Published on:30 July, 2019

Indian NBFCs are struggling not because of lack of liquidity in the system but because the money market has lost faith in most NBFCs’ balance sheets and in the credit rating agencies’ ratings. Hence rather than cutting CRR/SLR/repo rate, the RBI should vet the balance sheets of the NBFCs and make the findings public. A “voluntary AQR” for the 50 largest NBFCs will reverse the ongoing crisis.

A guide to how NBFCs function across the world
The business model of a non-bank lender is and always has been straightforward, in India and abroad. The lender has equity of $10 and borrows $90 (debt:equity of 9x) from the wholesale money market (say, at the run rate of $45 every six months).

This $100 is then lent at a certain interest rate either to people who want to buy flats (20 year home loans) or to a developer who wants to construct residential housing blocks (5 year developer loans) or to consumers who want to buy cars, trucks, TVs (2-3 year loans). Most of the interest collected from these borrowers goes to the wholesale money market participants who gave the NBFC the $90. Assuming a spread between the two interest rates of 3%, gives the NBFC a gross profit of $3 on the $100 it has lent.

With that $3, the NBFC pays for its operating costs (assume 50 cents) and for bad debts (i.e. for borrowers who do not repay). Assuming it is a well-run NBFC, the bad debts could be as little 50 cents. That means that on $100 of loans (funded by a mere $10 of equity), the NBFC will make a profit of $2 (3 – 0.50 – 0.50). That results in a very impressive Return on Equity of 20% (2 / 10), enough to convince almost every fund manager in India to seek a stake in the said NBFC.

Then one day, one of the developers (who has been lent, say, just $2) says that he cannot repay. So the NBFC takes possession of the half constructed building that the developer has erected but can’t find any buyers for the skeletal structure. That year the NBFC’s profits go to zero as the normal operating profit of $2 is wiped out by the developer’s default. Next month, the wholesale money market – unnerved by the NBFC’s zero profits – refuses to extend its usual $45 to the NBFC; rather it coughs up only $25. This is not enough for the NBFC to rollover its existing debt.

Since the NBFC’s shareholders’ equity is only $10, the NBFC is now left insufficient funds. It can do one of two things: (1) raise more equity (which would heavily dilute the current shareholders but protect the wholesale money market lenders who have lent money to the NBFC); or (2) default on the monies that it owes the wholesale market (which completely wipes out the current shareholders and the wholesale money market lenders). [The above text is taken from our 20th October 2018 note on how fund managers get fooled into investing in NBFCs: see https://marcellus.in/blogs/fooled-by-probabilities-and-by-indian-nbfcs/

The significance of NBFCs and HFCs in India
Indian NBFCs and HFCs account for 23% of loans outstanding in the country at the end of FY19, up from 15% of loans outstanding at the end of FY15 (throughout this note, we will use the abbreviation NBFCs to refer to NBFCs and HFCs). However, their importance is even more pronounced in two specific sectors – NBFCs account for 21% of the credit outstanding to SMEs and 54% of loans outstanding to the real estate sector as on 31st December, 2018. It is well known that NBFCs provide credit to that part of the Indian economy where the private sector banks prefer not to lend (either because the risks are too high or because the returns are too low).

It is therefore unfortunate that in the wake of the IL&FS debacle, NBFCs are increasingly finding it hard to access funding. The reason for this is not hard to find. Unlike banks, NBFCs credit growth has been fueled largely by borrowings from the banks and from the capital and money markets. In particular, NBFCs were accessing half of their funding from the mutual funds by issuing Commercial Papers (CPs) and Certificates of Deposits (CDs). Between FY14 and FY18, the share of CPs within the borrowing mix doubled for NBFCs while it tripled for HFCs. Due to relatively lower costs, the sharp rise in share of CP borrowings had a positive effect on the cost of funds and margins for NBFCs. However, it increased vulnerability to asset liability mismatches (ALM; this refers to the fact that these lenders have short dated borrowings and long dated assets).

In specific, if the NBFC is unable to rollover or refinance the CPs, solvency issues arise, and growth is adversely impacted (as explained at the beginning of the note). The NBFCs’ growth over FY14-18 was fueled by this huge influx of capital from multiple sources. This was owing to their perceived capability to grow ahead of the system and tap lending opportunities to under-served segments and geographies. The IL&FS debacle materially damaged the sector’s image and squeezed the flow of capital to the sector.

Further, the rating agencies have belatedly downgraded the debt papers of some of these lenders, making it even more difficult for them to raise funds from banks or MFs. While mutual funds are not allowed to lend to firms rated below B, the threshold for insurance firms and pension funds is set at AA. .

The shortage of funding for these lenders is having a direct impact on economic growth which has in the past 6 months slowed down to a decadal low. More specifically, auto sales are falling sharply, the real estate sector (historically, the largest creator of jobs in India) continues to struggle and channel financing is becoming hard to come by for everything from electrical equipment to undergarments.

How can the RBI remedy the situation?
As noted before, NBFCs were accessing half of their funding from the mutual funds by issuing CPs & CDs. Since the mutual funds are finding it more difficult now to rely upon the ratings disbursed by credit rating agencies and they no longer trust the stated balance sheets of the NBFCs, the mutual funds no longer  want to buy CPs and CDs. Thus the NBFCs are thus deprived of incremental funding which in turn is jamming economic activity amongst SMEs, auto manufactures and real estate developers.

A potential solution which can break this logjam is announcement of a “Voluntary AQR” scheme by the Reserve Bank of India (RBI). The RBI gave birth to the AQR (Asset Quality Review) when 4 years ago when it announced that all banks’ balance sheets will be scrutinised to assess if the banks are understating their Non-Performing Assets (NPAs). The six month long exercise found that several prominent banks were indeed understating their NPAs by a significant margin. In the wake of this development, CEOs of prominent banks resigned from their posts. Several of these banks have since raised fresh equity capital. Gradually, the financial markets are recovering their faith in the banks’ balance sheets.

What the RBI did to the banks can be called a compulsory AQR. At this juncture, NBFCs are in no financial position to be subjected to a compulsory AQR. Instead, what should be considered is a carrot and stick approach called voluntary AQR wherein NBFCs who opt to subject themselves to the RBI’s AQR are given a lower regulatory capital requirement (RCR) once the RBI has cleansed their balance sheet. More specifically, the RCR can be lowered in a targeted manner by giving the lenders lower regulatory risk weights for lending to economically sensitive sectors such as SMEs, affordable housing (say, homes below Rs 50 lakhs) and auto (say vehicles below Rs 10 lakhs).

Given that the annual audit cycle is done, the RBI should be able to hire on a temporary basis, auditors from the large Tax & Audit firms who specialise in auditing Banks & Financial Services companies. Moreover, if the goal is to get the economy back on track, the RBI can focus the voluntary AQR exercise on the top 20 HFCs and the top 50 NBFCs [the smaller lenders are unlikely to be disbursing significant amounts of credit from the perspective of the economy].

A voluntary AQR will allow the better run, cleaner NBFCs to signal their quality to the CP and CD market; in simple English, it will separate the wheat from the chaff. This in turn will encourage the mutual funds and large corporate treasuries to buy the CPs and CDs issued by the NBFCs who pass the voluntary AQR. These NBFCs will then be able to resume lending activity thus arresting the ongoing decline in economic growth.

Why should the better run NBFCs submit to voluntary AQR? Because of the carrot of lower regulatory capital requirements which in turn implies higher leverage, higher Return on Equity, better valuations and thus a chance to raise capital on better terms. To paraphrase the Godfather, that will be an offer which very few NBFCs will be able to refuse.
To read our other published material, please visit https://marcellus.in/blog/
Saurabh Mukherjea is the author of “The Unusual Billionaires” and “Coffee Can Investing: the Low Risk Route to Stupendous Wealth”.      

Note: the above material is neither investment research, nor investment advice. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.

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