The non-banking financial companies (NBFC) sector has been going through a rough phase for several months now. Shadow banking refers to the banking activities performed by these NBFCs which are not subject to strict regulations. India’s shadow banking sector is the midst of a crippling liquidity squeeze that is threatening to become a bubble of a full-fledged crisis.
What is the NBFC crisis all about?
India’s financial markets have been reeling under high selling pressure, triggering concerns about risks in the country’s shadow banking sector. The cause of this crisis is the posting of multiple defaults by the three-decade-old infrastructure lending giant, IL&FS – an institution with 169 subsidiaries. It is a 'shadow bank' or a non-banking financial company that provides services similar to traditional commercial banks. The hint of the crisis was seen when IL&FS crisis became public in August 2018 with a debt of Rs91000 crore and incidents of multiple defaults. The market faced a domino effect and the fears of the public of business failures across the NBFC sector started becoming a reality.
The shadow banks can deliver loans to lucrative sectors untouched by the banks. These banks play a significant role in powering the consumption and ensuring the smooth flow of credit to the segments where banks do not assist. This feature of the NBFCs makes these entities crucial for liquidity to the buyers.
The model of the NBFCs is itself flawed. NBFCs borrow short term loans and mutual funds from banks and lend these funds to the long term projects. There is a serious asset-liability mismatch due to this. The slowdown in sectors like real estate and infrastructure led to the blocking of the funds and default from the lenders, creating a ripple effect and leading to the ever-greening of the loans thereby leading to a lack of adequate liquidity for these companies to provide credit assistance to small and medium enterprises, retail customers and so on, as they used to before. In these kinds of situations, the NBFCs roll over fresh debt papers to repay the existing loans. In good times, the cycle is smooth however when the times are rough the cycle gets broken, as in this case.
In the past few years, due to demonetization, there was an excess supply of money in the market as a lot of deposits were made in the banks and investors invested in mutual funds. This also increased the borrowing of NBFCs from banks which was 21.2% as of 31st March 2017 jumping to 29.2% as on 31st March 2019. The easy availability of funds led the NBFCs to give out loans even to the sub-standard assets and decline in the lending standards. The companies grew their loan books at a higher pace than the banks. The mutual fund managers as well as the NBFCs were looking for a higher rate of returns and thereby taking risks and compromising with the quality of their underwriting.
The gross non-performing assets of the NBFCs stood at 6.6% as of 31st March 2019 which is the worst in six years. The figure was at 5.3% as of 31st March 2018 and has escalated by 130 basis points in one year.
Why is the NBFC liquidity crisis a big deal?
The existence of the NBFCs is undeniably important as these companies provide loans to the small and medium companies as well as the retail consumers in the sectors that are untouched by the banks thereby providing credit assistance and facilitating the purchase. The liquidity crunch in these companies has slowed down the demand in the economy. For example, almost 70% of the two-wheeler purchases made in India are financed by the NBFCs, and the inability to roll out loans to the public is one of the major reasons for the slowdown in the auto sector.
What is troubling the NBFCs?
1. NBFCs are running huge asset-liability mismatch and the asset quality is deteriorating
Due to the model of the NBFCs of lending short term in the form of commercial papers and giving out long term loans, there has been a huge asset-liability mismatch in the balance sheets. The asset quality of the NBFCs has also deteriorated. The proportion of non- performing assets in the loan book has been increasing. It has jumped from 2.6% in 2014 to 6.5% in September 2018.
2. Debt papers of the NBFCs have been downgraded
The credit ratings of the debt papers issued by the NBFCs have fallen. The defaults of the IL&FS bonds have spread over the liquidity crunch to other NBFCs are well. The rating of the IL&FS bonds fell from AAA to AA+ and then subsequently to DD. The bonds of DHFL downgraded from A3+ to A4+ and then fell to D. The NBFC sector is facing a tough time in taking loans from the public to finance itself due to the fall in the credit ratings of its debt papers and therefore is unable to provide the necessary credit to the loan takers.
Initiatives to mend the NBFC bruises
1. Infusion of Rs 70000 crore in the Public sector banks
The upfront capital loading of Rs 70000 crore into the Public sector banks by the government is a step to increase the flow of liquidity in the economy. This move is expected to generate additional lending to the extent of Rs 5 lakh crore and improve the situation. The NBFCs can take up the credit using the Aadhar authenticated KYCs ensuring that the benefit can be utilized.
2. Infusion of Rs1 lakh crore in the NBFCs
The government has announced a guarantee scheme for the non-banking financial companies which will allow the state rum banks to purchase their assets to prevent the distress sale of assets due to the lack of liquidity is the sector. This will ensure that the shadow banks have funds to lend and resolve the credit crisis.
As per the guidelines in the budget, the Department of Economic Affairs will provide the NBFCs with a government guarantee of up to 10 percent on the fair value of the assets sold which should be at least AA rated. This scheme is capped at Rs1 lakh crore and open for 6 months.
3. RBI to have greater control over the NBFCs
The NBFCs come under the supervision of RBI and need stricter rules to have greater authority over the sector to prevent any crisis in the future. The amendments proposed include the power relating to the resolution of the NBFCs, schemes relating to amalgamation, restructuring or splitting up, to make sure that the critical activities of the sector continue smoothly. The RBI will also have the power to remove a director of an NBFC, even from the privately held companies.
4. Exemption from Debenture redemption reserve
This move of the government will reduce the cost of capital through the issue of debentures as the requirement to keep 25% of the value of the outstanding debentures issued by the NBFCs has been removed. Debenture Redemption Reserve is a provision that a corporation issuing debentures have to create to protect the investors in case of the company defaulting. This step was taken by the government also aims to deepen the bond market through the increased issuance of debentures and also creates a levelling field between NBFCs and Banking companies, which are already exempted from the DRR.