Revisiting NBFCs (Non Banking Finance Companies)

NBFC sector has been receiving intense attention, most recently due to default by Dewan Housing finance Corporation Ltd (DHFL). The trouble which began about a year ago with the default of IL&FS has seen skeletons tumbling out of the closet. While RBI has proactively provided liquidity to the market, it has refused to bail out any specific company and rightly so. So, what are the issues involved and what is the way forward? Here is a look.

The genesis of current NBFCs crisis, like in most financial crisis, can be attributed to two factors – the quest for super-normal profits leading to ‘irrational exuberance’ and governance issues. While banks reduced their lending around 2012-2013 sensing increasing stress, NFBCs stepped-in to fill the gap. While banks’ lending declined from 17% during FY08-14 to 9% during Fy14-18 as per RBI data, NBFCs lending went up to 14%. However, their equity capital rose by only 10% leading to reduction in capital adequacy coverage. Risk based coverage would have come down even more sharply as greater proportion of loan was being given to riskier sector such as real estate.

While NBFCs borrow funds from the banks and from the bond market which are rather long term in nature, they also borrow significant amount as commercial papers with mutual funds being the largest subscriber. However, these are short-term funds, not matching with the repayment schedule of their loan, leading to what is called ‘asset-liability mismatch’ (ALM). While most of this was getting rolled-over earlier, the situation has reversed after the crisis surfaced.

A look at the loan book shows that sector has lent more than 50% to large and other corporate. It is pertinent to note that it is this section which contributes to over 80% of PSBs NPAs. And that is not all. NBFCs also have a huge exposure to real estate sector, more so, to the companies not having sufficiently strong rating. The lure of higher interest rates swayed NBFCs to lend to them. Loan to commercial real estate sector by NBFCs more than doubled from less than Rs 56,000 crore at the end of FY 16 to 1.25 lakh crore at the end of FY18 (latest available). During this period, banks’ loan to this segment rose by barely 5% reflecting the contrast.

Thus, the crisis is twofold, short term liquidity and longer-term solvency, the worthiness of the loans assets on the books of these NBFCs. To manage the demand and outcry for liquidity, RBI has pumped more than Rs 3 lakh crore into the market during FY19. The proactive response of RBI has taken care of the needs of the ones who are solvent but doesn’t and cannot eliminate the fear of lending to NBFCs with uncertain credit worthiness. An interesting data from RBI shows the market paradox. Banks parked over Rs 28 lakh crore with RBI during Jan-March’19 against less than Rs 12 lakh crore during the same period a year ago. (Amount looks huge since the money is parked for period of 1-14 days and same money could be coming back many times during this 3 month period). It implies that despite market crying for liquidity, banks chose to keep their funds with RBI rather than lending for reason as stated above.

So, how can NFBCs come out of the crisis? The obvious way is to for them to raise equity capital or sell their assets. The other move could be takeover of the weaker NBFCs by the ones with sufficient cash flow or those with a strong parent to bail out. The situation is somewhat similar to what banks faced over last 2-3 years. Since banks were largely owned by the government, it came to their rescue by suitable recapitalization, thereby, maintain the credibility of the banks.

However, the real extent of the crisis is still under wraps. RBI is certain to conduct an asset quality review (AQR) after the dust settles and get real sense of the quality of their loan book. This is similar to banking sector AQR carried out in 2015 which revealed the hidden stress and sharp rise in NPAs. RBI is probably not doing that immediately as the crisis would accentuate if their loan books turn out to worse than what is being perceived by the market. NBFCs may not have sufficient equity cover to hold themselves after AQR. Indeed, their operations, as the name ‘shadow bank’ suggests, is shrouded somewhat in mystery, with related party transactions, large exposure to a particular corporate/ corporate group etc.

While RBI has initiated measures to enhance its supervisory framework, nothing can beat the ingenuity of human mind to get super-normal returns. And that is when history repeats itself..!

To get a more comprehensive view on NBFCs, check these – https://www.indiaeconomyandbusiness.com/what-ails-nbfcs-part-i/

https://www.indiaeconomyandbusiness.com/understanding-nbfcs-non-banking-finance-companies-i/

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