Decoding the NBFC Liquidity Crunch

Let me start by saying that this is not an expert’s analysis, but a layman’s observation of the situation, written based on inputs from various articles, friends, and colleagues in the industry.

An NBFC is a company that can invest in financial assets, lend money, has financial income and is not a bank. NBFCs are also called shadow banks as their activities are akin to that of banks. The source of funding for these institutions comes in the form of Debentures, Mutual Funds in the form of commercial papers, Loans from banks, etc., as only a very few of the NBFCs in India are allowed to take public deposits. Now that we know there are deposit-taking and non-deposit taking NBFCs, the non-deposit taking NBFCs are further divided into the following based on their asset size:

Around August 2018, IL&FS (Infrastructure Leasing & Financial Services), one of India’s largest systemically important NBFCs (NBFC-NDSI) defaulted on their repayment commitments, leading to widespread worry about the health of NBFC sector in India. Before delving deep into the reasons for this crisis, let’s understand why such shadow banks are necessary for our economy, in spite of having 21 public sector banks and numerous private banks.

RBI set up NBFCs with the vision of providing credit to customers and geographies that traditional banks cannot reach. The close regulatory scrutiny on the traditional banks made them further contract their lending activities. This resulted in rising demand for credit, loans and other financial services, especially for people who couldn’t get past through the higher underwriting standards set by the bank. So, NBFCs were a necessity to keep the economy humming, and they did do a great job in lending to the priority sectors. The upside and the downside of this proposition was the same — Lack of regulation.

IL&FS started as an infrastructure development and finance company in 1987 backed by 3 prominent financial institutions in India, namely Central Bank of India, HDFC and Union Trust of India (UTI). Financing large infrastructure projects were its forte and in lieu of better funding opportunities, it opened up for investments from Mitsubishi, Abu Dhabi Investment Authority and LIC. SBI was also a major stakeholder until it sold its shares in 2017. Around 40% of the shares are held by government institutions of which, LIC holds the maximum (A whopping 25%!!).

IL&FS is not a publicly listed entity and is operated through 256 of its group companies/subsidiaries. However, 3 of its largest subsidiaries are listed on the NSE.

IL&FS has undertaken a lot of prestigious infrastructure projects in the country including the largest tunnel in India (9.28Kms) between Jammu and Srinagar. In order to finance these projects, IL&FS sought investments in the form of short-term instruments like commercial papers* and non-convertible debentures (NCDs**) from mutual funds, insurance companies, etc. In effect, they were playing it too close to the chest by taking short term debts for long term investments. The problem with this approach is that, if something goes wrong, the project goes into limbo and so does the investment. This is exactly what happened in the case of IL&FS. In some of its subsidiaries, it had a minority stake, and hence very less skin in the game. It’s very common to start a new subsidiary for infrastructure projects since most of them would be joint ventures and require huge capital. The issue came to light when IL&FS was not able to repay a short-term loan of around Rs.1000Crs to SIDBI (Small Industrial Development Bank of India). This brought them to the radar of RBI & SEBI. As the investigation into the company by SFIO (Serious Fraud Investigation Office) progressed, the total debt figure that surfaced was astounding. It’s believed that the company’s borrowing from banks and financial institutions adds to nearly Rs 94,000 crore! (Source: Economic times)

An asset-liability mismatch (in simple terms, what you own & what you owe) in the NBFC world is not uncommon. Especially in the housing finance market, repayment tenure of loans is typically between 10–20 years. But when liabilities far exceed the assets at any point of time, a liquidity crunch is imminent. The thin assumption on which financial institutions work is that all liabilities will not be demanded at the same time. But, any word about defaults triggers a domino effect in the market.

NBFCs are the largest net borrowers from the financial institutions and the majority of their funds were from banks (44%), followed by mutual funds (33%) and insurance companies (19%) as of 2018. Since banks realized the weakness of this sector and their high exposure to this risky proposition, the liquidity sources for all the NBFCs have dried up, triggering the crisis. Mutual funds have completely shut down their taps, banks have reduced credit lines, increased the interest rates, in effect choking the sector. NBFCs like TATA Capital, L&T Housing Finance, etc. who have a rich parentage is growing steadily, whereas other large (like DHFL & Reliance Capital) and small NBFCs are finding themselves in the middle of an acute liquidity crunch. This has also affected the new age Fintech lenders who were relying on banks & other NBFCs as their source of funds.

As screws are being tightened on the domestic front, more and more NBFCs in the country are looking to raise foreign investments and also investments from individuals to keep afloat. Some of them are even looking at consolidation and merger options with banks as they fail to raise new investments. But RBI is taking it slow as it is not so keen about issuing new banking licenses, and also believes that this will open the flood gates to more such requests from ailing NBFCs.

Having realized the weaknesses of this sector, RBI cracked down on all NBFCs and canceled almost 1700 licenses who could not meet the minimum capital requirements. Although RBI realizes that making NBFCs highly regulated like banks will defeat the purpose of their existence, they are working on necessary regulatory and supervisory steps to monitor the asset-liability and risk management framework of these entities. This includes setting up a central payments fraud registry to track the systems for frauds.

The bottom line is, NBFCs will no longer be the same loosely regulated, light touch entities that they used to be. As the RBI Governor rightly puts:

It is said that the system will never get cleaned up on its own unless there is a pain in the system. In a way, things could have been even worse if this crisis had not come to light, as such risk-taking behavior would have led to a bigger crisis.

It was just a decade ago that 2 NBFCs (Lehman Brothers and Bear Stearns) stood at the center of the global economic meltdown. The Indian economy was not so much affected by the economic crisis of 2008 as it was not so deeply integrated with the global economy then. But now if such a situation arises, we will be in deep trouble if we don’t maintain the regulatory discipline and exercise internal control.

*Commercial Paper — It’s money-market security issued by large corporations to obtain funds to meet short-term debt obligations. These are issued in the form of promissory notes.

**NCDs — It’s similar to a fixed deposit with a specific term and interest income, that companies issue to raise funds from the public. This cannot be converted into equity as the name suggests. NCDs are issued through the stock exchange.

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