That the non-banking financial companies (NBFC) sector has been facing troubled times for several months is well-known. Now, a top-ranking government official has proclaimed that the sector is facing an “imminent crisis.”
“There is a credit squeeze, over-leveraging, excessive concentration, massive mismatch between assets and liabilities, coupled with some misadventures by some very large entities, which is a perfect recipe for disaster,” Corporate Affairs Secretary Injeti Srinivas told the Press Trust of India in an interview.
In case you were wondering what the crisis was about and why it is important, here’s a quick FAQ.
What’s the NBFC crisis about?
NBFCs are facing a liquidity crunch. In other words, they don’t have money to lend or are facing enormous difficulties in raising funds. NBFCs typically borrow money from banks or sell commercial papers to mutual funds to raise money. They on-lend these money to small and medium enterprises, retail customers and so on. When NBFCs don’t have money to lend, that reduces the credit flow to the economy, hits economic growth and causes many borrowers to default on loans.
What led to this?
There are a couple of things to consider here. One, the NBFC business model itself is flawed, to begin with. It relied on raising short-term funds which were then lent out as long-term loans. This leads to a situation called an asset-liability mismatch. For example, an NBFC raises money by selling 6-month debt papers and on-lends this as a car loan with a tenure of 5 years. This leads to a situation where the NBFC has to roll over (or renew) the 6-month debt paper or raise fresh loans to repay the debt paper. In good times, this happens as a matter of course. But when times are tough, this cycle is broken.
That leads us to the second factor. The cycle was broken by a default of some firms of the IL&FS group. There were fears that this would turn out to be a contagion. Simply put, banks, mutual funds and their investors were afraid that more such entities wouldn’t default. As this fear took hold, many institutions refused to give money to NBFCs. The cost of funds rose by as much as 150 basis points for NBFCs.
Were the fears of contagion real?
In the last few years, especially after demonetisation, there was excess money sloshing around in the system. That is because a lot of cash was deposited with banks and investors parked more money with mutual funds. As fund managers of debt schemes deployed the funds in money markets, NBFCs were able to access cheap funds easily. They were able to grow their loan portfolios at double the pace of banks.
But on the flip side, note that mutual fund managers were chasing high returns for their investors and so too were NBFCs and banks. This led them to take risks and put pressure on the quality of their underwriting standards. Note that this excess money was given not only to NBFCs but also to other companies such as infrastructure players -- as loan against shares -- which have come back to bite now.
Why is the crisis a big deal?
As explained earlier, NBFCs are playing an increasingly important part in the economy. Their share of credit has increased because they were lending in sectors where banks refused to go or did not want to go. The used commercial market is a good example here.
Now that NBFCs are finding it difficult to raise money or having to pay a huge cost for doing so, this will choke the flow of credit to the economy. It will hit the MSME sector which is already suffering from the twin blows of demonetisation and the goods and services tax.
More importantly, it will hit consumption demand in the economy. With investment demand yet to pick up and exports flagging, consumption was the primary engine driving the economy. A reduction in credit further adds to economic slowdown pressures, which are already visible.
Besides, a slowdown in credit could lead to another pile of non-performing assets in sectors such as commercial real estate and infrastructure, which could have economy-wide knockdown effects.
Consider this example, an infra project needs working capital funds for completion so that it can start earning. When funds aren’t available or come at a higher cost, this undermines the feasibility of the project and puts the money already sunk in at risk. This adds to the stressed assets; mutual funds lending to such projects will have to mark down their net asset values; this leads to investors taking money out of mutual funds and in turn mutual funds won’t be able to give money to NBFCs/ other projects, setting off a vicious cycle.
The spate of recent downgrades in NBFCs, housing finance companies and infrastructure projects highlight the problems caused by the crisis.
In the last financial year, the Reserve Bank of India bought government debt paper worth Rs 3 lakh crore from the market. Basically, this meant that so much money was given to the banking system to on-lend. This is the only way for RBI to help NBFCs since the central bank can’t lend directly to the latter as they don’t hold government paper for use as collateral.
But the cost of borrowing for NBFCs is still high as banks are risk averse or have reached exposure limits.
This will prompt NBFCs to tap alternative sources such as external commercial borrowings, public bond issuances, or sales of assets. But even then, analysts point out that most of their borrowings will be used to repair balance sheets and refinance liabilities. Even if a full-blown crisis won’t happen, it will take at least 12 months for NBFCs to be back on the lending track.