In The Ongoing NBFC Mayhem, The Quality Performers Shall Prevail

-Investors are concerned about the NBFC sector pulling down the markets. Dnyanada Kulkarni analyses the sector and explains not all is lost for the sector and sticking to quality NBFCs will fetch rewards for the investors.


NBFCs faced a grim predicament when the news of Infrastructure Leasing & Financial Services (IL&FS) defaulting on payments shook the financial markets. The news came as a blow to the financiers of IL&FS’s commercial paper as they had always rated the instrument investment grade. It also instigated considerable mayhem in the stock market as investors and financiers alike never expected a company of such stature, with 25.3 per cent stake held by LIC of India, to be in financial trouble. They began deliberating about the severity of the issue and whether it extended to the subsidiaries of IL&FS as well. Their worst fears were realised as IL&FS got into a fresh series of defaults, leaving the company sputtering for capital as its markets for commercial paper were immobilized. Peeved by the turn of events, the government was forced to step in and replace the company’s board. The mayhem resulted in the entire sector experiencing a liquidity crisis, high valuations and asset-liability mismatches.



What’s intriguing is the enormity of the impact IL&FS has had on the NBFC sector, when only Rs.20,000 crore of its total loan exposure of over Rs.1 lakh crore constituted the NBFC book. It provoked concerns about infrastructure financing in India and the right way for the industry to assess credit risk in future.

The DSP fund house possessed DHFL commercial paper (CP) worth Rs.200-300 crore. The IL&FS catastrophe led DSP to get rid of the CP at lower rates. This sparked distrust in NBFCs in general as investors speculated why DSP would wish to exit CP with high ratings. NBFC stocks started declining. While some recovery was witnessed after DHFL reasserted its liquidity position; the downward pressure on prices of CPs, fear of rising NPAs and speculation surrounding repayment abilities left NBFCs in hot water. Lenders became wary of funding NBFCs for fear of defaults. However, once the dust settled down, quality NBFCs with a sturdy financial background were able to inspire confidence in banks and debt markets. Through this story, we wish to assert that not all NBFCs are doomed. Some NBFC stocks are well-placed to withstand the hardships, while others may fizzle out.



NBFCs are establishments which source funds from banks and by issuing debt instruments. Asset-liability mismatch is a common feature for such firms that borrow primarily through short-term instruments while financing long-term assets like infrastructure. Since their funding requirements are high and profit realisations are prolonged, banks, mutual funds, provident funds and insurance companies are wary of lending to NBFCs, particularly in the light of recent tribulations. This challenges the very business model of NBFCs, raises their cost of borrowing and portrays them as risky and unattractive. NBFCs cannot pass on interest costs to their customers immediately since their loan books are based on fixed rates and borrowing costs are tied to market rates. To quote a recent example, the interest rate on 3-month AAA CP, a major funding source for NBFCs, has escalated by 40 bps to 8.5 per cent within three weeks. No wonder, September 2018 produced the lowest CP issuances at 141 since 2000.



Liquidity crunch
Mutual funds (MFs), which used to be a willing supplier of credit, are withholding cash in anticipation of redemption pressure from investors. To prevent the liquidity-starved market from suffering another blow, officials of around 20 NBFCs engaged in discussions last week about the thousands of crores surfacing for redemption. Nearly Rs.50,000 crore of CPs will crop up for redemption by November 9, of which Rs.5,000 crore were issued by a troubled NBFC. However, with MFs sitting on cash, some NBFCs are forced to prepay CPs as they are not investing. The market sentiment is such that even a single default could elicit alarm, compel MF investors to seek redemption and cause the fund to sell-off top-rated debt papers, thereby dragging stock prices to the ground. Although the RBI has permitted more headroom to banks to facilitate lending to NBFCs, most banks–private and foreign banks in particular–are inclined towards loanportfolios by hand-picking NBFC assets instead of directly lending to NBFCs and HFCs.

Positive performers
The industry is taking a crack at pursuading the RBI by garnering support from large industrialists and promoters with a vested interest in NBFCs. They believe the government needs to appreciate that only a handful of companies are facing a crisis. The trouble faced by some PSU banks and certain NBFCs is actually beneficial for some of the top private banks and quality NBFCs as it will trigger an increase in their market share. The downward spiral does not encompass all NBFCs, as revealed by companies like Mahindra Finance. The company evidenced an extraordinary 132 per cent surge in profit to Rs.381 crore in Q2FY19. Although most mutual funds are investing selectively and the credit cycle is frozen, a Mumbai NBFC raised Rs.1,300 crore of CPs last week. HDFC Asset Management Company reported a rise in liquid funds under management to Rs.75,000 crore in October, compared to an average of Rs.40,000-50,000 crore. In an analyst call, Reliance Nippon Asset Management proclaimed that inflows into liquid funds in October surpassed the outflows witnessed in September. Shriram Transport Finance, Cholamandalam and LIC Housing have posted impressive results as well. Thus, it is evident that NBFCs with decent management and resources will ride out the crisis. It would be tragic if investors become averse to investing in NBFCs and perceive the sector as untrustworthy and condemned to fail, just on the basis of some overvalued bad performers.

Free-run inhibited?
The RBI cancelled the licences of 368 NBFCs during the first half of 2018 while it flagged 1,200 NBFCs as “high risk” for not complying with regulatory norms. NBFCs are required to provide details pertaining to the identity of their clients, maintain records and share data with Financial Intelligence Unit. Investors wondered if these steps, admittedly constructive for regulation, would impede free run of NBFCs.

Trickle-down impact on other sectors
The ongoing liquidity crunch faced by NBFCs has adversely impacted the housing demand-supply. The real estate sector is challenged with a restrained inflow of funding from banks and private equity. Also, capital for greenfield projects has stagnated, with lenders selectively favouring projects nearing completion.

Home loan rates are impacted as NBFCs exercise caution about disbursing loans until the markets stabilize. The automobile industry has also taken a hit on account of the broader liquidity squeeze. The two-wheeler companies are most susceptible to NBFC stress as a major chunk of incremental volume growth experienced in the last five years was sourced through these shadow banks.

RBI Intervention
Unquestionably, the RBI is determined to arrest the spreading of the IL&FS crisis to other sectors and infuse sufficient liquidity to ensure smooth sailing. RBI’s latest sectoral data confirms this. It reveals that NBFCs have fallen back on bank borrowings. The incremental credit offered by banks to NBFCs soared by Rs.56,000 crore in September, reporting the steepest month-on-month advancement during FY18. The Fiscal Development and Stability Council stated that a Computer Emergency Response Team in the financial sector (CERT-Fin) is being set up to work hand-in-hand with financial regulators on matters concerning cyber security. A legal framework is being formulated to ban crypto currencies in India and promote the use of Distributed can be bridged if the pace of fund-raising observed during the first half of October continues. Otherwise, another default could rattle the market in as little as six weeks. The RBI and the government do not necessarily see eye-to-eye on matters concerning liquidity. Ledger Technology as declared in the Budget 2018-19.

NBFCs are establishments which source funds from banks and by issuing debt instruments. Asset-liability mismatch is a common feature for such firms that borrow primarily through short-term instruments while financing long-term assets like infrastructure. Since their funding requirements are high and profit realisations are prolonged, banks, mutual funds, provident funds and insurance companies are wary of lending to NBFCs, particularly in the light of recent tribulations.


Tussle between Finance Ministry, RBI and the government- A persistent liquidity crunch could impede fund mobilisation in the debt market. NBFC and HFC debts worth nearly Rs.2 lakh crore are expected to become due by December 2018, while Rs.2.7 lakh crore CPs and NCDs will be due for redemption over January-March 2019.

However, the Department of Economic Affairs anticipates a funding gap of Rs.1 lakh crore by the end of the year. This gap can be bridged if the pace of fund-raising observed during the first half of October continues. Otherwise, another default could rattle the market in as little as six weeks. The RBI and the government do not necessarily see eye-to-eye on matters concerning liquidity.

The government is of the opinion that the RBI should extend liquidity support to NBFCs and HFCs, while also relaxing lending strictures for weak banks. Meanwhile, the central bank insists that the liquidity situation is under control as it has continued to infuse systemic durable liquidity through open market purchase of government bonds. It is unwilling to budge on the rules for weak banks with high NPAs. It also dispelled concerns about the crisis infiltrating other sectors and assured it would intervene in case of a spillover effect.

Conclusion
Although gradual, the support from banks is on the rise, thereby reducing the risk relating to maturity of NBFCs and HFCs. The continuity of the new board of IL&FS led by veteran banker Uday Kotak will reinstate confidence and trust in financial markets.

On October 31, the new board submitted a resolution plan which encompassed capital infusion at the group level, selling subsidiaries and resolution for specific assets. Although lenders have taken a measured stand, the NBFCs with robust balance sheets, strong management and proven business models across cycles will emerge relatively unscathed. NBFCs focusing on the retail segment having lower credit and accommodation risks are less likely to be impacted. Moreover, NBFCs boasting strong parentage by means of sovereign and large financial institutions will continue to receive support from debt markets and banks. The strength of underlying business trends in asset classes such as CVs, rural auto and retail housing is an important consideration.

In the long term, once the dust settles down, we can be assured that quality NBFCs will persist and the overall markets will stabilize.

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