Explained: What ails the NBFC sector

Liquidity squeeze facing non-banking financial companies is at the root of the ongoing conflict between govt and RBI. What triggered the crunch, where do RBI and govt differ on bailout, and what lies ahead?

Written by George Mathew | Mumbai | Published: November 2, 2018 12:44:10 am
NBC, NBC sector, non-banking financial companies, ILFAS, RBI, NBFC industry, Express explained,Indian Express A series of defaults by IL&FS led to a severe liquidity crunch for NBFCs. (Express archive)

India’s non-banking financial companies (NBFC) sector — also known as the shadow banking system that provides services similar to traditional commercial banks but outside normal banking regulations — is passing through a turbulent period following a series of defaults by Infrastructure Leasing and Financial Services (IL&FS) and the subsequent liquidity crunch. The liquidity squeeze faced by NBFCs has led to a conflict between the government and the Reserve Bank of India, with the Finance Ministry pushing for easier fund flows while the RBI insists there’s enough money available in the system.

What is the crisis in the NBFC sector?

Several corporates, mutual funds and insurance companies had invested in short-term instruments such as commercial papers (CPs) and non-convertible debentures (NCDs) of the IL&FS group that has been defaulting on payments since August. This has stoked fears that many of them could have funds stuck in IL&FS debt instruments which, in turn could lead to a liquidity crunch in their own backyard. Liquidity conditions had tightened, with a deficit of Rs 1.37 lakh crore on October 22, 2018, though this has has declined since. There are rising fears that the funding cost for NBFCs will zoom and result in a sharp decline in their margins.

Is this a result of the fact that banks that were the biggest lenders to NBFCs have applied the brakes?

Banks did slow down lending to NBFCs, virtually closing a major resource avenue for NBFCs and housing finance companies (HFCs). The fundamental issue, however, is an asset-liability mismatch in the operations of NBFCs like IL&FS. What this means is that these firms borrow funds from the market — say for 3 or 5 years — and lend for longer tenures — 10 to 15 years. In a scenario where interest rates are rising, this hurt the NBFCs as their margins came under pressure and sourcing of funds became tough. Defaults will keep potential investors away from the debt instruments of HFCs and NBFCs. On top of this, sharp losses in NBFC stocks triggered a vicious cycle as losses in leveraged positions led to selling in other stocks, which in turn fuelled further losses in markets.

What did the RBI do to provide liquidity?

There was a complaint from some quarters that the RBI was slow in stepping in and injecting funds. On October 26, the RBI said it will inject Rs 40,000 crore into the system in November through purchase of government securities to meet the festive season demand for funds. This is on top of the Rs 36,000 crore it injected through open market operations in October. The government and industry pushed for a special window to meet the fund requirements of the NBFC sector. The RBI refused, on the ground that once a special window or dispensation to provide liquidity is opened, the RBI will have to provide liquidity to all companies approaching it for funds. The rationale is that there is adequate liquidity available for the sector through normal channels, and the RBI won’t be able to assess the asset quality of NBFCs to distinguish between those that deserve funds and those that do not. It also expressed concerns that this could lead to similar demands from other sectors, too, creating new problems for the regulator.

On October 10, before the RBI could step in, State Bank of India offered to bail out NBFCs with a proposal to buy good quality assets worth Rs 45,000 crore from them. SBI, which earlier planned to purchase assets worth Rs 15,000 crore, has decided to buy additional assets of up to Rs 30,000 crore.

But hasn’t RBI offered special liquidity support to the sector in the past?

What the RBI offered in 2008-09 was a special repo window for banks to lend to NBFCs, mutual funds and housing finance companies after the global financial crisis. In July 2013, too, the RBI opened a three-day special liquidity window of Rs 25,000 crore for banks to meet the cash requirements of debt mutual funds facing redemption pressures after bond prices fell leading to lower Net Asset Values.

How big is the NBFC industry?

NBFCs have been slowly moving into the space of commercial banking. When banks slowed down their lending business in the wake of huge bad loans, NBFCs continued to grow at a higher pace. As of March 2018, there were 11,402 NBFCs registered with the RBI, of which 156 were deposit accepting NBFCs (NBFCs-D), and 249 systemically important non-deposit accepting NBFCs (NBFCs-ND-SI). The aggregate balance sheet size of the NBFC sector as of March 2018 was Rs 22.1 lakh crore. There was deceleration in share capital growth of NBFCs in 2017-18 whereas borrowings grew at 19.1%.

NBFCs in India include not just finance companies, but also a wider group of companies that are engaged in investment, insurance, chit fund, nidhi, merchant banking, stock broking, alternative investments etc. as their principal business. NBFCs being financial intermediaries are supposed to play a supplementary role to banks. NBFCs, especially those catering to the urban and rural poor — including the micro-finance institutions (NBFC-MFIs) and asset finance companies — have a complementary role in the financial inclusion agenda of the country. Further, some of the big NBFCs — infrastructure finance companies — are engaged in lending exclusively to the infrastructure sector, and some are into factoring business, thereby giving a fillip to the growth and development of various sectors. In short, NBFCs bring diversity to the financial sector.

What’s the fund source of NBFCs?

NBFCs were the largest net borrowers of funds from the financial system, with gross payables (loans) of around Rs 717,000 crore and gross receivables of around Rs 419,000 crore in March 2018. A breakup of gross payables indicates that the highest funds were received from banks (44%), followed by mutual funds (33%) and insurance companies (19%). HFCs were the second largest borrowers with gross payables of around Rs 528,400 crore and gross receivables of only Rs 31,200 crore. As of March 2018, HFCs’ borrowing pattern was quite similar to that of NBFCs except that financial institutions also played a significant role in providing funds to HFCs. Like NBFCs, long-term debt, loans and CPs were the top three instruments through which HFCs raised funds from the financial markets. Now with the system facing a liquidity crunch, mutual funds, insurance companies and other big investors are unlikely to invest in NBFCs in a big way. The exposure of banks to NBFCs had shot up by 27%, or over Rs 1 lakh crore, to Rs 496,400 crore in a span of six weeks in March 2018. However, banks started cutting their exposure since April this year, leading to a 4.6% decline in their exposure to NBFCs, according to RBI data. The outstanding credit of banks was at Rs 391,000 crore in March 2017. The sudden spike in bank exposure to NBFCs prompted the RBI to direct banks to bring down the exposure.

Where do NBFCs go from here?

The reversal in liquidity implies funding for NBFCs may remain tight. The recent adverse sentiment in the bond market could mean even higher borrowing costs. They are likely to see lower growth/margins ahead, analysts say. On the other hand, the RBI is likely to tighten the guidelines for HFCs and NBFCs, bringing them almost on par with commercial banks in terms of regulation. After the 2008 financial crisis, the RBI has prescribed tighter prudential norms for NBFCs. The minimum tier-I capital requirement was raised to 10% from 7% in a phased manner by the end of March 2017. Asset classification norms were revised from 180 days to 90 days in a phased manner by the end of March 2018, in line with that of banks. Analysts say NBFCs are facing a liquidity squeeze and not a new credit shock. While the government has announced bailout of IL&FS, reflecting its intent to prevent escalation of the crisis, the RBI is expected to neutralise the liquidity squeeze but an easy money period is unlikely to come back in a hurry.

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