The NBFC Crisis in India
By: Dhruv Singh
What is a Non-Banking Financial Company (NBFC)?
According to Indian Law, NBFC refers to a company that is engaged in the business of loans and advances, leasing, insurance business, hire-purchase, chit business (often microfinance organisations), and acquisition of stocks, shares, bonds, securities, debentures (a way of borrowing money used by firms) etc. In essence, these firms offer various financial services like a bank with some notable differences; a prominent one being that they do not have a banking license and thus, are not allowed to take traditional demand deposits which refer to the savings and current account services offered by regular banks. Furthermore, NBFCs cannot issue cheques drawn on themselves (i.e. they do not have the power to issue cheques like a bank) as they are not a part of the payment and settlement system (a system regulated by the RBI to settle transactions between different banks). Besides this, a deposit insurance facility (a government guarantee of deposits upto Rs. 5 lakhs in a bank) of securing the deposits made to an entity generally provided by the Deposit Insurance and Credit Guarantee Corporation is not available for NBFC depositors, making NBFC deposits much riskier than a traditional bank.
All Banks have to be registered with the RBI, thus giving the RBI a significant oversight to ensure the smooth functioning and check compliance with the Basel 3 norms (Regulations imposed on licensed banks by the RBI). However, this is not the case with NBFCs, with all of them registered with the government under different regulating agencies like SEBI (Securities and Exchange Board of India) for NBFCs focusing on Stock market operations, IRDAI (Insurance Regulatory and Development Authority of India) for insurance companies and the RBI for the firms dealing with loans and advances. This was allowed to avoid dual regulation of these firms by various agencies.
How does a NBFC function?
Unlike a bank, a NBFC cannot accept deposits from the general population (due to their lack of a banking license) and thus has to raise funds from other means before being able to lend them out or make investments. There are generally three main ways NBFCs raise funds, namely- Banks, Debt Mutual Funds (a type of mutual fund that invests in fixed income securities like bonds and treasury bills, they are generally considered safer than equity funds) and Retail Investors. In India, Banks are forced to lend around 40% of the total loans to priority sectors like Farming and MSMEs (Micro, Small & Medium Enterprises) where the scope of profit is little to none. Adding to the pain is the fact that they are not allowed to give loans to real estate companies directly. This is a way of decoupling the real estate and finance industries to ensure that downturn falls in one sector don't drag the other along. However, Banks are allowed to have exposure to the profitable real estate sector through NBFCs by taking advantage of regulatory arbitrage. The Debt Mutual Fund Managers and the Retail Investors often lend money to NBFCs as they get higher yields in return than what is offered by banks in the form of Fixed Deposits as well as due to the fact that NBFCs generally offer higher interests than other companies issuing bonds of the same credit rating. A credit rating of a company is a representation of its past track record of handling debt repayments along with the future likelihood of the ability of the company to pay back the acquired debt.
This borrowing from Retail investors and Mutual funds is mostly done by sale of commercial paper with a short-term maturity, while the borrowing from banks is through short term loans. A commercial paper is a written agreement between two parties stipulating the conditions of the borrowing and repayment of the financial capital by one party to the other. This formed the fundamental business model of a NBFC taking short term loans on low interest and giving them out as long-term loans at a higher interest rate and netting the interest difference as a profit. This is where the seeds of the problem were sown, as these firms were supposed to return the money at a much shorter time frame than what they in-turn had lent it out for, which is called Asset-Liability Mismatch. For their survival, these firms were reliant on the liquidity (ability to quickly purchase or sell an asset) in the market ensuring their ability to raise funds and the willingness of existing lenders to simply rollover their debt - that is to simply renew their contracts upon expiry without demanding the repayment of the existing debt. This means that NBFCs have to raise new debts nearly every 6 months to repay the old loans. This happens very smoothly in times when there is enough liquidity in the market, however as soon as the times get tough, this cycle breaks down.
What was the cause of this crisis?
Times seemed extremely good for NBFCs after demonetisation, as bank deposits hit record highs, banks newly flushed with cash looked for more avenues to give loans and NBFCs emerged as an obvious choice. As they were exempted from the RBI regulations, they chose not to pass on the rate cuts by the RBI to the final customer which they themselves enjoyed as a customer of the banks along with increasing the total interest collection by varying the prime lending rates. Mutual Funds and retail investors also continued to pour in money, ignoring the large liquidity and solvency risk (possession of liabilities in excess of assets) that was born by the NBFCs. Solvency risk was born on account of the chance of default by the borrower from the NBFC which in turn affected the ability of the NBFC to payback and the liquidity crisis was in the form of failure of meeting short term debt obligations and failure of raising fresh capital to continue operations, the very fundamental business-model of a NBFC.
The entire crisis began with Infrastructure Leasing & Financial Services Limited (IL&FS), a core investment company registered with the RBI that operates with its more than 250 subsidiaries, with 91,000 Crore in consolidated debt and several notable investors including Life Insurance Corporation (LIC), State Bank of India, ORIX Corp. Japan and Abu Dhabi Investment Authority. It began when IL&FS Transportation Networks India Limited (ITNL) delayed its repayment of 500 crore to SIDBI (Small Industries Development Bank of India) from 28th to 31st August, 2018. However, this is also classified as a default and investors became aware of the liquidity issues being faced by the IL&FS group. In the coming weeks, various subsidiaries of the group started defaulting on their debt repayments. The reason for this default was the complications in land acquisition being faced by the company after the passage of the 2013 land acquisition law (under this companies acquiring lands from farmers for government projects were required to bring a much higher percentage of affected individuals onboard) which made several projects being financed by the company unviable. Following the defaults, credit rating agencies abruptly downgraded IL&FS and its subsidiaries from high investment grade (AA plus) to non-investment grade and junk status in a matter of weeks, indicating large scale imminent default by the group. Due to this downgrade, many corporates, mutual funds that otherwise would have invested in commercial papers and Non-Convertible Debentures of the IL&FS group did not do so due the fear of the default created by their downgrade of credit rating. This became a self-fulfilling prophecy by the credit rating agencies and the group faced a liquidity crunch where not many people were ready to lend to them, lowering the liquidity available; which meant they had to raise money at higher interest rates which in-turn increased their likelihood of default, leaving even fewer people willing to lend money to them.
Government Response to the fall of IL&FS
Seeing that IL&FS was a quasi-sovereign entity with major ownership of public sector banks, and its important role in funding vital infrastructure projects across the country; its demise would have been crushing for the economy and the already falling Indian stock market led by a downfall in shares of all NBFCs. To restore confidence in the markets and rescuing IL&FS both the RBI and the government were quick on their feet and sprang into action. RBI recognised the need of liquidity in the markets and infused around Rs. 36,000 crores via open market bond purchases (central bank purchases and sales of government securities in order to expand or contract the money in the banking system) ensuring that the financial institutions remain flushed with cash. On 1st October, 2018 the Government of India in a swift action took control of the company and sacked its disgraced board members, replacing them with bankers of unquestionable international repute. The board included Uday Kotak from Kotak Mahindra Bank and GC Chaturvedi among others. This was hailed as a major way of arresting the spread of the contagion to the financial markets and reviving trust in the NBFC sector.
Fall of DHFL a parallel tale
Deewan Housing Finance Limited (DHFL), was another NBFC, a housing finance company, and a major player in the Shadow Banking Sector of India. DHFL relied on the sale of short-term commercial papers and NCDs to various mutual funds for financing long term home loans. It all started when DSP Mutual Funds sold non-convertible debentures of DHFL at a yield of 11%, much higher than the previous deals of the company. This abrupt sale by DSP MF sparked off speculation that DHFL was facing a liquidity crisis and was next in line to default on its debt obligations after the fall of IL&FS. The market fears came true when the company delayed the servicing of its debt obligations of its Commercial Papers.
As a result, DHFL was downgraded by several ratings agencies. DHFL also came under the scanner of the Enforcement Directorate (government agency responsible for investigating financial crimes) for giving loans to Sunblink Real Estate Private Ltd. which facilitated these funds to an associate of Dawood Ibrahim. The company’s founders were also found guilty of several financial scams routing money through several shell companies (a company that exists only on paper and has no office or employees) before netting it for themselves. A coalition of the lenders of the firm including banks, mutual Funds and Retail investors came to the rescue with a 15,000 crore lifeline and sacked off the existing board while acquiring a 51% stake in the company through convertible debt. The lenders had taken a significant blow to their initial investments in the company, but were able to still recoup a significant amount through liquidation of large parts of DHFL’s business. This liquidation came in the form of DHFL exiting its Mutual Funds business, wholesale of home loans to other banks, monetization of other businesses to various buyers. The investors are now looking to sell the entire company instead of breaking it down into parts, and if the deal goes through with the Adani Group, the current leading contender, the investors should be able to come out with a hefty part of their losses recouped.
Impact and Learnings from the Crisis
After the fall of the NBFC sector, the markets continued to face a liquidity crunch for almost a year to come. While the government and the Banks focused on the rescue and recoupment of the NBFCs, it was clear that greater oversight and regulation was required to prevent any such event happening again in the future. The NBFC sector that had been the growth engine behind the expansion of credit in India was brought down to its knees, as a result, the credit availability in the market was severely reduced clearly marked by the reduction in the amount of loans sanctioned after the fall of the sector. Even after two years, the Companies trade at a fraction of the prices they enjoyed at their pinnacle. The failure of the Credit Rating agencies in fulfilling their role was also brought to light by their inability to predict the defaults by the companies and the fact that they were downgraded after already defaulting on loans. The negligence of the accounting firms and inability to bring forth the financial difficulties by these firms was also questioned.
After the blowout of the crisis, RBI formed an internal working group to come up with effective long term solutions for the revival of the NBFC sector. As a result of this NBFCs with larger than 50,000 crore asset size were allowed to convert into banks and accept demand deposits from the masses to maintain adequate liquidity. The RBI also came out with “UTKARSH 2022” a 3 year policy roadmap to improve regulation and supervision by the RBI. Its main focus is to allow RBI to take on a more proactive role in taking pre-emptive action to prevent any such crisis in the future.