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Photo: Mint

Opinion | The numerous risks surrounding bailout of NBFCs

A bailout could cause NBFCs with weak risk governance to continue their yield-chasing behaviour

Globally, in any debate around equity infusion by governments in financial institutions, all sides of the debate agree about the moral hazard problem. The debate hovers around the need and extent of the bailout package. While not debating the correctness of the bailout, one may argue that the non-banking financial companies (NBFC) sector has been provided a soft bailout package. This bailout, which is in terms of liquidity infusion, is not widely recognized. This recognition is critical for follow-up regulatory steps and to prescribe corporate actions to prevent a repetition.

The NBFC liquidity scare peaked immediately after the Infrastructure Leasing and Financial Services Ltd (IL&FS) default. Then, as per media reports, the finance ministry and the Reserve Bank of India (RBI) held divergent views on the need for addressing NBFCs’ constrained liquidity. The RBI pointed to the absence of systemic default to avoid giving them leniency, while the finance ministry was focused on how NBFCs’ stretched funding was affecting the much-needed credit supply. Both viewpoints were justifiable, but no one was assessing the situation from the perspective of a “liquidity bailout" or potential moral hazard problem. The liquidity situation has improved since then. The RBI went the extra mile and decided to remove the risk-weight cap on bank lending to NBFCs, the hope being that AA/AAA-rated NBFCs would need less capital and get cheaper funds from banks. Interestingly, though, currently the number of NBFCs in AAA and AA categories is the highest ever and, of course, AA/AAA defaults are also at an all-time high.

NBFCs have not only been at the forefront of financial inclusion, but have also been wooing markets with solid returns for several years. It is this huge expectation around NBFCs that may have caused some of them to slip on the risk management front. Only gold loan-focused NBFCs showed an expansion in net interest margin (NIM) in the last 2-3 years. For most others, it has remained range-bound since 2014. Delinquency levels have shown a gradual uptick, despite reasonable credit risk management. High asset growth has ensured that gross non-performing assets (NPAs), as a proportion of assets, remain range-bound.

Given the uptick in delinquencies, there was a need to reduce the cost of funding (COF) to maintain margins. NBFCs’ funding costs did fall in the last five years. But the fall in system-wide yields between 2014 and 2017 alone do not explain the more than 200 basis point reduction in COF of a lot of NBFCs. Improved credit rating played its part in improving market access and reducing COF.

Further, certain NBFCs, in a bid to reduce their funding costs, started changing their mix. Some actively borrowed a higher proportion of debt in the sub-12-month commercial paper market, which has lower interest cost than higher-maturity non-convertible debentures.

In fiscal 2014, short-term debt used to be around 11% (median) of long-term debt; in fiscal 2018, it was 44% (median) of long-term debt. At certain NBFCs, short-term debt is 200-300% of long-term debt. Refinancing risks of such NBFCs rose but high returns and low NPAs kept admirers enthralled. Some NBFCs have reduced their cost of funding by over 300 basis points in the last four years and boosted their margins, till a liquidity event exposed this self-created vulnerability.

NBFCs have higher COFs than banks. Besides, unlike banks, they do not have easy access to several liquidity dispensation facilities. Certain NBFCs reduced their liquid holdings from 8-10% of assets in fiscal 2014 to barely 2% in fiscal 2018. As a group, NBFCs have almost halved their cash and cash equivalent positions over the last five years. The higher deployment in lending assets boosted margins at the cost of liquidity. However, this liquidity-related vulnerability that some NBFCs built up came to haunt them during the liquidity squeeze. Following this, some NBFCs had to cut down on loan disbursements, eroding investor confidence further. Too much cash holding reduces the yield. NBFCs need more deft liquidity management than banks to get this balance right.

Arguably, the compromised risk processes did benefit short-term returns at the cost of long-term sustainability. Thus, the plea for infusing liquidity may be tagged as a liquidity bailout with an element of moral hazard. A liquidity bailout will not cost taxpayers’ money. However, it does expose the system to risk of inflation, potentially lower real interest rate and enhanced domestic currency vulnerability. A bailout, without appreciating the structural nature of the problem, will cause certain NBFCs with weak risk governance to continue with their yield-chasing behaviour. The situation calls for alleviation of the current liquidity issues while enhancing risk management (particularly liquidity and interest-rate risk) and governance at NBFCs. That is not to underplay the fact that certain NBFCs already have a strong risk governance set-up. RBI may possibly consider structural supports such as ongoing liquidity windows of NBFCs (of course, at a cost). The Securities and Exchange Board of India may seek enhanced level of disclosures about liquidity positions and asset liability management issues from listed NBFCs, or those accessing debt markets, with some targeted at retail investors.

NBFCs are not shadow banks. They are the “back-up" banking to the larger banking system. And, a steady back-up always helps.

Deep N. Mukherjee is a risk management professional and a visiting faculty at IIM Calcutta.

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