The NBFC Crisis

Its Effect on Indian Economy

The NBFC Crisis
The NBFC Crisis

A severe crisis is being faced by the Non-banking financial companies (NBFCs), especially by the smaller ones who are wrestling with problems of assets liability mismatch in the midst of corporate governance issues. The liquidity crisis that the NBFCs are currently facing possesses threat of bringing down severe impact on the country’s overall growth rate in the long run. But before we speak on the crisis, let us understand NBFCs first.

NBFCs are quasi-banking organizations of India. They provide loans like banks but do not possess banking licence. They are not permitted to accept traditional demand deposit for providing the loans. Therefore, they raise the funds from the bond market for providing the loans. They play a crucial role in promoting country’s comprehensive growth by catering the financial needs of those customers excluded by the bank. Apart from this, the NBFCs also provide financial assistance to Micro, Small, and Medium Enterprises (MSMEs) according to their business needs. Additionally, it plays a critical role in generating employment, bank credit in rural sectors, wealth creation, assisting the weaker sections of the society by providing financial help. However, NBFCs falls under the theory of “shadow banking”, thus they have less regulatory compliances.

Now in case if you are wondering about what the crisis was and why is it important, here’s the answer.

What is NBFC crisis all about?

A major liquidity crisis is being faced by the NBFCs. In other words, they do not have enough money to lend or are surrounded by infinite barriers in raising the funds. Typically, to raise the funds, NBFCs move to bank to borrow the money or sell commercial papers to mutual funds. They then lends this money to MSMEs, retail customers etc. In the case when NBFCs fails to lend the money, it tapers the credit flow to the country’s economy, affects the economic growth and also becomes the reason of borrowers to be the loan defaulters.

Crisis started surfacing from the second quarter of 2018 when the NFBCs faced a perfect storm. Their stocks stated hammering. There was a decline of 60% in the stock price of DHFL. DHFL was considered to be a blue chip stock of NFBC. Same went for Infrastructure Leasing & Financial Services (IL&FS). IL&FS was considered to be the stalwart of this sector. IL&FS got hit by a debt burden of approximately₹ 91000cr. Their Debt Equity Ratio almost moved to 18 times – a horrendous situation and hyper burden for the company.  IL&FS was established in 1987 as an “RBI registered Core Investment Company” by three financial institutions – CBI (Central Bank of India), HDFC (Housing Development Finance Corporation), and UTI (Unit Trust of India) for providing finance & loans to major infrastructure projects. As of 2018 it had 256 group companies including joint venture companies, subsidiaries & associate entities. Its major stake holders include LIC of India (25%), ORIX – a Japanese company (23%), ADIA – Abu Dhabi Investment Authority (12%). It had several projects in multiple sector like Transportation, Area Development, Health Initiative, e-commerce, Finance, Cluster Development, Water & Waste management, Ports, Environment, Tourism, Urban Infrastructure and Education. Thus, the enormous amount of debt burden had hit these sectors. Many projects have been stopped in the middle way due to lack of funds. Meanwhile, the Indian banking sector was struggling with bad loans and high non-performing assets due to kickbacks & nepotism. The banks asked for higher returns on the loans that they provide to the NBFCs. The NBFCs felt short of fund. The squeeze from the NBFCs’ end & subsequently higher rate of interest hurt the real estate, jewellery firms, the auto sector and even the FMCG sector. Car sales dropped drastically as well as there was a weak growth in the volume of FMCG firms. However, to understand how this crisis situation came up, we need to go into a little bit more in-depth analysis.

Reason behind Crisis

Among several reasons, first, to begin with, the business model was itself a flawed one. It heavily relied on short term funds which were on-lend as long terms. This resulted to situation known as asset-liability mismatch. It is a situation where NBFC rolls over debt paper or raises fresh loans in order to repay previous debt paper. This looks good at favourable hours but at tough times, the cycle gets broken which leads to the second factor. As some subsidiaries of IL&FS groups broke the chain, fears triggered that it would transpire into a contagion. Subsequently, many institutions turned down from lending money to NBFCs leading cash flows to dry up and hence NBFCs were unable to pay back their lenders. This raised the funding cost by 150 basis point for NBFCs. The major crisis started from September 2018 when IL&FS couldn’t meet its obligation of commercial paper redemption.

Mutual funds like HDFC, DSP and several others were hard hit by IL&FS scam which forced them to stop funding the NBFC. Consequently, a sharp decline in the consumption was observed in the third quarter of FY2018-19. Subsequently, a decline in the growth rate of GDP was also observed.  The impact was clear when the GDP growth rate declined to 5.6 percent in the last quarter of FY2018-19.

However, this situation might not had been worsened so much if government had stepped up when IL&FS scam got exposed and the NBFC sector started having the crisis situation. But government could not much action as during the last three months of 2018 late former finance minister Arun Jaitley was suffering from health issues. Even the RBI also had not paid much heed as it was also undergoing a few changes during that time. Then started the budget session followed by election phase for which the government was not able to pay much attention. After the NDA government was formed for the second time, the government got busy in making the budget followed by the Kashmir issues which kept them further occupied.

The representatives of the market moved to the government to discuss on the liquidity crisis that they were facing for a long time then. But, RBI kept on decreasing the rate of interest mentioning that there was enough liquidity in the banking sector.

Now, the issue was that the banks did not lend to the consumers. The lending was done by NBFCs who since September 2019 have withdrawn lakhs and crores of rupees from the market to pay back their liabilities. Hence, they were not getting back the money they were lending in order to lend them further. As a consequence the market was facing a liquidity squeeze. Here the question is how had this liquidity squeeze manifested itself? This liquidity squeeze manifested itself by sharply declining the purchase rate of autos & cars, real estate and also constructions done by the real estate companies. Over 95% of the financing for the vehicles were said to be done by the NBFC sector.

How does it affect the economy?

When we visit a dealer with the desire of buying a car, we also seek for finance. If we approach the approach the banks for loan, it usually takes around 20 days for the bank to grant it. Additionally, banks ask for too many securities against the loan, whereas NBFCs grant us immediate loan against much less security and paper works compared to banks. Hence, most of the financing which were done by the NBFCs stopped due to the liquidity crunch. As a result, consumer car loans dripped which lead to the fall in the car purchases. The same was the case for two-wheelers also.

Next, the NBFCs were also hugely lending money to the real estate companies since they were not getting loans from the banks. NBFCs were providing funds to these companies for new projects, constructions & financing. However, after Real Estate Regulatory Authority Act (RERA), the money given by the house owners could be diverted, hence, they were forced to get dependent on NBFCs for their working capital requirements also.

Now, because of the ongoing crisis in the NBFC sector, the real estate companies could not move ahead with their projects and subsequently they are being forced to shut them down. As a result the projects are remaining incomplete due to lack of funds.

The effect of NBFC crisis has also fallen on the car dealers. NBFCs used to finance the car dealer and also a part of the supply chain. But as the car sales have declined, the effect has fallen even on them. They are forced to shut down their shops because they are unable to store the inventories & make money from them. Due to lack of financing they cannot stock the cars & without having stock, selling is impossible. Therefore, there is a chain.

Going through the balance sheet of the NBFC sector, it was found that they had built liquidity of one lakh crore rupees. But, liquidity in the balance sheet of the NBFC means they have kept it for repaying their liabilities and not for lending. Therefore the main problem arises here. Since they are not lending but paying back their liabilities in order not to be defaulters, there is no infusion of money into the market.

Government Steps to revive NBFCs

To improve the liquidity access in the NBFC sector, the government proposed to give one-time 6-month partial guarantee of ₹1 lakh crore to the state run banks in order to purchase consolidated high-rated pooled assets of financially-sound NBFCs. It would cover up their first loss of up to 10%.

Secondly, Finance Minister Nirmala Sitharaman proposed to permit investments done by foreign institutional & portfolio investors in debt securities issued by the Infrastructure Debt Fund-NBFC to be sold or transferred to any domestic investor within a specified lock-in period.

For treating NBFCs systematically like banks, interest on certain bad or doubtful debts were allowed by the government to be taxed in the year on which the interest is actually received.

Additionally, to raise the funds NBFCs have been allowed to create a Debenture Redemption Reserve (DRR), which was previously allowed to only public issues. Moreover, the government also proposed to allow NBFCs participate directly on the TReDS platform.

The Way Ahead

It’s time that government takes more innovative steps to solve the liquidity issue at first by implementing schemes through which the NBFCs can sell off their assets & raise the liquidity. Here, the RBI also needs to step in and monitor the total lending process so that borrowings once again can pick up in the economy. RBI has changed its rules and temporarily allowed the banks to lend 15% of their loans (previously the limit was 10%) to NBFCs in order to make it easier for them to obtain capital. The instant effect of this step by the RBI has been to release approximately $10 billion worth of liquidity into the cash-starved NBFC sector.

Moreover, the government has recently allowed the RBI to seek resolution of NBFCs having net assets of more than ₹500cr under the ‘generic framework’ of Insolvency & Bankruptcy Code. The introduction of ‘generic framework’ came against the backdrop of ongoing liquidity crisis in NBFCs that has critically sparked solicitude on overall stability of the nation’s financial sector. This move is likely to address the woes in the NBFC sector.

Next, the government needs to assure the industries that they do not get any more shocks. The industries received enormous shocks with demonetisation followed by Goods &Service Tax, RERA, IBC (Insolvency & Bankruptcy Code) and the current liquidity shock due to the NBFC crisis. Due to subsequent shocks, situations in most of the companies are like standing in the middle of the water and not having any idea on what to do as they have no one to listen to them, hence they are giving up.

Lastly, its not due to absence of regulations but because of ineffectual supervision by the NHB & RBI that has opened the doors for IL&FS &non-bank crises to play their part. Hence, instead of adding up to their voluminous ordinances, both the regulators should deploy additional manpower & obtain forensic capabilities in order to critically monitor the incessant statutory filings of each firm. Only this might have the possibility of nipping future crisis in the NBFC sector.


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Banking Sector Reforms- II


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