NBFC Crises- One big Jhamela

What are Non-Banking Financial Companies (‘NBFCs’) ?

NBFCs are often interpreted as shadow banks, a concept/ system which China has explored the most. Shadow Banks can be defined as entities that work on little to no regulation. However, the same cannot be held true in the Indian context since, in India, NBFCs (registered under the Companies Act) have to adhere to the prudential norms issued by the Reserve Bank of India (‘RBI’), albeit it can be said that these regulations are not as stringent as those required to be followed by the private sector banks and public sector banks (‘PSBs’).

Some differences in regulations are:

• NBFCs can undertake activities that are not permitted to be undertaken by banks or which the banks are permitted to undertake in a restricted manner, for example, financing acquisitions and mergers, capital market activities, etc. The differences in the level of regulations of the banks and NBFCs, which are undertaking similar activities, gives rise to considerable scope for regulatory arbitrage. Hence, routing transactions through NBFCs would tantamount to undermining banking regulation.
• Foreign investments are allowed up to 100% in NBFCs whereas private sector banks are allowed up to 74%.
• It is mandatory for banks to maintain reserve ratios such as Cash Reserve Ratio (‘CRR’) and Statutory Liquidity Ratio (‘SLR’).

Their importance ?

The strength of the financial sector in any country is considered a proxy to the strength of the economy observed as a whole. In India, when the PSBs were struggling with mounting bad loans, forcing them to pull out or at least restrict themselves from the lending space, NBFCs were the ones which helped to plug in the funding gap. How did that help? The seamless lending kept the growth of economy on track. In hindsight, any derailment at that point in time would have had economy-wide consequences.

So, if they were so important to the financial system, where did it all go wrong ?

Why are people tracking their situation so closely ?

Firstly, if they were regulated, how did they get into such a bad shape ?If you actually go to see, not all NBFCs are struggling. Some of the NBFCs have been growing at record pace for almost a decade now. Companies with fundamentally strong business model (Bajaj Finance, Bajaj Finserv, Muthoot Finance to name a few) have been resilient despite the sector being under immense pressure. At this juncture, it would be important to note that most of the NBFCs are non-deposit taking entities. Non-deposit taking entities mean that they d0 not accept public deposits. Hence, these companies registered as NBFCs (Non-deposit taking) are not subject to stringent regulations that RBI has in place otherwise. Because of this gap in the provisions governing banks and the NBFCs, NBFCs are undertaking those activities which help them to grow at an outrageous pace while at the same time compromising the quality of growth. To put that into perspective, NBFCs have been growing their loan books at almost twice the pace of banks. This pace is achieved (partly) at the cost of default (in repayment of loan) by some customers who are advanced loans irrespective of their weak credit quality.

Like any other balance sheet, an NBFC’s balance sheet has two parts to it, namely the asset side and the liability side. The major components of an NBFC’s assets would be the funds lent out to customers for their use having a specific duration (i.e. loan tenure). Now, for an NBFC to lend funds, it needs to have funds. NBFCs borrow from various institutions in various forms. It can be by way of loans, but it is primarily done, by issuing commercial papers (‘CPs’). Commercial paper is an instrument by which an entity (read NBFC here) can borrow funds for a short period of time (duration of one year or less). CPs mature once the repayment period is complete. This is the root of the issue!The funds lent by NBFCs to their customers are for a period much, much longer than the maturity of CPs.

For example, Housing Finance Companies (‘HFCs’) lend funds for a term of about 10-20 years to a customer who wishes to buy a house. To fund this, the HFCs borrow funds through CPs which have to be repaid within a year.

This leads to something called as the ‘Asset Liability Mismatch’ (‘ALM’). When liabilities far exceed the assets in any period, it may lead to liquidity stress for the NBFC. The asset will mature in 10-20 years whereas the liability has to be repaid within year. When the market is all gung-ho about the economy, there is free flow of money from financial institutions (banks, mutual fund houses etc.) to these NBFCs by way of loans, CPs etc. In such a situation, the NBFC just ‘rolls over’ funds to meet the liability obligation. Rollover of funds means issuance of fresh papers when the old series matures. But when the perception of economy is on a downward trajectory, it becomes difficult for the NBFCs to rollover the funds, primarily for three reasons. The first one being unwillingness of financial institutions to lend money to NBFCs due to fear of default (by NBFCs). Secondly, even if they do lend money, the relative asking interest rate (i.e. cost of raising funds) on the roll over is much higher than its previous series. Last and foremost factor is the degrading asset quality of the NBFCs.

The failure of major NBFCs has put the lime light on their inefficiency in collecting money (from its customers to whom it lent and advanced money) and has made the case for stress testing of NBFCs stronger than ever.

Some numbers to help understand the intensity of the situation:

• Capital adequacy ratio (CAR) for NBFCs (as a group) has fallen from 27.5% (FY 14) to 22.8% (FY18) as per a research conducted by SBI.
• Growth in advances (loans given) have fallen for all major NBFCs (from various sectors) (Source of data: Capitaline data pertaining to NBFCs having market capitalisation above Rs. 5,000 crores)
• Recently, a response of the central bank to an RTI query showed that 89 companies surrendered licenses in 2016, 139 in 2017 and 164 in 2018. Apart from companies surrendering licenses, the central bank also cancels NBFC licenses when they fail to meet certain regulatory criteria. The RBI cancelled licenses of 1,701 NBFCs in the financial year ended 31stMarch’19 for failing to meet minimum capital requirements. As many as 779 licenses were cancelled in October and November, just after the crisis of shadow banking sector unfolded with Infrastructure Leasing and Financial Services Ltd. (IL&FS) defaulting on debt repayments. The defaults led to scarcity of liquidity for other non-banks, triggering a crisis in the sector (more on this topic later). In comparison, the RBI cancelled licenses on 26 NBFCs in FY 18 (when the crisis hadn’t broken yet).

Some protagonists of this ‘Jhamela’

• IL&FS:Set up in 1987 by a consortium of banks to play a major role in infrastructure sector, IL&FS is said to have been associated with projects worth Rs. 1,75,000 crore till date. Now, a monstrous organisation with over 300 group companies, it has debt of over Rs. 1,00,000 crore. But it wasn’t always like this. They too had their share of good times. Then, why would they take on so much debt which they don’t have capability of servicing ? Some of the major projects that were financed by them started to stall due to various issues ranging from additional requirement of funds, environmental clearances to demand of property. The 2008 Lehman led crisis didn’t help their case either as it slowed IL&FS down even further. They had to rely increasingly on debt financing for procuring funds to lend to customers. IL&FS took additional loans to service their already existing loans. They continued like this until the funds dried up and investors (banks, mutual funds etc.) stopped giving them money due to the risk it carried of defaulting on the repayments of prior issues.

The IL&FS crisis has since last year spooked the stock markets and cast a pall over on India’s shadow banking sector, which comprises of more than 10,000 firms with a combined balance-sheet of about $304 billion.

• Dewan Housing Finance Corporation Ltd. (DHFL):Post IL&FS fiasco, investors starting taking note of every move that involved NBFCs. Banks became much more cautious about lending money to NBFCs. The sector had become really fragile. DHFL is an NBFC, specifically an HFC, which disburses loans with repayment periods of 15-20 years. They generally issue CPs to fund their business as short-term funds carry lower interests (considering the investors think it carries lower risk of default compared to longer term loans). In September’18, DSP Mutual Fund sold Non-convertible Debentures (‘NCDs’) worth Rs. 300 crore of DHFL at a yield of 11%, which was way higher than the rate prevailing then, in the secondary bond market. This deal sparked speculation that DHFL could be facing liquidity issues. Currently, about 1/5thof DHFL’s loan portfolio comprises of loans to real estate developers which are not securitised by banks. And with the real estate sector struggling with its own woes, the chances of DHFL being repaid in full or in part look bleak. To compound DHFL’s woes, in January’19, Cobrapost, a non-profit Indian news website, unearthed in what appeared to be the biggest banking scam in Indian history by closely analysing documents available with public authorities and information available in public domain. The promoters of DHFL have been found to have siphoned off more than Rs. 31,000 crore of public money. The scam was primarily pulled off through grants of loans and advances to shell companies and by using other means. Money was then routed through these dubious companies and used to acquire assets outside India. Shares of DHFL were trading at Rs. 41.25 per share on 5thAugust’19 (at the time of writing this article) from a high of Rs. 690 in September’18 (A fall of ~ 94% in less than a year).

• Post this, some other NBFCs followed the suit. To name one, Reliance Capital (Anil Dhirubhai Ambani Group – ‘ADAG’) along with two of its subsidiaries, Reliance Commercial Finance and Reliance Home Finance have been downgraded by CARE.

Did the auditors fail in their duty ?

There have been numerous occasions where lapses have been identified in a statutory audit. For example, EY member firm SR Batliboi & Co who audited Yes Bank for fiscal year ended March 2016 reported Rs. 748.98 crore gross Non-Performing Assets (‘NPAs’). An RBI assessment pegged the t0tal bank NPAs at Rs. 4,925.68 crore, leading to a divergence of Rs. 4,176.70 crore.

Another instance is in the case of IL&FS Financial Services Limited (‘IFIN’) where the corporate affairs ministry alleged that the auditing firms gave clean audit reports and ‘deliberately’ failed to report fraudulent activities at IFIN. In a 32,000 page charge sheet filed by the Special Fraud Investigation Office (‘SFIO’) of the ministry of corporate affairs (‘MCA’), it was alleged that the auditors surpassed information on various loans, inflated profits and presented a rosy picture of the company.

Government’s stance on this situation:

• Making the auditors of such companies accountable for their negligence:
  • RBI has banned an EY member firm SR Batliboi & Co for one year from auditing the books of accounts of commercial banks (They were the auditors of Yes Bank until FY ended 2016).
  • Government has demanded a ban on Deloitte Haskins & Sells and BSR & Co, part of the KPMG network, which could prevent the two firms from auditing any listed or unlisted company for 5 years, for their alleged role in concealing the bad loans at IFIN.

• Amendments in the recent budget:
  • The recently introduced scheme details read as follows: “Non-Banking Financial Companies (NBFCs) are playing an extremely important role in sustaining demand as well as capital formation in small and medium industrial segment. NBFCs that are fundamentally sound should continue to get funding from banks and mutual funds without being unduly risk averse. For purchase of high rated pooled assets of financially sound NBFCs, amounting to a total of Rupees one lakh crore during the current financial year, Government will provide one time six months’ partial credit guarantee to Public Sector Banks for first loss up to 10%. Further, Reserve Bank of India (RBI) is the regulator for NBFCs. However, RBI has limited regulatory over NBFCs. Appropriate proposals for strengthening the regulatory authority of RBI over NBFCs are being placed in the Finance Bill.”

Let’s dejargonize the above: The Government has not yet notified what high rated pooled assets mean, but ideally the first loss credit guarantee should be extended only for securitised funds having credit rating of at least AA- (as it indicates very low credit risk). This first loss guarantee will be valid only for the first six months from the date of issue. Post six months, the government will not bear the brunt in case of defaults. What is important to note here is that first loss guarantee by government is available only for the first one lakh crore of securitised pool. That means the government, at maximum, will bear a risk of Rs. 10,000 crore (10% of Rs. 1,00,000 crore) of the securitised pool. What also stands out is government will extend this facility only and only if PSBs buy the security pools and not private sectors banks or other investors.

We should get more clarity on the above once the final guidelines are published.

• Another notable amendment was with regards to taxation of interest income earned by the NBFCs. Earlier, NBFCs had to pay tax on interest pending from any bad or doubtful debt. Once they actually receive the interest, the NBFCs will adjust tax accordingly. This simply led to prepayment of tax. The rule has been amended to bring it in parity with the tax rules applicable to the banks i.e. tax must be paid in the year in which the interest is actually received for bad or doubtful debts.

Way forward?

Finance Industry Development Council, a self-regulatory organisation (‘SRO’) for NBFCs registered with RBI, suggested setting up a permanent refinance window for NBFCs akin to that provided by the National Housing Bank to housing finance companies. Further, it has suggested setting up an alternative investment fund (‘AIF’) to channelise institutional funds to the NBFCs. The AIF could subscribe to non-convertible debentures for onward lending by NBFCs.

The Council has also suggested that NBFCs be allowed an on-tap facility for issuance of NCDs to the retail market by offering these instruments through an easy and cheaper procedure.

The RBI has told NBFCs with assets size of over Rs. 5,000 crore to appoint a chief risk officer (‘CRO’) to improve standards of their risk management. This directive comes at a time when India’s shadow banks are facing a funding crisis as some of the firms are burdened with over-leveraging and mismatch between assets and liabilities. RBI also told NBFCs to ensure independence of their CRO.

The CRO shall be a senior official in the hierarchy of an NBFC and shall have professional qualification/ experience in the area of risk management. The CRO shall not have any reporting relationship with the business verticals of the NBFC and shall not be given any business targets. Further, there shall not be any ‘dual hatting’ i.e. the CRO shall not be given any other responsibility. In case the NBFC is listed, any change in incumbency of the CRO shall also be reported to the stock exchanges.

Under the revised guidelines on large exposure framework that came into effect from 1stApril’19, RBI has relaxed bank lending norms to NBFCs i.e. a bank’s exposure limit to a single NBFC has been raised to 20% of Tier-1 capital of the bank (up from 15% of Tier-1 capital as was the case earlier). However, considering the banks themselves are struggling with degrading asset quality, only select few NBFCs that are not stressed might benefit from this change.

As the case for stress testing of NBFCs grows stronger by each passing day, it is also important from the perspective of restoring investor confidence. Stress testing is conducted by RBI (in India) wherein it calculates the capital ratio of financial service companies under hypothetical unfavourable economic scenarios, such as a deep recession or financial market crisis, to determine whether the financial service company has enough capital and reserves to withstand the impact of adverse economic developments.

ALM is majorly an issue for the HFCs and infrastructure financing companies.

The other consumer finance companies (eg: Bajaj Finance, Bajaj Finserv), companies providing loan against gold (eg: Muthoot Finance, Manappuram) etc. are growing at a good pace, credit to their business model.Some NBFCs (for example, HFCs, infrastructure financing NBFCs) require structural changes in their business model. Subsequent assurance of government aid or RBI intervention (whenever needed) for fundamentally sound NBFCs will help this sector regain their lost momentum and restore much needed investor confidence.

Source: Economic Times, Various RBI Circulars and Notifications, and Reuters