Home / Opinion / Views /  Opinion | Who is to blame for the non-bank lending sector crisis?

The non-banking financial companies (NBFC) crisis is being held up as one of the culprits of the current slowdown. There is a near consensus that this crisis was triggered by the collapse of Infrastructure Leasing and Financial Services Ltd (IL&FS) and the unfolding of the problems of Dewan Housing Finance Corporation Ltd (DHFL). However, should their failure have led to such a crisis in the sector and impacted the economy as a whole? While both IL&FS and DHFL were large financial institutions, their collapse did not lead to the crumbling of too many other balance sheets. At most, some tremors were experienced.

The collapse of an institution impacts the sector and/or the economy only if the institution in question is too big to fail—that is, it is systemically important—and there is a systemic risk festering in its balance sheet.

IL&FS started as a lending and leasing institution for infrastructure. Over time, it expanded to other financial services and beyond, such as investment banking, mutual funds, broking, depository participation, securities services, education and training, and spread its tentacles abroad. In 2010-11, it transformed its business model vis-à-vis projects from develop-build-and-transfer to develop-build-own-and-operate. However, its balance sheet was not restructured.

DHFL started as a mortgage lender. It also spread its canopy to insurance and mutual funds. Its balance sheet had long-term assets while its liabilities were to be repaid in the short-term. At the time of its collapse, it was at least 40% short of the assets needed to generate funds for near-term repayments.

IL&FS and DHFL, with their businesses spread across various segments of financial services, were subject to different sectoral regulators, including the Reserve Bank of India, Securities and Exchange Board of India, National Housing Bank and the Insurance Regulatory and Development Authority of India. Their balance sheets were hiding asset-liability mismatch risks. While IL&FS, after changing its business model, could not borrow long, DHFL took advantage of market liquidity at the time by borrowing short and lending long to enhance its margins.

Investopedia describes systemic risk as “the possibility that an event at the company level could trigger severe instability or collapse of an entire industry or economy".

The question arises whether the asset-liability mismatch problems of these two companies alone could have become a systemic risk. Possibly not. In fact, the entire NBFC and housing finance company (HFC) sectors had such a mismatch—of over 35%. This became a low-lying systemic risk.

After demonetization, a big part of Indian cash moved into bank deposits, mutual funds, deposit-taking NBFCs and the stock market. Flooded with short-term money, many institutions started lending it to NBFCs, HFCs and companies via commercial deposits (CDs) and commercial paper (CPs) at interest rates ranging from 6% to 6.5%. With long-term borrowing rates ranging from 10% to 14%, depending on the rating of the paper, borrowing short provided an extra margin of 4% to 8%. As of 31 August 2018, mutual funds were holding more than 2.25 trillion of CPs/CDs issued by NBFCs and HFCs alone.

The “twin balance sheet" challenges provided NBFCs a huge opportunity to lend money to real estate developers, small businesses and individuals. Their share of lending went up significantly post demonetization. They capitalized on conditions by lending more and boosting liquidity, which helped expand operations and improve profitability. As a result, their valuations skyrocketed.

The blow-up in the balance sheets of IL&FS and DHFL brought a low-lying systemic risk to the fore and hurt industry-wide lending. Short-term lenders grew reluctant to issue fresh loans or rollover existing ones, and even demanded early redemption. The market cried out for liquidity.

The moot question, though, is whether the regulatory framework recognized the low-lying systemic risk and whether it was prepared to deal with it.

In case of low-lying systemic risk, regulators have to exercise a choice on when to act. The choice is between taking pre-emptive action or keeping gun powder ready to deal with the risk whenever it materializes, while letting the economy make the most of the conditions in the meantime. Pre-emptive action is often cast as a “party-pooper" by markets and castigated. In this particular instance, whether regulators could have acted differently remains a matter of debate.

Systemic risks can be broadly classified as cross-sectional and time-dimensional risks. Regulators craft policies to limit externalities, so as to minimize the adverse impact of common exposure arising from various inter-linkages. If time-dimensional risks materialize, however, regulators insist on capital enhancement and higher margins of safety.

The asset-liability mismatch of NBFCs was a time-dimensional systemic risk. Higher capital adequacy requirements and balance sheet liquidity enhancements could have reduced the risk, and the mismatch could steadily have been addressed. Unfortunately, the music stopped suddenly.

Raising capital adequacy limits and liquidity margins for NBFCs might have tempered their profitability and hurt their valuations, but would not have deprived the economy of credit. Investors in NBFCs would not have lost so much on their collapse. Alacrity in taking adequate measures could have spared them the devastation.

G.N. Bajpai is former chairman of Sebi and LIC

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