In September 2018, IL&FS | a large NBFC with ₹91,000 crore of debt | defaulted. Within weeks, the entire NBFC sector faced a liquidity crisis. Mutual funds stopped lending. Interest rates for NBFCs spiked. Housing finance companies saw their stocks fall 50-70%. The contagion spread to real estate, auto, and consumer durables. All because one large credit institution couldn't roll over its short-term paper. Understanding the credit cycle is not optional for Indian equity investors.
How India's credit cycle works
The credit cycle follows a predictable pattern:
- Expansion phase: RBI eases rates → banks and NBFCs lend freely → credit growth accelerates → businesses invest → employment rises → consumer spending grows → corporate earnings improve → equity markets rise
- Peak phase: Credit growth is high, but lending standards have loosened | more risky borrowers are getting loans. Asset prices (real estate, equities pledged as collateral) look good. Leverage builds up.
- Contraction phase: RBI hikes rates OR a credit event occurs (IL&FS default) → lending tightens → credit growth slows → investment pulls back → earnings slow → equity markets correct
- Trough/recovery phase: Bad loans are cleaned up (NPAs recognised and provisioned) → balance sheets are healthier → new credit cycle begins
The NBFC sector | India's shadow banking system
NBFCs (Non-Banking Financial Companies) are financial institutions that lend but don't hold banking licences. They cannot take demand deposits (unlike banks) but raise money through commercial paper, bonds, and bank loans. India has thousands of NBFCs, from large listed entities (Bajaj Finance, Cholamandalam, Shriram Finance) to small micro-finance institutions.
NBFCs serve segments that banks underserve: vehicle financing (trucks, tractors, two-wheelers), microfinance, gold loans, housing finance for self-employed borrowers, and MSME lending. As of 2024, NBFCs account for roughly 25% of total credit in India | a systemic role that makes their health critical to the broader economy.
The IL&FS crisis | a case study in credit cycle reversal
IL&FS (Infrastructure Leasing and Financial Services) was a large, AAA-rated NBFC that primarily borrowed short-term (commercial paper, bonds) and lent long-term (infrastructure projects). When short-term funding became unavailable in 2018, it couldn't roll over debt. The default shocked the market for two reasons:
- Rating surprise: IL&FS was AAA-rated | the highest possible credit rating | until just weeks before default. It showed credit ratings can be catastrophically wrong.
- Contagion mechanism: Mutual funds held IL&FS commercial paper. Once they faced redemptions and mark-to-market losses, they stopped buying new NBFC commercial paper. This cut off funding for all NBFCs, not just IL&FS.
The DHFL story (2019): DHFL (Dewan Housing Finance Corporation) followed a similar path | asset-liability mismatch, governance issues, eventual default and resolution. Combined, IL&FS and DHFL demonstrated that in India's credit system, asset-liability mismatch in NBFCs is the most persistent risk. Short-term borrowing + long-term lending = structural vulnerability during any liquidity crunch.
NPA cycle | how bad loans move through the system
The NPA (Non-Performing Asset) cycle refers to the rise and fall of bad loans in the banking system. In India, the most recent full NPA cycle ran from ~2012-2022:
- 2008-2012: Banks lent aggressively to infrastructure, real estate, and power sectors. Project costs ballooned. Promoters over-leveraged.
- 2012-2016: Projects stalled. Banks restructured loans repeatedly | kicking the problem forward. NPAs grew but were hidden through "evergreening."
- 2016-2018: RBI's Asset Quality Review (AQR) forced banks to recognise NPAs. Bank balance sheets deteriorated sharply. PSU banks raised capital. Private banks tightened lending standards.
- 2018-2022: IBC (Insolvency and Bankruptcy Code, enacted 2016) resolved large NPAs. Balance sheets cleaned up. By 2022, system gross NPA had fallen to under 5% | a decade low.
Investor implication of the NPA cycle: Banks provisioning for NPAs report lower profits but build cleaner balance sheets. Once NPA recognition peaks and provisioning coverage is high, it signals the beginning of a bank earnings recovery cycle. This is one of the most reliable medium-term signals for banking sector outperformance | provisioning peak → credit cost normalisation → earnings recovery → re-rating.
- Vehicle finance (Mahindra Finance, Shriram)26%
- Housing finance (HDFC merger now in bank, Bajaj Housing)20%
- MSME and business loans16%
- Gold loans (Muthoot, Manappuram)14%
- Consumer finance (Bajaj Finance core book)12%
- Infrastructure and wholesale (the 2018 trouble zone)12%
Credit growth as a leading economic indicator
RBI publishes weekly bank credit data. System credit growth (year-on-year change in total bank credit outstanding) is one of the best real-time proxies for economic momentum:
- Credit growth above 15%: Strong economic expansion underway | positive for banking, NBFCs, and cyclical sectors
- Credit growth 10-15%: Moderate expansion | broadly positive
- Credit growth below 8%: Slowdown signal | watch earnings guidance from consumer companies and capital goods companies
- Credit growth sharply decelrating: Early warning of economic stress ahead
RupeeCase's macro regime model monitors quarterly system credit growth from RBI data. Accelerating credit growth is a positive regime signal | particularly for financial sector factor exposure. Decelerating credit growth triggers a more defensive positioning in the Allcap Multi Asset. The credit cycle dashboard is available at invest.rupeecase.com.
I remember September 2018 very clearly. We were watching short term CP (commercial paper) yields for NBFCs spike in real time, Dewan Housing, IL&FS, Indiabulls, all rolling three month paper that suddenly nobody wanted to take. The equity market had not repriced yet, but the bond desk already knew. If you track one thing to read credit stress in India, it is the spread between AAA NBFC three month CP and T bills. When that spread blows out 200 basis points in a week, something is breaking. Do not wait for Moneycontrol to tell you.
Glossary
Sources & further reading
Quick check, Module 7.7
NBFC Credit Cost Stress Estimator
Credit cost (provisions and write-offs as a percentage of average loan book) is the single largest swing factor in NBFC profitability. Stress-test how much a 50 to 200 bps spike costs ROE.