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Earlier, retail as well as institutional borrowers had to borrow from banks, with nowhere else to go. Therefore NBFCs were set up. Non-Banking Financial Companies (NBFCs) are, as the name suggests, non-banking institutions in India. They are allowed to provide loans just like banks. However, most of the entities with an NBFC License in India are not allowed to take deposits from people in order to make funds for these loans. Hence, these NBFCs borrow money. Still, banks were the preferred source. But, lately, this scenario has changed because of the precarious financial situation that the banks found themselves in. The Indian banking sector was already struggling with bad loans made due to political interference. This was also the time when the NBFC sector was on a high. However, soon afterward, this sector was seeing the biggest slump since its inception. NBFC were now caught at the centre of a massive market crisis. It was even termed as India’s Lehman moment. Let’s have a closer look at the detailed overview of the NBFC crisis, in this article.
What Was NBFC Crisis About
To understand the situation, we, first have to understand how NBFCs functions.
A way to raise finance to lend further is to accept deposits from the customers and then use this money to lend and invest further. Interest is paid to its customers on the deposits and a higher interest is charged on the loan amount. This is how a bank operates.
However, this is not the case with most NBFCs. NBFC companies are in the finance business but many of them are not entitled to accept deposits from the general public. Hence, their way of raising money is somewhat different.
Since, NBFCs do not have deposits from the public, so they raise money from commercial banks, mutual funds, and other sources. They may raise through instruments like Loans, Debentures, Commercial Papers (CPs), Bonds, etc. Loan raised from banks. And the NBFC needs to repay the money within a specified period along with the interest amount. Bonds and Debentures are money raised not from one individual but from a large group, who are called “Debenture (or Bond)-holders”. CPs are short term instruments used to raise funds required for a short while only. These are unsecured and hence, the entity issuing the CPs must have a good credit rating for the lender to invest in them.
Now, the loans that are taken by NBFCs from banks generally bear a higher rate of interest, whereas the CPs and the bonds have a relatively lower rate of interest. Obviously NBFCs would prefer raising money more from the source which costs less. Then they lend this money and charge interest from their borrowers. The difference is their income, which is called “Net Interest Margin or NIM”.
How NBFC Crisis Happened
IL&FS, one of the prominent companies in the NBFC sector, was set up in 1987 when a consortium of banks decided that there was an urgent need for a financing institution in infrastructure development and finance. By fund and profiteer from the infrastructure boom of the ’90s, IL&FS grew to be the principal lender behind the construction of many infrastructures throughout the country. It grew to be a gargantuan behemoth with around 300 group companies, with powerful backing from a rich set of institutional shareholders.
When the rate of growth of the economy slowed to lower-than-expected, the projects got stalled projects and payments were delayed to the firm. The financier had to rely increasingly on debt funding until the burden snowballed into an outstanding amount of Rs. 90,000 crores. By now, IL&FS was proving to be a major liability to the financing industry.
The NBFC crisis started when IL&FS defaulted to SIDBI, in August 2018, on ICD (Inter Corporate Deposits, an unsecured borrowing of the fund deficit company from fund enrich company). Then, later delayed payment on this CPs. This clearly indicated that liquidity was low and news spread like wildfire among the other sector of the economy. The reason for the default was primarily because of a mismatch in the Asset Liability Management (ALM).
ALM Mismatch happens when the duration profile of liabilities don’t match with that of the assets. ALM mismatch occurs regularly in the financial sector, but is a critical risk to the company and needs to be managed.
The sectors like infrastructure, housing, etc. the loans are disbursed for long duration, but may be funded by short-term liabilities. The instruments like CPs and NCDs provided cheaper funding and renewed interest from investor classes like mutual funds. But these were extremely short-term finances, with maturity tenure of 3-6 months. But the NBFC is poised to be repaid the loans over the next 20 years. How could it be expected to pay back its dues within 3–6 months? Once the repayment is due, the company simply issues a new set of CPs and borrows once again. This way the NBFCs “rolled over” funds and got around this little inconvenience to meet their short-term obligations.
Until the lenders refused to invest in next set of CPs. This resulted in the liquidity drying up. The company was unable to raise funds. This led to liquidity stress, causing a mismatch of assets and liabilities.
Now there was a panic, since the liabilities were of short term nature which couldn’t match with long term loans which were paying them back over longer time frame. Additionally, fresh funding from investors, as well as banks completely dried up or came in at an increased cost only.
The second central figure in the story of NBFC crisis emerged from the confines of the housing finance sector. An HFC-NBFC like DHFL disbursed loans with repayment periods of about 20 years. Despite the unusually long repayments periods, the loan was rather safe. It generated reasonable interest income and in case of the borrower’s default, DHFL will still have a property that could be liquidated to recover their investment. DHFL tried to decrease its costs by borrowing at cheap rates. But cheaper borrowing was conditional. On short duration. Lenders gladly invest at cheap rates if the loan is repaid sooner. The same situation that was faced by IL&FS.
After-Effects of NBFC Crisis
In September 2018, IL&FS defaulted on a series of repayments. The corporates and the fund houses who were its generous lenders were stunned. The market panicked and it spread across sectors. ICRA and CARE, the rating agencies downgraded its ranking from AA to Default overnight. Earlier the same bonds had been rated AAA, implying that the possibility of a default was near nil. Other IL&FS bonds were also significantly downgraded.
It was time for a thorough re-evaluation. , meaning the likelihood of default was now much higher – an obvious conclusion but long overdue. The panic reached Sensex and NBFC stocks fell within the next few days. The investor’s got alerted. It lead to a general loss of trust in the NBFC sector.
The event also raised concern about the rating methods being used by the rating agencies. It also questioned the role of independent auditor agencies, as they were unable to anticipate this despite having access to the company’s balance sheet.
The situation become worse when DHFL, Reliance Capital Finance as well as Reliance Home Finance etc. tumbled over. The loans in balance sheets of the banks became NPAs (non-performing assets). And the effect was felt on the entire financial ecosystem.
This liquidity crisis made banks and NBFC wary of lending. The borrowers, whose survival depended on NBFC lending got into distress, and this distress further declined the asset quality of banks and NBFC. For example, in the auto sector, in which both showrooms and customers depend on NBFC financing, automobile sales declined terribly. And real estate, when the manufacturer needed finance to complete the project, but the lenders closed shop due to their liquidity issues. This hit the construction plans and the properties were not completed. And couldn’t be sold to recover the loans. Such borrowers defaulted. The financial stress of delays, the accumulation of interest, and tough business conditions turned into a solvency issue. And the vicious cycle of market recession begun. The companies were left with good assets but unable to borrow against them.
How it was solved
Though it would be wrong to say that the NBFC crisis was completely solved. But the steps taken by RBI, and, then some, by the government too, contained the desperation of the situation. And the market has started recovering.
RBI, to solve this issue of NBFC crisis, first, pooled large funds in the NBFC, as well as the banking sector, to minimize the impact through OMO (Open Market Operations). Together with monitoring the top major NBFCs based on business volume, size, etc., closely. A committee was formed for reviewing the framework of liquidity management.
Later, the government supported RBI’s efforts by announcing that it will be providing 6-month partial guarantee against buyout of high-quality pools; to ensure the sector has enough liquidity.
RBI bought government debt paper worth Rs. 3 lakh crore from the market. This way the money was provided to the banking system to on-lend. But the cost of borrowing from risk-averse banks is still high for NBFCs is still high. This prompted NBFCs to hit alternative sources such as external commercial borrowings, public bond issuances, and sale of assets. Still, this only helped to repair balance sheets and refinance liabilities.
Therefore, RBI changed some of its rules and reduced restrictions on banks on the number of loans they could make to NBFCs. Making it easier for NBFCs to obtain funds. Banks could earlier lend only up to a maximum of 10% of their loans to NBFCs. This limit was raised to 15%, temporarily, for a few months. This step released close to $10 billion worth of liquidity into the cash-starved NBFC companies. NBFCs could raise cash in the short term and roll over their debts.
On the other side, RBI cancelled NBFC License of several companies which were found to be disregarding the regulations.
Road ahead
NBFC crisis left us with innumerable lessons. The first and the foremost being the need to relook at the rating methods adopted by various agencies to make the predictions more accurate and advance, before the event actually occurs.
The regulations on the role of auditors and independent Directors appointed by these companies need to be looked into as well.
The impact of this crisis was not felt only by a few sectors but the whole economy. Slowdown in NBFC lending has affected real estate and automobile sectors, claiming at least 2.5 lakh jobs. Therefore, a solid mechanism to identify the weak ones need to be put up.
Apart from that, stress test for NBFCs needs to be done frequently; in order to regain the confidence among the investors and lenders. The investors and lenders should also not blindly trust the rating agencies; rather they should take decision using both the rating agencies and their internal risk assessment of the client & investment opportunity. The crisis has also highlighted the importance of maintaining sound ALM practices on balance sheet and the proportion of products which doesn’t cause ALM mismatch in debt raising plan of companies should be higher.
Despite the crisis, the sector seems to have learned its lessons and come back stronger. Some steps to avoid such scenarios will take time for they are to be taken by the government, on a nation-wide level. Such as improvement in regulations. By either giving more teeth to RBI with capacity to enforce implementations of NBFC regulations or setting up a separate regulatory agency for NBFCs, equity and bond markets, pensions, mutual funds, insurance, etc.
Till then, the financial institutions will remain conservative with their cash and the borrowing more expensive. It is quite likely that the progress will be muted.
Though the worst is over. The market of NBFCs is reviving and companies are lining up to get NBFC license.
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Frequently Asked Questions
Q. What is the NBFC crisis?
A few of the major and systematically important NBFCs or Non-Banking Financial Companies in India faced severe liquidity issue that was attributed to mismanagement of their assets and liabilities. Due to which it had a ripple effect on the economy.
Q. How did the NBFC crisis happen?
- To put in simple words, NBFC IL&FS was borrowing funds to be repaid within 6-12 months. But this was being lent for purposes that the NBFC would have received back after a long duration. This made it vulnerable to Asset Liability Mismatch. At the time of economic slow-down, the cash flow got low and it defaulted on the payments of the borrowed funds.
Q. How the whole NBFC sector was affected?
The logjam of IL&FS acquired crisis proportions when many NBFCs were forced to sell their profitable assets to generate cash to repay maturing debts. The defaults occurred around the same time as liquidity in the banking sector was under deep stress. Banks, because they were already reeling under the weight of past debts, became excessively risk-averse to lend to NBFCs.
Q. What was the impact of the NBFC crisis?
NBFCs have become increasingly important for all-inclusive growth of the economy. Their share of the credit has increased because they operated in sectors where banks refused to or did not want to lend.
Now that it is getting difficult for NBFCs to raise money or costing higher, this, in turn, is choking the flow of credit to the market. Specifically to the sectors not served by the banks. One of them being the MSME sector.
Q. How NBFCs contribute to the economy?
NBFCs play an important role in promoting inclusive growth in the country, by catering to the financial needs of customers that the organized banking couldn’t serve. They have far more flexible in terms of developing proactive products and reaching out to the untouched sectors. Funds from NBFCs proved to be most suitable to the business requirements of Micro, Small, and Medium Enterprises (MSMEs).
NBFCs provided a fillip to transportation, employment generation, wealth creation, bank credit in rural segments and supported financially weaker sections of the society. Related services such as financial assistance and guidance are also provided to the customers by NBFCs.