NBFCs : Caught Between A Rock And A Hard Place
Non-banking financial companies (NBFCs) have been going through extremely difficult times, first on account of the IL&FS fallout that shook the industry and now due to the virus-triggered pandemic. Anthony Fernandes investigates the overall impact on this sector and studies how the government’s stimulus packages may offer a ray of hope
The corona virus outbreak and the ensuing lockdown have hurt almost all industries in India, but for the country’s USD 370 billion shadow banking sector, the virus-led freeze is only the latest headwind in a multi-year storm that’s dragged this sector. Over the past two years, several non-banking financial companies (NBFCs) in India have been dealing with bad news upon bad news, including a cash crunch, the high cost of capital and burgeoning bad loans. Once praised for reaching every nook and cranny of India, today NBFCs are struggling for survival. Before we try to study the impact the pandemic has had on NBFCs, we need to understand the factors that have put this sector in such a predicament in the first place.
Credit Crunch Ripple
It was September 2018 when the financial sector witnessed the onset of a crisis with a major player, Infrastructure Leasing & Financial Services (IL&FS) Group, an NBFC, defaulting on several repayments. At the time, this was a largely out-ofcharacter and unheard-of action and it shook the industry to its core, creating ripples of panic and apprehension. Established in 1987, IL&FS was set up as a financial institution that could also function as a technical consultant. Over the years, it grew in size and its influence in the industry, consisting of 300 group companies. However, slow economic growth forced the company to rely on debt funding which led to an accumulated debt of over Rs 90,000 crore.
The occurrence of a default in one group created a ripple effect of shock throughout the industry, making difficult for others to refinance their debt. Suddenly, the industry was put on a red alert and every group, authority, company or institution was put under scrutiny. This was a largely unexpected event since rating agencies had given AAA rating to the bonds which were soon downgraded. All this time, around 45 per cent of the NBFCs were being financed through mutual funds but due to the sudden change in perception of the industry, they stopped funding NBFCs, further worsening the situation.
After much scrutiny and investigation trying to figure out the reason for the crisis, several flaws in the core operational structure of NBFCs in India were identified – one of them being an asset-liability mismatch in the core structure of NBFCs. In simple terms, they started lending long-term loans while depending on short-term funds, meaning the money they borrowed was up for repayment much before the repayment of the rolled-out loan was due. This led the companies to further take short-term funds to repay the other short-term funds. Since cheap funds were available during the demonetisation phase, NBFCs were motivated to keep on lending more money.
The excess of credit flow available to the NBFCs led them to hasten their loans’ procedure, compromising their various underwritten standards for lending loans. This cycle kept on growing unchecked and caused a major cash crunch, thereby leading the companies to default in their repayment of interest on bank loans and commercial paper redemption obligations. The crisis is being compared to the 2008 market crash caused by the US mortgage-backed loans and its major contributors. Hence, the NBFC crisis is dubbed by many as India’s ‘Lehman Movement’.
Pandemic Impact on NBFCs
The outbreak of corona virus and the resultant slowdown has had a tremendous impact on the economy. NBFCs have been significantly impacted as well. The reason for that is that NBFCs are the prime lenders to MSMEs and real estate – two sectors that have been very severely impacted because of the pandemic and the subsequent lockdown that it has spawned. Reserve Bank of India’s (RBI) announcement of allowing the moratorium on term loan instalments by lending institutions would be availed by most of the NBFCs and should offer them much material liquidity support.
The liquidity covers have not depleted significantly because NBFCs managed some collections in April and May, which varied depending on the segment of operations. Negligible disbursements also helped prop up liquidity covers to some extent. Fund-raising, on the other hand, will continue to be a challenge for most NBFCs because investors remain riskaverse. With debt repayments remaining high in the near term – especially June 2020 – how NBFCs manage the refinancing risk will be a key aspect to monitor.
☛Retail NBFCs
These companies cater to the informal and self-employed borrower segment and thus face a higher impact owing to the pandemic due to the income volatility at the consumer’s end. The severity would be higher for segments such as unsecured personal loans, two-wheelers loans, used commercial vehicle loans, loan against property and light commercial vehicle loans. The loss of income for light commercial vehicle players due to business disruption would be much higher since this segment is the most vulnerable and depends on the local market economic activity to get freight. Moreover, this set of customers does not carry the required liquidity cushion to tide over a prolonged crisis situation.
☛Housing
There is likely to be a more immediate impact on small-ticket affordable housing due to job losses and reverse migration of labourers to their native places. Loan growth could potentially fall for affordable housing financers in FY21, as the borrowers would delay their purchasing decision amid economic challenges. Buyers in the large-ticket housing segment would delay their purchase decisions. In particular, the self-employed segment is likely to face greater headwinds. However, salaried customers with a stable income profile could pose a lesser risk.
☛Wholesale NBFCs
Wholesale NBFCs are those engaged with corporate and real estate lending. These companies would face severe stress as well. NBFCs focusing only on real estate, for example, would be under severe pressure on the asset side in matching their inflows with periodic debt repayments. The borrowers would delay home purchases and the lack of progress of construction work by a quarter would squeeze the developers’ cash flow. The situation can worsen with a large proportion of book moving out of the moratorium for many lenders.
☛Small Finance Banks (SFBs) and Microfinance NBFCs
Although the moratorium will help the weakest set of customers in the NBFC spectrum to deal with the crisis, the income disruption could be higher for them. Microfinance institutions have learned from the demonetisation impact and built in substantial balance-sheet liquidity and sought unavailed bank lines sufficient for four to six months without causing significant dependence on repayments. While SFBs are better placed with the Reserve Bank of India being the lender of the last resort in addition to the lending support from policy institutions, asset-liability management challenges could crop up if there is substantial deposit withdrawal or non-renewal of deposits.
☛Insurance
For general insurance companies, there is likely to be pressure on renewals along with fresh business in own automotive damage and third party products owing to the slowdown in automobile sales and disruption in the automotive industry lifecycle. Meanwhile, on the health insurance side, there could be some improvement in loss ratios with people delaying their discretionary medical checks in the near to medium term. In the long run, however, there is bound to be an increase in awareness of having health covers which will thereby benefit the health insurance industry. The volatility in equity markets would marginally impact the investment book of general insurance companies; however, declining interest rates could affect their investment income, leading to a fall in profitability in the medium term.
Impact of Stimulus Packages
The package announced by the centre includes multiple measures aimed at providing relief to NBFCs and MSMEs, which are the target borrower segments. According to credit rating agency India Ratings, the Rs 30,000 crore special liquidity scheme which is free of guarantee can incentivise banks to take exposure in the lower-rated investment-grade NBFCs. These banks would be able to have slightly better pricing on these loans being backed by a government guarantee. However, the lower-rated NBFCs are not active in the bond market and hence investments through NCDs could create challenges.
The Rs 50,000 crore equity infusion in MSMEs through the fund of funds route is aimed at increasing the capacity of viable MSMEs. However, this is route of assisting MSMEs may be time-consuming as it could involve a valuation exercise. Given the urgent need of funds for the sector, the modalities of equity infusion can be time-consuming. The Rs 45,000 crore partial credit guarantee scheme with 20 per cent first loss protection from the government is aimed at providing some incentive to lenders. This is similar to the earlier scheme but unlike the earlier which was meant only for direct assignment transactions, this scheme covers even primary borrowings by NBFCs such as bonds and commercial papers.
Small NBFCs should thus be provided with a liquidity window through this scene provided lenders have the risk appetite to fund these entities after getting 20 per cent loss cushion. While the 20 per cent first loss protection in assignment or securitisation can be a strong incentive if put into operation suitably, investments by lenders in primary papers based on the 20 per cent guarantee would ultimately be based on loss estimation by lenders, and hence this will lead to the funds largely flowing to higher-rated entities.
Finally, the government has also announced collateral-free loans worth Rs 3 trillion for MSMEs and will provide 100 per cent guaranteed cover on them. This additional funding should take care of the liquidity requirements of these entities for some time and to that extent could prevent them from being classified as NPAs. These schemes introduced are well thought out; however, the major factor that will decide their effectiveness will rest on how well the government can iron out operational challenges to implement them. That said, ultimately, the main problem facing NBFCs is demand compression and until that gets resolved, providing loans can only lever the balance-sheet but is not a sustainable solution.
Abhijit Ghosh
Whole Time Director and CEO of U GRO Capital
What is your outlook on the NBFC sector? By when do you see the sector getting back into a growth trajectory?
The NBFC sector has been under some stress for a while now, triggered by the IL&FS default. The continued troubles at firms such as DHFL, Altico and Reliance Capital have exacerbated the concerns of external parties, particularly lenders. The onset of the corona virus pandemic has only compounded such extant issues. This highlights the fact that the key to success in lending in this new age is a liability-centric asset strategy backed by the strongest corporate governance standards. Those NBFCs which focus on these aspects will be the best placed to come out of the crisis stronger.
Back in 2019, the government initiated a number of measures to ease the liquidity crisis and revive the NBFC sector, recognising the role of NBFCs in capital formation in the MSME sector. However, the government’s monetary policy efforts have had limited efficacy to date given banks’ reluctance to lend to smaller NBFCs, which are the ones that actually cater to the bottom of the pyramid SMEs. The pandemic has exacerbated ALM and liquidity troubles at smaller NBFCs, and the sector will likely witness significant consolidation, with liquidity-constrained NBFCs being prime acquisition targets for their better capitalised peers.
Given the prevailing scenario, NBFCs are expected to reduce disbursements considerably in the first half of FY2021 with an aim to maintain liquidity. Asset quality and collections are likely to be affected as well. To address the liquidity stress, more NBFCs should explore the originate-to-sell model and move beyond the borrow-and-lend model. Well-run firms will utilise the current opportunities to increase their profile and set the foundations for future growth.
What is your outlook on the MSME sector? How important is the MSME sector to Indian GDP? Has the government provided enough support to MSMEs?
The MSME sector had already been facing severe challenges due to prolonged economic slowdown. The pandemic has made the situation worse for the sector, which is regarded as a mainstay of the economy. Economic disruptions due to the nationwide lockdown have resulted in interruption in the cash flow cycle of most of the MSMEs, leading to immense working capital stress. Business losses have made a lot of MSMEs unsustainable.
A sizeable number of MSMEs are likely to close down due to working capital crunch and unavailability of required manpower on account of the exodus of migrant workers from various cities and manufacturing hubs. The detrimental effects of the lockdown on MSMEs is particularly concerning given that 111 million people were employed by MSMEs, as of 2019. Without adequate support at this critical juncture, the level of damage to the sector and indeed the Indian economy as a whole can be irreparable in the short term.
The contribution of MSMEs to the country’s GDP is quite significant. The sector contributes approximately 25 per cent to the GDP from the service segment and more than 33 per cent to the manufacturing output. Thus, the sector requires support from the government to retain and exceed that level of GDP contribution. Prior to the virus crisis, the government had projected MSMEs making up 50 per cent of Indian GDP by 2024 – a figure that will be difficult to achieve given the pandemic setback.
The recently announced 3.75 lakh crore package for the MSME has tried to address the liquidity stress of the sector. Announcements such as 3 lakh crore collateral free automatic loans, Rs 20,000 crore subordinate debt for stressed MSMEs, Rs 50,000 crore of equity infusion for MSMEs through a fund of funds, etc. will help the sector to get back on its feet. The government needs to ensure the transmission of those benefits to the affected segments – and for the MSME space this can most efficiently be facilitated by NBFCs with digital underwriting.
Could you elaborate on impact financing in India?
Impact financing in India is evolving as a concept in India. As impact financing aims to generate positive, quantifiable social and environmental impact apart from financial returns for the investors or lenders, it is gradually finding resonance in the SME lending ecosystem of the country. Development finance institutions tend to be the organisations driving impact financing globally, and they have in recent times placed great emphasis on demonstrable impact created – particularly as it pertains to each DFI’s core sustainable development goals (SDGs).
SME lending is priority sector lending due to the huge amount of employment created by SMEs (111 million as of 2019), while also providing one of the best organic routes for underprivileged individuals to beat the so-called ‘poverty trap’ and establish their financial independence. We have recently collaborated with Global Value Partners (GVCP), an emerging market advisory firm, to solve the small business credit problem with impact financing. We have from inception been very cognizant of the social responsibility that a lending firm holds, and we have already financed a large range of schools and hospitals across the country.
Additionally, we have launched ‘Narayani’, a loan program from women entrepreneurs to assist them in their growth journeys. Only about 20 per cent of MSMEs in India are owned by women, and that figure drops to 5 per cent when considering small and medium businesses only. Unlocking the potential of half of the nation’s population is critical to the overall growth of the Indian economy, and we are highly committed to this as an organisation.