Making sense of the NBFC crisis

Non-Banking Financial Companies (NBFC) are facing severe liquidity issues which have been attributed to their mismanagement of asset liability mixes. It is important to assess the situation and look at possible solutions, because if not tackled, the non-bank crisis can have a contagious effect on the economy.

Background

• Non-Banking Financial Companies (NBFC) and some housing companies are facing liquidity issues. Troubles began when major shadow bank IL&FS Group unexpectedly defaulted.
• IL&FS was a systemically important finance company with a very large balance sheet.
• IL&FS defaulting on its interest and loan repayments set off a panic reaction from lenders across the spectrum, which also led to the crash in the stock markets.
• It prompted a broader shock that made it hard for many companies to refinance their debts.
• NBFCs are thus increasingly finding it hard to access funding.
• History: A few years ago banks were constrained by new regulations and the weight of bad loans on their books, thus outsourcing part of their lending activity to shadow banks. The share of NBFCs in overall credit rose sharply to over 20% from 10% a mere seven years ago.
  • These non-banks played a key role in ensuring credit to risky sectors such as real estate, even while ensuring that banks did not have to bear the risk.
  • However, these shadow banks were much more under-capitalized and under-regulated compared to the traditional banks.
  • And at the slightest hint of trouble (the IL&FS default), the shadow banking sector came under a cloud, making it difficult for shadow banks to recover the debts.
  • This created a liquidity squeeze in sectors such as real estate that were dependent on the shadow banks.

Analysis

Why did IL&FS default?

• The problem with IL&FS was that it had been borrowing very short-term money through commercial papers (CP) and certificates of deposits (CDs) to invest in infrastructure projects, which have very long and sometimes very uncertain gestation periods.
• It increased vulnerability to asset-liability mismatches (ALM; this refers to the fact that these lenders have short-dated borrowings and long-dated assets).
• In the wake of demonetization in 2016, the lack of cash eroded liquidity for several months, thereby delaying loan recoveries. The system was just about recovering from the effects of demonetization when IL&FS collapsed.
• When the cash flows from its many road and other infrastructure projects did not complete on time, IL&FS found itself with a severe mismatch in its borrowing and lending tenors.
• This resulted in the inevitable default and the fallout spilling onto other NBFCs and mutual funds (MFs).

Was this crisis predictable?

• Due to relatively lower costs, the sharp rise in share of CP and CD borrowings lower the cost of funds and increase profit margins for NBFCs.
• But if NBFC is unable to rollover or refinance the CPs, solvency issues arise, and growth is adversely impacted.
• An RBI report showed that 7% of shadow banking in India makes long-term loans against short-term funding, primarily carried out by NBFCs and housing finance companies.
• In 2012, the Usha Thorat committee had highlighted the risks that NBFCs carry by being dependent on money market instruments like CD and CP, having little flexibility covering for their long-term assets under situations of stress.
• The report had suggested uniformity in prudential regulations between the two financial entities—banks and non-banks.

Is the relation between the IL&FS and other NFBCs justified?

• IL&FS is a very different institution from a typical NBFC.
• It is one of a kind and was financing very long gestation infrastructure projects, which no other NBFC was capable of financing.
• There definitely were oversight failures at IL&FS but the default was not a systemic issue.
• It is neither correct nor prudent to compare all NBFCs with IL&FS.
• The asset-liability mismatch is largely an issue for long-term lenders like Housing Finance Companies (HFCs) and infrastructure NBFCs.
• Nonetheless, the IL&FS default created a ‘risk aversion’ for the system as a whole.
• The NBFCs are struggling less because of lack of liquidity in the system but more because the money market has lost faith in most NBFCs’ balance sheets and in the credit rating agencies’ ratings.

Why is then NBFC as a sector affected?

• Most large NBFCs are well capitalised, but have got exposed due to excessive short-term borrowing (CDs and CPs).
• The IL&FS default signalled the end of easy money — that is, using cheaper, short term market instruments to fund longer-term assets.
• The logjam acquired crisis proportions when many NBFCs were forced to sell profitable assets to generate cash to repay maturing debts.
• The defaults came around the same time as liquidity in banking sector as a whole also got stressed. Banks, which were already reeling under the weight of past debts, became exceedingly risk-averse to lend to NBFCs.
• Shying to set a precedent, RBI did not give NBFCs necessary leeway of a liquidity window but instead resorted to slashing rates.
• Since NBFCs also do not have access to RBI’s liquidity operations, which are restricted to commercial banks, a temporary systemic mismatch, which should have been nipped in the bud, snowballed into a crisis.

What is the significance of NBFCs in India?

• NBFCs provide credit to that part of the Indian economy where the private sector banks prefer not to lend (either because the risks are too high or because the returns are too low).
• Many NBFCs specialise in lending in a particular sector, and develop skill sets unique to that customer base; for example, SMEs and real estate.
• Many unbanked borrowers avail credit from NBFCs and later use their track record to become bankable borrowers.
• Non-bank firms fund everyone from poor entrepreneurs to business titans looking to roll over debt. By covering a wide spectrum of customised services and innovative products, NBFCs have played an active role in strengthening the economy.
• NBFCs have in fact contributed in addressing economic demand, and that has helped in financial inclusion.
• They play an important role in sustaining consumption demand as well as capital formation in small and medium industrial segment.
• They played a vital role in diversifying the financial sector, giving impetus to financial stability and made the sector more efficient.

What are the broader connotations of this crisis on the economy?

• The shortage of funding for lenders is having a direct impact on economic growth which has recently slowed to a decadal low.
• The liquidity issue in NBFC has caused the fall in credit to the auto, real estate, agriculture and small and medium enterprises sectors.
• With economic growth slowing, compounded by rising fuel prices and a falling currency, the country cannot afford the NBFC crisis.
• The current NBFC crisis needs to be resolved on a priority basis to revive the corporate earnings growth and the government needs to play a major role to spur demand in the economy.

What are the solutions to correct this crisis?

Measures by RBI:

• RBI increased monitoring of NBFCs after the IL&FS crisis. It eased lending norms and exposure limits to alleviate stress in the sector, and has intensified monitoring based on the size and payment behaviour of NBFCs.
• RBI proposed a liquidity coverage ratio for large NBFCs, which is currently applicable only to banks.

Measures by the government:

• Government has introduced a ? 25,000 Crore special window to revive stuck projects, subject to certain conditions.
• In Budget 2019-20, the government provided a one-time partial credit guarantee to PSBs to buy high-rated (basically less risky) pooled assets of financially sound NBFCs.
• Though NBFCs are still waiting for these funds, as risk-averse banks have not followed up.
• There is also lack of clarity weather such dealings between banks and NBFCs should be considered as ‘securitisation’ deals or as ‘pass-through certificates’ (PTC).

Other solutions to consider:

• Quality function of RBI: RBI should initiate conversations with senior bankers and provide assurances, so that banks can start feeling more confident of funding NBFCs.
• Merger of Banks and NBFCs: Government must consider a merger of NBFCs into banks, with appropriate guidelines to exempt existing NBFC balance sheets from maintenance of CRR, SLR and PLR requirements of a bank.
• Raising entry capital norms: Since regulating over 10,000 NBFCs is a very difficult task, increase in threshold entry level of NBFCs and HFCs can be considered by raising the minimum capital requirements.
• Securitisation of mortgage loans: Securitisation provides much-needed liquidity to the balance sheet. According to IMF, securitisation helps free up capital and that allows banks to extend new credit to the economy. It can be an alternate source of long-term funding
• Covered Bonds: Covered bonds are debt securities issued by a financial institution and backed by high rated pool of assets; in the event the financial institution becomes insolvent, the bond is covered. It is a more efficient and low-cost source of fund than unsecured debt instruments.
• Develop corporate bond market: Take appropriate measures towards this.
• Insolvency and Bankruptcy Code (IBC): For faster resolution, NBFCs can be brought under IBC purview.
• Voluntary asset quality review (AQR): A voluntary AQR for 50 largest NBFCs will help clean NBFC balance sheets and send positive signals to the MFs and large corporate treasuries to buy CPs and CDs issued by the NBFCs who pass the voluntary AQR.
• Bring HFCs under RBI: In order to improve regulatory oversight, government can consider bringing HFCs under the RBI from the fold of National Housing Bank (NHB).
• Create Alternative investment fund (AIF): Institutional funds can be channelized to NBFCs through AIF.
• Private equity firm investment in NBFC: Lenders can feel safer when they see large stakes by private equity funds in an NBFC.
• Unified regulatory agency: The Financial Sector Legislative Reforms Commission, 2011, had proposed a unified regulatory agency for NBFCs, equity and bond markets, insurance, pensions, mutual funds, etc. This proposal can be revisited.

Conclusion

Because NBFCs have stepped in where banks feared to tread, their role has become far more significant now. Hence reviving confidence in the NBFC sector will benefit all stakeholders, and economy at large.