NBFC crisis: A reality check (The Hindu)

Mains Paper 3: Economy
Prelims level : NBFC
Mains level : Implications of liquidity or solvency risks

Context

•  India’s NBFC sector has swung 180 degrees in a short span of time.
•  Barely two years ago, the sector was being feted for its ability to deliver high margins and scorching growth rates, by lending to lucrative segments neglected by banks.
•  The same players are being blackballed for taking on undue risks in their pursuit of growth.
•  Given that the NBFC sector plays a critical role in powering consumption and ensuring credit flow to unbanked segments, its troubles need objective assessment and quick resolution.
•  Here’s an attempt to examine the NBFC issue as it stands today.

No domino effect

•  After the dramatic default by IL&FS in September 2018, the market was rife with fears that its collapse would set off a chain reaction of business failures across the NBFC space.
•  Nine months later, however, this domino effect hasn’t quite played out.
•  The funds crunch caused by IL&FS has led to isolated credit downgrades of some NBFCs/HFCs.
•  There have been two cases of actual default (the Reliance ADAG and DHFL groups).

Two explanations for the absence of a chain reaction

•  With its 340-odd subsidiaries and fingers in many pies across infrastructure projects, IL&FS was really a unique animal within the non-bank space which bore little resemblance to most NBFCs.
•  Forensic investigations revealing IL&FS’ dubious accounting and gold-plating practices have also led markets to recognise that there were company-specific factors at play.
•  Even if one were to worry about infrastructure financing per se, of the 10,000-odd NBFCs registered with the RBI, only eight are in this space with five being sovereign-backed entities.
•  It given that IL&FS was not a deposit-taking entity and did not raise funds through public NCDs, its spectacular collapse did not elicit a panic reaction from the public at large.
•  The mutual fund industry, the most vulnerable among institutional players to a run, had just 5 per cent of IL&FS’ aggregate borrowings on its books.
•  The bulk of IL&FS paper is held by banks, insurers, provident funds and pension funds, where investors are shielded from direct hits from a default.

The ALM issue

•  The IL&FS debacle has served to underline the high business risks inherent in NBFC business models that rely on short-term market borrowings for long-term loans.
•  The resulting risk aversion by lenders has landed NBFCs and HFCs with high asset-liability mismatches in hot water (Reliance ADAG firms and DHFL, for instance).
•  After initially recoiling from all NBFCs, lenders are now scrutinising NBFC balance sheets more closely in order to avoid firms with high leverage, ALM mismatches or shaky clients.
•  With lenders taking note of differentiated business models, NBFCs engaged in short-term asset financing (including consumer, gold, MFI, auto and truck financing companies) have seen their funding constraints ease up in recent months.
•  But funding has dried up for select housing finance companies with high ALM mismatches and NBFCs with exposure to real estate and property loans which are seen as turning bad. They seem to be bearing the brunt of the current liquidity crunch.

The liquidity issue

•  Data on issuances show no dramatic fall in the funds raised by the NBFC and HFC sectors from the bond markets in FY19.
•  NBFCs raked in 4.01 lakh crore from commercial papers (CPs) in FY19, while HFCs raised ₹2.2 lakh crore. After the IL&FS shocker in August 2018, monthly CP issues for NBFCs and HFCs fell steeply until October but thereafter have staged a tentative recovery.

Aggregate trends do hide problem areas

•  One, under pressure from their investors to curtail exposure to NBFCs and lower-rated bonds, mutual funds have sharply cut back on their participation in the CP market, forcing NBFCs/HFCs relying on rollovers to scrounge for funds.
•  Two, redemption pressures on credit funds and general risk aversion from institutional investors has led to a skew in funding towards big-name NBFCs/HFCs while lesser names struggle.
•  Three, funding costs have seen a sharp spike irrespective of the category of non-bank borrower.

Way forward

•  The regulators and investors need to recognise that both the ALM and liquidity crises are restricted to a handful of NBFCs/HFCs.
•  They need closer regulatory supervision, with the firms accessing public deposits or retail NCDs requiring special attention. Rescuing IL&FS is not a priority now.
•  It given that the IL&FS case and the string of AAA downgrades have severely undermined market confidence in credit ratings and the accounting practices of non-banks, both the RBI and the NHB may now need to undertake special audits of their constituents.
•  This is essential to shore up market confidence in the sector and help lenders separate the wheat from the chaff.
•  NBFCs/HFCs with retail participation and good quality books may need a liquidity lifeline to ward off solvency issues. While objections have been raised to RBI taking on credit risk by opening a liquidity window for corporate bonds, this problem is not insurmountable.
•  The deals can be conducted through nodal agencies or banks, with conservative haircuts on collateral.
•  There are precedents from the liquidity crises of 2008 and the 1980s, when the RBI and IDBI opened liquidity windows for market players. Not many players rushed to avail themselves of the accommodation, but it did boost confidence.

Conclusion

•  It is not the absence of regulations but ineffectual supervision by the RBI and NHB that has left the doors open for the IL&FS and non-bank crises to play out.
•  Therefore, rather than adding to their voluminous regulations, both regulators need to deploy additional manpower and acquire forensic capabilities to more closely monitor the frequent statutory filings of individual firms.
•  Only that can nip future crises in the NBFC sector in the bud.

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Prelims Questions:

Q.1) With reference to National Green Tribunal, consider the following statements:
1. The tribunal is bound by the procedure laid down under the Code of Civil Procedure, 1908.
2. Members of the tribunal are not eligible for re-appointment.
3. The tribunal consists of only judicial members.

Which of the statements given above is/are correct?
(a) 1 and 3 only
(b) 2 and 3 only
(c) 2 only
(d) 1, 2 and 3

Answer: C
Mains Questions:
Q.1) Liquidity or solvency risks are restricted to some pockets, but they need to be addressed. Comment.