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

The potential write-off would place an additional burden on Indian banks already struggling with $130 billion of bad loans, one of the highest levels in the world

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.