Greensill Insolvency: Cautionary Tale for Indian Fintech
Our memory is short and lessons from the past may not always ward off the doom. This is especially true of the VUCA environment we live in, that is Volatile, Uncertain, Complex and Ambiguous. Repeatedly we witness, overconfident and over enthused entrepreneurs erupting on the business stage with their disruptive but complex business models and snare even the biggest banks in their net. We often see large and established banking icons such has Credit Suisse, which instituted extra sturdy risk management systems after the 2008 financial meltdown, falling prey to being shown a picture of the glorious future where they will earn fat fees and executives amassing obscene bonuses. In their single-minded focus on profits and bonuses, they fail to see the underlying weaknesses of the disruptive model, which they are backing. VUCA inevitably teaches a painful lesson to such institutions and individuals.
The 2008 global financial meltdown, also referred as The Great Recession, was triggered by the bursting of housing loan bubble in the United States. The biggest casualty was the demise of Lehman Brothers. It continued to buy securities rated AAA and thus low risk which were later found to be high-risk based on subprime mortgages. Moody’s which rated these securities was later fined by $848 million by the U.S. government in. Did the system learn? Perhaps no.
Circa 2021, a fintech company Greensill Capital which was in the business of supply-chain finance (SCF) was declared insolvent under similar circumstances. SCF is a centuries old financial instrument also known as factoring or bill discounting. This is a short-term instrument to help companies get prepayment from banks, from 1-3 months, on supplier invoices to augment their working capital funds while the banks get paid by the buyer once seller’s credit period is over. Up to this point the business is low-risk and millions of small businesses benefit from it. Greensill started extending the tenure of SCF from 30 to 180 to 360 days which essentially means that these funds were not being used as a short-term working capital but obtaining a credit-line from the issuer. Therefore, in practice, this was an unsecured credit. However, the SCF was not shown as debt in the books of accounts and thus escaped the scrutiny of the regulatory authorities. The SCF business was worth $26bn. in 2020. Greensill made its money through extending the tenure of supply-chain facility to its clients who would not be entertained by the bigger banks due to their poor creditworthiness.
Within the bounds of usual supply-chain tenure, which averages around 30 days, it was a safe business but as the tenure increased so did the uncertainty and repayment under difficult business conditions such as covid pandemic. Softbank supported Greensill used investor funds of to provide these unsecured loans in the guise of supply-chain finance. As the business became more profitable, Greensill kept on extending such unsecured loans amounting to billions of dollars. Further, Greensill innovated the model further and started offering advance funds against predicted future invoices, often with no obvious predictive evidence, extending unsecured loans dressed up as something less risky and without any disclosures. These loans were securitized through asset managers such as Credit Suisse and sold to gullible investors. Greensill securities was also given top ratings.
This suited struggling firms who were turned away by traditional banking system and was a win-win situation for all, hidden from the regulatory authorities, till VUCA struck in the form of Covid-19 Pandemic and clients started defaulting.
What are the lessons for India? Fintech is a new and growing part of the commercial lending business in India and to compete with the traditional banking channels, they offer easier and faster access to funds. These not subject to strict regulation and often resort to risky lending practices.
According to the data on the National Automated Clearing House (NACH) platform in November of last year, as much as 40.1% of auto-debit transactions by volume in October had failed, largely due to insufficient funds. Most failures were borrowers of non-banking financial companies (NBFC) with poor creditworthiness and as the pandemic struck, it shrank the incomes and borrowers defaulted. Pandemic reluctantly compelled individuals and businesses to borrow afresh from fintech lenders at a high interest rate of up to 30 percent.
There are more than 63 million Micro, Small and Medium Enterprises (MSME) in India. They are weakest chain in the Indian business environment with little escape net from VUCA events such as demonetization and Covid-19 pandemic. These are vulnerable to fintech overtures.
Fintech sector will witness increasing velocity, innovation and disruption and expand the market for SCF in a big way. Fintech is also attracting a large amount of private equity which expect large financial returns.
Therefore, under these circumstances, it would not be difficult for another adventurous Greensill to present a dazzling new product. It is for the RBI to ensure that fintech follow prudent business practices without restricting the lending to the small sector. RBI can look at two suggestions to protect the fintech sector.
The first is to use technology to oversee technology-based lending products. The most important of these is blockchain. If blockchain was instituted at Greensill, the system would have rejected the extended tenure SCF.
The second is to strengthen the Risk Management System (RMS) in lending companies. In both, Lehman Brothers and Greensill, the Chief Risk Officer’s caution and advice was overruled. In India too, Risk Management Committee at ILFS had not met for two years before the crisis broke. Our entire banking system has outdated and poorly managed RMS. The government should consider giving the same weight to RMS as to statutory audits. These two steps will reduce, if not totally prevent excesses to a large extent.
