What are NBFCs and why are they important?
Non-banking financial companies perform the services generally performed by banks with two caveats: they don’t hold a banking license (and hence are not as tightly regulated) and they cannot accept demand deposits.
NBFCs as a segment have exhibited high growth rates over the last few years, partly filling in the vacuum created by the banking sector due to the high NPA issues. As per RBI’s latest financial stability report, the share of NBFCs in total credit extended has increased from around 9.4% in March 2009 to more than 17% by March 2018.
The shadow banking sector now comprises more than 11,400 firms with a combined balance-sheet worth INR 22 trillion (USD 304 billion).
On September 4, 2018, Infrastructure Leasing & Financial Services (IL&FS) defaulted on its payment obligations. Just before the default, its bonds were rated AAA and hence a default was highly unexpected and took market participants by surprise. Overnight, the credit rating agencies re-rated IL&FS’s bonds, giving them a ‘junk’ status. The worry over how credible the NBFC ratings were led to panic selling, and most NBFC stock prices took a deep dive.
On September 21, 2018, the market was yet again taken by surprise. DSP Mutual Fund (which had exposure of INR 629 crores to IL&FS) decided to sell INR 300cr worth of commercial paper belonging to Dewan Housing Finance Limited (DHFL). This sale was carried out a discounted price. Market participants took this as a sign of contagion risk (despite the fund manager’s assurances that DHFL had not defaulted), and extrapolated IL&FS’s fate to DHFL and other NBFCs. Within 5 days, DHFL stock fell down by 55%.
Suddenly, NBFCs came under close scrutiny of both regulators and investors. There was one thing which clearly stood out as people pored over the financials – Asset Liability Mismatch. But before discussing that, let’s take a look at how NBFCs operate.
How do NBFCs operate?
Since NBFCs cannot raise deposits from the public, they generally borrow money from banks and other institutions like mutual funds, pension funds etc. This borrowing may be in the form of long-term loans (like term loans) or short-term loans like commercial papers (CPs). Then, the NBFC uses these funds for onward lending (at a higher rate than at what they borrowed) – for example, providing housing finance, microfinance, construction finance etc.
Of course, banks also lend in these areas. The reason they lend to NBFCs (that is, their own competition), is because they might not have good access to or information about a particular customer segment or geography. Further, lending money to NBFCs is a quicker way to meet disbursement targets rather than originating loans by oneself. Also, banks might need to have exposure to NBFCs to meet their priority sector lending (PSL) norms.
Borrowings constitutes close to 70% of total liabilities of non-deposit taking NBFCs. While banks have long been the major source of funding for NBFCs, they have been increasingly replaced by market-based instruments (typically short-term in nature) in the past few years. One of the key reasons for this change is the declining interest rate cycle.
As the RBI started cutting rates from FY13, market interest rates also fell. Market rates generally react more quickly to RBI policy changes, hence, NBFCs moved their borrowings away from banks to market based instruments to take advantage of falling rates. From 50.8% in FY12, share of corporate bonds and commercial papers in overall NBFC borrowing mix increased to 59% in FY17.
Asset Liability Management issues
Put simply, an asset-liability mismatch occurs when the tenure of maturing loans (asset side of balance sheet of banks/NBFCs) does not match the tenure of sources of funds (liabilities side). For example, think of a bank which has given a 10-year term loan to a company, but has financed the same through short term deposits which it has to repay in 3 years. Thus, the entity’s loans given and borrowings taken do not come up for repayment at the same time.
The Asset Liability mismatch risk is a common feature of financial services firms with a ‘Controlled mismatch’ often being central to their business model. Lenders often strive to have a high proportion of short-term borrowings in their financing mix since they are cheaper than longer-tenure loans. The idea, therefore, is to maintain a prudent level of mismatch to minimize interest rate risk and liquidity risk, while at the same time maintaining net interest margins.
Let’s get back to DHFL.
DHFL, a housing finance company, disburses loans that have repayment periods of close to 15-20 years. While the repayment period is quite long, housing loans are generally considered as ‘safe loans’ since they generate a reasonable interest income and have the house (as collateral) to fall back on in case of a default. But how will DHFL finance this loan? It would of course want to borrow at the cheapest rates possible. As we saw earlier, short-term instruments would generally be cheaper than long-tenure loans. So let’s say, DHFL, in its bid to make high margins, borrows funds with very short tenures (say 6 months) by issuing a commercial paper. This, as we just saw, leads to an Asset-liability mismatch. But there is a simple solution to this problem. As soon as the repayment tenure of 6 months is over, DHFL can take issue another set of CPs, again for a tenure of 6 months. The cycle repeats, this is called ‘rolling over’ funds.
But therein lies the rub. This scheme can work only if DHFL is continually able to raise funds through these short-term instruments. What happens when credit freezes, even partially?
Atleast two things happen.
First, lack of funds from banks and mutual funds would slow down its growth. Second, lack of adequate short term funding would force DHFL to resort to longer-tenure loans, which are more expensive and hence will negatively impact its margins.
However, the ALM problem is not limited to DHFL only. Many other NBFCs are facing similar issues, and hence the NBFC sector as a whole would be affected.
As per CRISIL, 54% of the liabilities of NBFCs have to be re-priced within a year. In the current situation, the re-financing would most likely happen at a higher rate.
The reluctance of banks, mutual funds and other investors toward NBFCs is expected to continue considering the uncertainty prevailing regarding the credit/funding profile of NBFCs and the credibility of rating agencies. Thus, NBFCs would no longer have access to ‘easy money’ which they enjoyed over the past few years. While NBFCs would shift from market-based instruments towards banks, there would still be some additional issues there considering overall sectoral limits on banks and restricted lending (11 PSBs under Prompt Corrective Action).
In June 2018, ICRA had estimated that retail-focused NBFCs (with an estimated portfolio size of INR 7.5 lakh crore) would need INR 3.8-4 lakh crore of fresh debt funding in FY2019 to support their expected portfolio growth of about 20% in FY19. That looks highly unlikely now.
The NBFC sector would have to temper down its growth expectations, with focus on keeping adequate liquidity and reducing reliance on short-term paper to correct the ALM mismatches (leading to lower profitability).
While this seems like a short to medium term liquidity crisis (or more appropriately, a crisis of confidence), there are some indications of it heralding a structural shift in the way NBFCs operate. RBI has said that it is looking at strengthening its guidelines pertaining to NBFCs’ asset liability management. Capital adequacy norms might also come under the scanner.
Nevertheless, there is no denying that NBFCs continue to play a crucial role in the Indian economy. It is expected that this crisis would eventually strengthen the NBFC space by bringing in more discipline.
Written by Arpit Lahoty
Arpit is a PGP student at IIM Ahmedabad