There are large non-banking finance companies (NBFCs) operating in the financial system, posing fresh serious threats to the banking system

The NPA mess in India’s commercial banks may be largely under control post the painful clean-up process, but that isn’t the case with the shadow banks. Fresh shocks are emerging, especially in the rosy books of non-banks with high exposure to real estate builder loans. Unavailability of liquidity, high cost of funds and asset quality pressure are hurting a good number of NBFCs which warrant a deeper look on their balance sheets.

For banks, this cleansing process began in 2015. Two things worked well for banks in Narendra Modi’s first term. One, the creation of Insolvency and Bankruptcy Code (IBC); IBC was essential to reduce the time required for resolution for banks with respect to large, sticky non-performing assets (NPAs). Prior to IBC, many corporate default cases lingered in courtrooms for six-seven years. Cash-rich promoters used to drag banks in prolonged legal battles, at the end of which hardly anything left in the underlying asset. This has been brought down to a few months now.

Second, the clean-up of the banking system was long overdue. The Asset Quality Review (AQR) initiated in 2015 under former governor Raghuram Rajan, aided by strong political will of the Narendra Modi government, has played an important role in digging out the hidden dirt in banks’ balance sheets, which till then, happily retained much of the NPAs on their books as standard assets using technical adjustments. The addition of the Rs 9 lakh odd crore Gross NPAs on banks’ books is, thus, actually good news and not a cause of worry. The illness within would have turned fatal if remained untreated.

But what about NBFCs?

As said earlier, India’s vast and complicated financial system doesn’t end with commercial banks. There are large (some of them even bigger than smaller SCBs) non-banking finance companies (NBFCs) operating in the financial system, lightly regulated by the Reserve Bank of India (RBI) posing fresh serious threats to the banking system as well. These entities, which are shadow banks, have complex interlinks with the broader financial markets—banks, mutual funds and public depositors.

Some of these NBFCs are beginning to falter under severe liquidity crunch, loose governance practices and allegations of financial irregularities.

IL&FS scare

IL&FS, which started as a road construction financing company and now a financial behemoth with a rumoured 348 subsidiaries, grew its debt to about Rs 91,000 crore without getting much attention. It’s debt to earnings ratio was jumping to dangerous proportions. Yet, rating agencies, analysts and regulators waited till the last moment to ring alarm bells. When IL&FS finally started to default on its payments to institutions, a scare spread in financial markets forcing the government to take over the board and begin the repair work. That process is underway.

Top 10 debt funds’ by exposure to NBFC as of April 2019 Scheme name Categorisation % exposure Essel Short Term Fund - Growth Short Duration Fund 39.97 Essel Liquid Fund - Regular Plan - Growth Liquid Fund 30.51 DSP Savings Fund - Regular Plan - Growth Money Market Fund 24.43 DSP Ultra Short Fund - Regular Plan - Growth Ultra Short Duration Fund 23.56 BNP Paribas Liquid Fund - Regular Plan - Growth Liquid Fund 23.13 Mirae Asset Short Term Fund - Regular Plan - Growth Short Duration Fund 22.34 BNP Paribas Corporate Bond Fund - Regular Plan - Growth Corporate Bond Fund 22.24 Union Liquid Fund - Growth Liquid Fund 22.21 Canara Robeco Corporate Bond Fund - Regular Plan - Growth Corporate Bond Fund 22.04 BOI AXA Liquid Fund - Retail - Growth Liquid Fund 21.76 Source: Crisil

IL&FS crisis triggered a panic situation among commercial banks which are major funding sources to these institutions. Credit lines were halted for a while before the government intervened and assured all steps to salvage the situation. But, the wound left by IL&FS stayed and banks and mutual funds significantly cut their exposure to NBFCs creating a persistent strain on liquidity and forcing the investor outlook to change on NBFCs.

But as in the case of most financial crises, everyone woke up to the IL&FS episode too late. According to The Economic Times report, RBI twice warned that IL&FS financial services’ net-owned funds were wiped out. None, including board members or rating agencies, paid any attention to it. Along with this, the liquidity position was turning grim. Cost overruns and escalating interest cost added to the weakness. All major shareholders, including LIC, let the crisis run its course and blow up ultimately, forcing the government to take over the board of IL&FS.

Logically, NBFC stocks lost big on Indian bourses since IL&FS crisis. According to a Bloomberg report, mutual fund investments in commercial paper and bonds that mature within 90 days dropped to Rs 3.24 trillion ($46.5 billion) at the end of March, the lowest in six quarters. The report quoted sector expert to say that MFs have cut their exposure to NBFCs debt to 27 percent of assets under management as of the end of March from about 34 percent last September.

DHFL next

The next big shocker in the non-banking finance space came when Dewan Housing Finance Ltd (DHFL), one of the largest NBFC home loan financiers in the country started feeling the liquidity pinch. DHFL got attention when DSP Mutual Fund sold Rs 3,00 crore of DHFL papers at 11 percent in the secondary market, way higher than the traded rates raising fears that borrowing costs may be shooting through the roof.

Rating agencies soon began to downgrade DHFL papers one by one, finally forcing the NBFC to stop taking fresh deposits and even restrict premature withdrawals. The problem with DHFL episode too was in its linkages with the rest of the financial system. At the last count, there were as many as 164 MF schemes across 23 asset management companies with total industry exposure to DHFL alone at around Rs 5,183 crore, as on 30 April 2019, according to data provided by Value Research.

What did the RBI do? In a draft circular last week, the RBI proposed to introduce Liquidity Coverage Ratio (LCR) for all deposit-taking NBFCs and non-deposit taking NBFCs with an asset size of Rs 5,000 crore and above even as it denied a special credit window to the NBFCs. The central bank’s proposal is to implement the LCR requirement in a calibrated manner through a glide path over a period of four years commencing from April 2020 and going up to April 2024.

NBFC AQR due?

But, is a new LCR requirement enough to contain the risk in the NBFC sector? There is a growing view that the banking regulator put NBFCs in the country through an asset quality review just like banks were subjected to in 2015. The recent episodes have raised serious questions about the actual state of the books of mid-sized and larger NBFCs whose papers are with mutual funds. The process will be, of course, painful for the liquidity-starved NBFCs. But, it will help to sort out the uncertainty of the quality of assets.

Siddharth Purohit, an analyst at SMC Global Securities said few NBFCs with high exposure towards builder loans and LAP (Loan against property) have asset quality issues and Liquidity issues as well. “But I don't think there is a need for separate AQR for the NBFC sector. What is important is to provide more liquidity to some well managed NBFC so that there won’t be any contagion effect,” Purohit said.

But no one can deny that there is a sizeable exposure from banks to NBFCs. As of March, 2019, banks’ exposure to NBFCs stood at Rs 6.4 trillion, which grew from Rs 5.6 trillion a year-ago. In the 12 months ended March, this exposure grew about 30 percent. NBFCs will face a major problem if their funding taps dry and asset quality issues come up. That will have a cascading impact on the banking sector, without a doubt. India’s problematic shadow banks need an AQR pill before it is too late.