Mumbai: Non-banking financial companies (NBFCs) have been in the news since September last year for all the wrong reasons. From defaults to rating downgrades, fears of potential collapse to wild allegations, it’s been a prolonged season of misery. This is nothing new for NBFCs: the sector has been through multiple crises, each time throwing up a newer challenge for regulators.

And yet, despite all the noise and the overwhelming sense of an impending crisis, the June monetary policy document from the central bank was conspicuously silent on the issue. There are two ways of viewing this. One, RBI wants the market to sort out the mess, with market-based tools. Or, the RBI’s studied nonchalance is signalling that there is no immediate threat to financial stability. In fact, governor Shaktikanta Das said that the RBI would step in only if required.

That begs the question: is there a widening disconnect between the regulator’s and the market’s perception of the situation, or is the market actually over-reacting? On the ground, though, the going has been tough for NBFCs. They have found it quite difficult to meet their funding needs and repayment obligations over the past nine months. To make matters worse, banks have also turned off the funding tap.

For instance, Anil Ambani, chairman of Anil Dhirubhai Ambani Group, in a conference call last week said that the group has not got any additional liquidity from banks, mutual funds or insurance companies for the past 14 months and had to rely on monetizing assets to meet debt obligations. How did things get to such a stage?

It all started with Infrastructure Leasing and Financial Services (IL&FS) defaulting on its debt in June 2018 and a subsequent breakdown of this large NBFC in September 2018. The huge debt obligation of 91,000 crore as of September 2018, and ensuing defaults, gave the world a sense of the fatal flaws intrinsic to NBFCs—such as skewed asset-liability management practices with short-term borrowing funding long-term assets, imprudent lending practices, and lack of due diligence coupled with ambitious growth targets.

The contagion effect from the IL&FS collapse quickly spread to at least two other major NBFCs—Dewan Housing Finance Ltd (DHFL) and Reliance Capital Ltd (RCAP). These two, and a number of other firms, are struggling to meet their short-term debt obligations and repay bondholders like debt mutual funds (MFs), pension funds, and insurance firms.

“We cannot take the NBFC crisis lightly. This kind of event will force the industry to change structurally," said S.S. Mundra, former deputy governor, RBI. “They won’t be able to clock the same kind of growth and margins would also be compressed going forward. Hence, investor interest would see a change," he added.

Mint—through a series of interviews with NBFCs, fund managers, and other stakeholders—has tried to piece together the magnitude of the problem and what is the way forward.

Click here to see the enlarged version of the graphic

Root of the crisis

The IL&FS crisis brought to the fore the inherent problem of asset-liability mismatch in the shadow banking system. It showed up how NBFCs have been raising short-term loans—typically ranging between three and six months, through commercial papers—and lending long-term to infrastructure loans, home loans, among others. An RBI research report showed that 99.7% of shadow banking in India makes long-term loans against short-term funding, primarily carried out by NBFCs and housing finance companies. The ongoing meltdown did not go entirely unnoticed by the central bank and was somewhat predicted in a report by one of its committees. In 2012, the Usha Thorat committee had highlighted the risks that NBFCs carry by being dependent on money market instruments with little flexibility in shedding off their long-term assets under situations of stress. It suggested uniformity in prudential regulations between the two financial entities—banks and non-banks.

However, a few years ago, NBFCs were presented with a rather propitious growth opportunity: with bad loans ballooning on their balance sheets, commercial banks had to perforce slow down their lending activities. NBFCs stepped in to fill the gap: the share of NBFCs in overall credit rose sharply to over 20% from 10% a mere seven years ago.

“IL&FS was a double whammy and a jolt for the system which was already limping," said a senior economist who consults with the government on policy issues. “Many NBFCs lent to real estate and informal sectors, which largely relied on cash for their liquidity needs. 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."

Following the IL&FS debacle, funding streams for non-banks have dried up. Banks and MFs—their major sources—have been unwilling to lend a helping hand. Further, rating agencies have downgraded the debt papers of some of these firms, making it even more difficult for them to raise funds from banks or MFs since financial institutions base their lending decision on ratings to a large extent. While mutual funds are not allowed to lend to firms rated below B, the threshold for insurance firms and pension funds is at AA.

Amit Bapna, RCAP’s group chief financial officer, told Mint that following the IL&FS crisis, funding lines from banks and MFs for the NBFC sector has hit a virtual halt. “The only means to remain liquid and meet our short-term debt obligations is to securitize assets. Finding investors to infuse equity is only a medium to long term solution," said Bapna.

Analysts told Mint that banks and the debt market are providing funds only to the top NBFCs based on their asset-liability management and their strong parentage. “Worryingly, the domestic wholesale debt market appears to be differentiating amongst NBFCs. Even as those perceived to be strong or backed by a parent company (HDFC, LIC, Bajaj Finance, Mahindra & Mahindra Financial Services) have been able to tap bond markets, issuances by the likes of Dewan Housing, Indiabulls Housing and Edelweiss have been minimal," said Credit Suisse in a report on 22 April.

India’s Lehman moment

While the blame for the crisis lies squarely with the sector, with their ill-managed liquidity and exorbitant growth aspirations, the government’s role too is hard to overlook. In terms of direct culpability, the government delaying payments to IL&FS or freezing payments by raising disputes upset the finance company’s cash flow rhythm. Indirectly, the government’s failure to give clearances for infrastructure proposals that came up during the boom phase of the investments, the controversies surrounding the 2G spectrum allocation, and irregularities in the road projects awarded by the National Highway Authority of India forced banks to put a brake on further lending for infrastructure projects. Many projects, completed halfway, then approached IL&FS for funding. But is the situation so dire that it can be called India’s Lehman moment? Probably not, as in the aftermath of Lehman Brothers, the entire credit market went into a seizure, with all inter-bank lending coming to a halt. Thankfully, in India, NBFCs have served as a stop-gap arrangement for funding entities that the banks won’t touch. And in the past 10 years, NBFCs have survived three stress cycles. “In 2009-10 (financial crisis) and 2013-14 (taper tantrum), there were four to eight quarters of subdued growth and then (things) picked up," said Gurpreet Chhatwal, president, Crisil Ratings. Analysts point out that most of the current stress is more acute in NBFCs or housing finance companies (HFCs) with a huge portfolio of real estate construction assets.

Over the years, HFCs have continued lending to real estate developers despite the sector being marred by incomplete projects, litigation, and overall slowdown. Developer loans make up around 21% of NBFCs’ loan book, compared to 7% for private banks and 3% for public sector banks, as per a 2018 Credit Suisse report.

As per a Mint analysis, NBFCs which traditionally lent to real estate projects have an aggregate real estate book of 1.87 trillion. These include HDFC Ltd, Piramal, DHFL, and Edelweiss, to name a few. “Given the lack of transactions for new properties in the real-estate sector, the asset-liability mismatch for some of the companies can worsen if they end up holding property instead of loans," said an analyst with a research firm who declined to be named.

The way ahead

It is no secret that NBFCs served a unique purpose when bank balance sheets started showing stress. But NBFCs got their own funds from the same banks. RBI data shows that banks have steadily increased their lending to NBFCs since 2008, which has ballooned to 6.23 trillion at the end of April 2019. Banks particularly exposed to the stressed NBFCs are Yes Bank with 6% of its assets, IndusInd Bank with 5.8% of its assets, followed by Bank of India and Bank of Baroda with a little over 2%, as per Credit Suisse. “I think what the banks have been saying all along is that there are good NBFCs to lend to. Banks have not completely stopped lending to non-banks and it is only some NBFCs where there are problems (to whom) we are not lending," said P.K. Gupta, managing director, SBI.

Apart from banks, MFs were also bullish on non-banks with their exposure to NBFCs rising sharply over the past few years to 3.12 trillion as of April 2019. Many NBFCs, including DHFL, have large MF repayments coming up in the first quarter of FY20. As of April, asset management companies have an exposure of 6,501 crore to DHFL. “For AMCs, 4-15% of AUM (asset under management) is to stressed groups (Essel, IL&FS, Dewan and ADAG) and 56% of these mature in first quarter," said the Credit Suisse report.

All said and done, MFs’ lending behaviour to NBFCs has seen a marked change since September 2018. Since September, MFs have either not rolled over or sold their holdings in NBFCs and HFCs to the tune of 67,000 crore. And here too, they have reduced exposure to NBFCs which are skewed towards real estate, barring HDFC. Pension funds are the most conservative of the lot. India’s pension money has traditionally been invested in fixed income assets, which, in turn, are predominantly invested in bonds. As of 2016, 84% of India’s pension assets are in bonds, said a recent Credit Suisse report.

The conservative approach and over-reliance on bonds, especially when NBFCs are the biggest supplier of bonds, can lead to a concentration risk. However, funds are downplaying the impact as the exposure to NBFCs as a percentage of pension assets would be less than 10%, so the hit on net asset value will be marginal compared to debt funds. Meanwhile, insurance firms, the largest domestic institutional investors would have exposure to NBFCs similar to that of mutual funds if not more.Taking cognizance of recent events and with an eye on future stability, RBI has proposed to introduce a liquidity coverage ratio for NBFCs, somewhat akin to what is followed by banks, which requires them to set aside cash in high-quality liquid assets, such as government securities and cash.

This is definitely a long-term solution that will stabilize the sector, but does not address the current concerns of asset-liability mismatch; of NBFCs being saddled with unsaleable assets; of collapsing NBFCs further dragging down bank balance sheets; of the impact of some struggling NBFCs on MFs and insurers. Das has indeed conceded that there is a case for a fresh look at NBFC regulation and supervision. There must be realization that given the interconnectedness of the system, a default in one set of companies can quickly spread to the entire sector and turn India’s financial edifice into a shaky house of cards.

Neil Borate in Mumbai contributed to this story.