The economic impact of COVID-19 has been largely disruptive where we expect economic recovery to take at least seven quarters before we settle into a new normal. However, severely stressed Non-Banking Financial Companies (NBFCs) are even more vulnerable to economic downturn due to exposure to risky segments. A recent CRISIL report estimates Assets Under Management (AUMs) of NBFCs to shrink in FY21 for the first time in nearly 20 years due to fall in disbursements.
NBFCs are the key source of funding for many diverse segments that fall outside the purview of banks. However, currently, sectors that are critical to NBFCs, such as auto, real estate, manufacturing, and retail, are either halted or operating at a subpar level. This has added pressure to NBFCs which were already hit by a funding squeeze after the IL&FS defaults. The increasing loan losses due to the pandemic and unlikeliness of raising funds are likely to exacerbate the liquidity stress.
Unlike banks that finance loans through public deposits, less than 1 percent of NBFCs take deposits, leading most NBFCs to primarily rely on borrowings from banks to fund their disbursements. What’s worse is post-September 2018, there was a shift to bank borrowings from market borrowings due to higher borrowing costs and lack of availability of funds. However, the pandemic has left banks wary of lending to NBFCs.
Further, while NBFCs were directed to offer moratorium to their debtors, they did not receive the same relief from banks. A slew of measures, first in April and then in August, were made by the RBI to provide relief. However, no moratorium was announced for capital market borrowings, which also form a significant chunk for NBFCs.
Combined with low collections to service such debt, NBFCs will be forced to depend on either their cash reserves or possible back-up lines of bank credit. Although the government has stepped in with a Rs 75,000 crore stimulus package, the question is if it will be enough to solve the liquidity crisis?
One certain thing is NBFCs will need to focus on their strengths to deal with changing business scenarios after the pandemic. To understand this, we must first delve into the core functions of an NBFC. Simply put, an NBFC has five functions:
Origination, underwriting and decision-making: Involves assessing creditworthiness or risk of a potential borrower; even more important for NBFCs as they typically lend to more risky customers
Loan fulfilment and servicing: Involves ensuring end-to-end customised services by employing different strategies to reach the target audience (under-banked and unbanked) and retain customers
Risk management: Involves undertaking proper risk mitigation measures and enhanced governance protocols, given regulatory disadvantage and customer mix
Collections: Usually a well-regulated process for most lenders, requiring different collection strategies and a prioritisation framework to avoid delinquencies
Funding: Involves raising money without which NBFCs cannot perform any of the above four functions
Currently, NBFCs are facing two issues: declining asset quality and severe liquidity crisis. NBFCs can solve the first issue by focusing on what they do best — the first four core functions. However, a different skill set is required to solve the liquidity crisis. Given a choice, NBFCs would always choose to fix the first issue and outsource the second. Is it then not possible for NBFCs to transition from doing everything to doing what they excel in, and leaving funding to those who understand liquidity better? Now, more than ever, the pandemic has forced the NBFC industry to rejig its business models to deal with the liquidity crisis.
As the Theory of Competitive Advantage suggests everyone is better off if decisions are based on competitive advantage at all levels. In an ideal scenario, outsourcing the work to an expert is a win-win situation and would lead to better outcomes for everyone. Who better to outsource this funding to than banks for whom liquidity is at the core of their operations? If banks were to take on the liquidity risk on behalf of NBFCs, the loans would remain on the bank’s balance sheet while NBFCs would still bear the default risk. This would solve two issues — banks would no longer be wary of providing liquidity, and NBFCs could focus on their core strengths.
Can we then expect to see newer business models emerge as the economy restarts and banks and NBFCs are pushed towards prudent lending for retrieving businesses?
Shishir Mankad is Practice Leader, Financial Services, and Varsha Agrawal is Member, Financial Services, Praxis Global Alliance. Views are personal.
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