The NBFC (non-banking financial companies) sector is at the crossroads. It’s difficult to crystal-ball gaze which road the sector will take. One thing certain is that the road ahead will not be the same as the road left behind. Let us understand the background of the current situation and then take a look at the roads ahead.
A look at the different facets of the problem
The NBFC sector is an integral part of the Indian financial system and capital markets. The current precarious position is a result of the convergence of several factors. It started with panic after the IL&FS default about a year ago and was exacerbated by systemic tight liquidity then and the ALM (asset liability management) mismatch that many NBFCs had. They were borrowing short-term mostly from the mutual funds through commercial paper (CPs) and lending for longer-tenure assets. Typically, short-term interest rates are lower than the long-term ones and most lenders succumb to the temptation. In fact, this was the root cause of the global financial crisis led by the Lehman Brothers default. The situation was further complicated by an economic slowdown as well as a slowdown in the real estate sector.
The NBFC sector had passed through a similar major crisis in 1998 and the regulatory system was overhauled. The sector did very well for the last 20 years, growing in an orderly manner and fulfilling the credit gaps in several segments of the economy. Credit gaps that the NBFCs fulfil are the ones where availability of credit by banks is either lacking or is inadequate. These gaps can be bifurcated broadly into two categories:
Wholesale funding: The extant regulations do not allow banks to fund real estate developers against the collateral of land even before the approvals are received for construction. Similarly, banks cannot finance promoters against their equity shares. These two classes comprise the wholesale book of many NBFCs.
Retail lending: A large number of retail consumers and micro and small businesses find it difficult, albeit not impossible, to get financing from banks. This is due to the fact that many such borrowers do not have income records or adequate credit history, or they find bank procedures and turnaround time too tedious. Also, banks with their relatively high overhead costs of manpower and branches do not find it economically viable to do credit assessment and collection of such small-ticket retail loans. Several NBFCs have specialised to fill this gap.
Many NBFCs witnessed panic withdrawal of credit from almost all types of lenders after the IL&FS crisis. The rumour mills on social media aggravated the damage. The government and the Reserve Bank of India (RBI) took several steps towards improving liquidity and restoring confidence.
Retail NBFCs have also struggled with liquidity and economic slowdown but most of them had ready buyers of retail assets in banks. They could securitise and sell down their loan portfolio to banks to generate liquidity. Recently, they have been getting funds from banks, other institutions, and the overseas bond market as well. On the other hand, wholesale NBFCs’ larger exposure is to real estate developer loans. Most real estate developers are facing significant slowdown in offtake by the end users. The GST on real estate under construction makes it unviable for investors or speculators to chip in. Further, many developers are not able to raise last-mile funding due to the liquidity squeeze faced by their lenders. Some projects have become simply unviable due to delays in approval or execution and bloated costs or litigations.
The response from regulators and practitioners
The government/RBI have taken many measures including easing of liquidity, credit guarantee of securitised portfolio, ‘on lending’ scheme, co-lending guidelines, easing regulations for external borrowings, etc. The government has also announced a special window worth Rs 10,000 crore for last-mile funding of housing projects which haven’t been classified as non-performing assets (NPAs) or aren’t with the National Company Law Tribunal (NCLT). However, this came with several caveats which required the projects to be net-worth positive in the affordable and middle-income housing category, etc. Simply put, all the measures announced till date do not reach out to the epicentre of the earthquake, which is big-ticket real estate loans in large metros, chiefly for high-end customers. As people see a few cracks on the surface and feel some jitters, the panic of a full-blown quake starts to spread.
Fortunately, most wholesale NBFCs have innovative and smart entrepreneurial management, who have managed the situation well till now. As traditional lenders like banks and mutual funds shun underlying exposure to real estate developers, a number of new alternatives are being explored. They include funding by foreign private equity investors and distribution of high yielding debt to wealthy investors. However, these emergency measures do not address the medium- to long-term challenges of funding such real estate projects.
In this backdrop, we also see bizarre cases of gross fraud at some cooperative banks and cased of fraud and corruption at public sector banks, historically caused by a few promoters, regularly coming to light. Many of us may not have realised that there are more than 5,000 cooperative banks, 15,000 NBFCs, and an uncounted number of chit funds in the system. All of them should be brought under the RBI’s regulatory rein. However, to make them viable for RBI to regulate, the tiny ones need to be shut down. Even a minimum capital requirement of ₹500 crore will reduce the number dramatically.
The policies and steps taken by the RBI and the Government of India indicate that they recognise the need for NBFCs to deliver retail credit and complement banks. This will drive production and consumption at the bottom of the pyramid and improve financial inclusion. However, the policy makers need to make sure that the schemes announced are also implemented by commercial banks. For instance, the government/RBI can monitor the use of credit guarantee schemes and the total amount lent in onward lending or assets generated in co-lending schemes.
What can be done to support wholesale NBFCs?
For the wholesale NBFCs, the situation is tricky. Nobody would like to support the real estate developers building high-value, luxury apartments with funds from the exchequer or through policies. Yet, there is an urgent need to understand that the system is interlinked and a default by some of the players can impact the credibility of the entire system. The government can consider a courageous step like the Troubled Asset Relief Program (TARP) fund the U.S. government introduced in the wake of the 2008 financial crisis. The government can sponsor a fund or liquidity facility to buy out stressed real estate projects at fair valuation and ensure their completion. This will need a high-quality independent investment committee to assess quickly and approve the projects, a high-calibre execution team to deliver, government support in terms of approvals and a marketing tie-up or own marketing apparatus to ensure sales and realisation from the project. The fund has the potential to make significant profits as well. Even at present, ready properties are housed at locations where there is enough demand. Additionally, the existing funds that the government has already announced can be made a little more liberal and accommodating to get projects off the ground quickly.
The other alternative is to resolve the current situation and restore confidence in the liquidity adjustment facility for NBFCs above a particular threshold, rating etc., akin to the way banks have access to liquidity. In any financial system over a period of time, there may be a few entities that go bust but it is important for the system to make sure that the management has changed, and the damage is minimised. The new management should be fully empowered and committed to resolve the issues and the creditors and the shareholders should not be impacted by criminal investigations or judicial proceedings. In our legal system, such cases can take indefinite time and result in an unforeseeable turn of events, often distracting attention from the main issue of realising cash and making payments to creditors.
Once the storm blows over and the dust settles, the NBFC sector will emerge stronger. The surviving players will have superior liquidity management and governance, tested in a trial by fire. The wholesale and risky funding will find alternatives in private equity or alternative investment funds or become specialised NBFCs with higher capitalisation. The road ahead is not a bed of roses and it is not the end of the road either. The NBFCs have played a stellar role in providing credit to the under-served segment and they will continue to do so. They have an important role to play in the sustained and inclusive economic growth of the nation.
Views are personal. The author is founder and chairman of IIFL Finance.