate projects.

NBFCs took up the slack by not only refinancing the existing loans on the books of the banks but also providing additional financing to developers to complete the projects. Unlike the banks, NBFCs were less stringent in their underwriting criteria. NBFCs financed themselves from two sources. One, borrowing from the banks (the irony__ by lending to NBFCs, banks avoided directly lending to real estate and ended up indirectly lending to real estate). Two, by issuing short term papers and bonds in the capital market which were gobbled up by yield-hungry money market funds (MMFs). From a funding model perspective, NBFCs were committing the original sin of financing: funding long term projects with short term borrowing. When the going was good, this led to increase in the size of NBFCs in the Indian financial system.

Three additional developments led to further enhancing the role of NBFCs.

1. Demonetization

2. RERA Act

3. Unsold Inventory

Demonetization

The November 2016 sudden demonetization byModi government saw a huge increase in deposits of the banking sector. With the economy slowing down under the impact of the unprecedented move, banks had nowhere to deploy these deposits. As a result, the banks were left with no option but to increase their exposure to NBFCs who in turn lent this money to real estate companies.

As the economy recovered from demonetization and GST slowdown, NBFCs lent out additional money to real estate companies.

RERA Act

Earlier in July 2016, Modi government introduced the RERA Act to clamp down on irregularities in construction projects. RERA required developers to one, have all their approvals and permits in place before launching new projects; two, to keep customers deposits in escrow accounts and three, to use deposits meant for a particular project to only be used in project. This meant that developers were required to have their capital invested upfront to launch and complete projects. RERA also required banks to release the funds from escrow based on construction progress. This reduced bank funding to real estate development projects as banks enhanced their monitoring of the projects. Not surprisingly, NBFCs filled this gap.

While on the one hand, RERA was making banks stable by preventing them from lending on speculative real estate projects where the approvals weren’t complete or construction progress wasn’t satisfactory. On the other hand, the unintended consequence was banks started lending to NBFCs who then lent to the very real estate companies that the bank didn’t lend to.

Unsold Inventory

The coverage of Indian real estate problems in media is mainly focused on uncompleted projects. Part of the reason, I think is, it is easy to convey the scale of problem by showing visuals of uncompleted high rises (as in this blogpost earlier). But completed and unsold inventory is also a large part of the challenge. Expecting a large number of middle class to move into upper middle and upper class on the back of rising economy, developers launched number of projects targeted at upper crust of the society. These completed apartments are now lying unsold with the developers.

To give an example, there are 3,000 empty apartments in Mumbai Area with an average price of rupees 10 Crore. There are 3,870 multimillionaires in Mumbai, most of whom already own their homes in South Mumbai (most expensive real estate in the country). There’s a limit to how many homes they want to buy.

In terms of the number of units, unsold inventory in the top 8 cities has risen to nearly 10 lakhs at end-June 2019, compared to annual sales of just over 2 lakh units. Translated into rupees, unsold inventory amounts to Rs. 8 lakh crores, equivalent to around 4 years’ worth of sales.

This unsold inventory also needs to be financed. Can you guess who was financing this inventory.

The result of all these development has been that by 2018–19, NBFCs accounted for the half of 5,000 crore of outstanding real estate loans.

Part II : The Collapse

In September 2018, a seismic event shook the shadow banking sector of India. The event was the collapse of IL&FS which was the largest NBFC and had 90,000 crores of debt outstanding at the time. The seismic waves were felt far and wide because the collapse was completely unexpected. This forced the banks and funds to reassess their exposure to NBFCs. The banks/MMFs realized that the NBFCs they were lending to were in turn lending to real estate (Not as if it was a secret. Willful oversight and/or negligence on the part of banks/MMFs). Makes you wonder whether the analysts, regulators and credit rating agencies were asleep all through the decade of growth. The impact of the event on real estate and finance sector is similar to effect the collapse of Lehman Brothers had on US financial sector.

The banks curtailed their exposure to NBFCs. Money market funds cut their exposure to NBFCs by one third. As a result, funding to real estate companies dried up.

Compounding the problem for the real estate and NBFC sector, Dewan Housing Finance Limited defaulted on their debt in June 2019 and then again on November 2019 on Rs.15.7 billion of commercial papers and convertible debt.

Much later, listed developer Housing Development and Infra Limited (HDIL) went bankrupt, which exposed a long running fraud at Punjab and Maharashtra Cooperative Bank, forcing RBI to cap withdrawals at the bank to Rs. 1,000 per account per day. The bank was concealing books from the RBI, as over time, its exposure to HDIL had become 70% of its assets.

The NPA ratios of the state owned banks with the exception of SBI increased due the worsening loans to NBFCs.

Banks stepped up their direct lending to the private developers with good reputation to fill the gap created by NBFCs, but the bank lending was not enough to compensate for the funding withdrawn by NBFCs. The reduction in credit flow of credit almost dropped from peak of 20 lakh crore in 2018–19 to almost zero within the next 6 months (not all related to real estate and NBFCs but they did have a significant impact).

NBFCs are a major source of funding to MSMEs in India and the impact of this credit crunch would have far reaching impacts on the Indian economy but that discussion is, thankfully, beyond the scope of this post.

In an ironic twist, RERA, which was introduced to reduce the risk in the real estate sector ended up worsening the sector in the short term. Earlier developers would have siphoned off money from other projects to complete their existing ones, but RERA didn’t allow it anymore with the result that even if the developers had funds/liquidity available in a different project accounts, they could not divert it to complete a different project. The result was a large number of uncompleted projects.

Part III: Steps taken

One

RBI cancelled registration of 1,851 NBFCs in 2019, more than eight times than in previous years.

Two

RBI allowed NBFCs to extend loan to developers by one year. This extension was not to be called restructuring as a restructuring required NBFCs to incur provisions in the books. The extension allowed developers not to default on NBFC loan. Not calling it a restructuring allowed NBFCs to not take provisions as that would have meant some NBFCs incurring losses and probably going bankrupt and defaulting on their loans to the bank thus turning a real estate and NBFC crisis into a banking crisis.

Three

There is capital available to complete specific projects and special situation funds (SSFs) or Alternative Investment Funds (AIFs) have been established for that purpose. The SSFs provide funding to complete the projects based on the following criteria

The project should be advanced stage of construction i.e. 50 to 70% complete.
Pre-sales of 30 to 60% should have been achieved.
Existing lenders to allow NOCs for the fund to have priority charge i.e. existing lender to take second change.
IRR return from high teens to low 20s.
Timeline to repayment: 12 to 36 months.

The largest is Special Window for Affordable and Middle Income Housing — I (SWAMIH-I) fund, which is a sovereign fund to infuse liquidity into affordable and middle income housing projects, with a capital base of 25,000 crore. Swami is sponsored by the Ministry of Finance, Government of India, and is managed by SBI Cap Venture, which is a wholly owned subsidiary of State Bank of India. It is expected SWAMIH will restart 1,500 projects bringing to completion around half a million housing units.

SWAMIH will fund only RERA approved projects. Ministry of Finance has established a strict monitoring mechanism for the projects that will be funded by SWAMIH

By July 2020, SWAMIH-I had disbursed Rs.8,767 crore for 81 residential projects, which will enable completion of 60,000 homes across India.

In addition, private sector entities have also raised SSFs to invest in stalled or semi-constructed projects. The total size of private SSFs is around Rs. 35,000 crores. 60% of this money is from US based funds, 31% from Asia (excluding India) and balance from other jurisdictions including India. Notable funds are Black Soil which raised 320 crores, Lumos Alternative Investment Advisors raised 300 crores, MPower raised $21 million series-A round and Alpha Core with Rs. 100 crore.

There are two differences between SWAMIH and private funds. SWAMIH, being a sovereign fund, is providing funding at slightly cheaper rates compared to the private funds. Secondly, private SSFs allow developers to take out some existing payment whereas SWAMIH is only for future expenses on the project.

It has to be seen if these developments will help revive the real estate sector in a major way.