As concerns move from liquidity to solvency of select NBFCs, uncertainty is the bigger challenge
Neelkanth Mishra | Last Updated at November 7, 2018 22:57 IST
(This was published in the Business Standard: link)
The credit outstanding with Non-Banking Finance Companies (NBFCs: in this article this includes the Housing Finance Companies or HFCs as well) was 28 per cent of banking system credit in March 2018, versus 19 per cent in 2014, and just 14 per cent in 2007. Perhaps more importantly, they have accounted for nearly a third of incremental credit in the last three years, stepping in as the public sector banks (PSBs) slowed. Therefore, much more than prior such cycles, as their growth slows down due to a protracted difficulty in accessing funds, there could be a significant impact on economic growth.
To be sure, the potential size of the problem should not be very large. With the combined leverage in the larger NBFCs (excluding the HFCs) only around 4.5, solvency risk at an aggregate level is not a concern: A fifth of the loans would have to fail for the bond-holders of NBFCs to be at risk. For the HFCs the ratio is slightly higher at 6.7, but then most of their loans are mortgages, backed by significant collateral. There may be, and likely are, firms that are over-leveraged and possibly at risk. But this is very different from the North Atlantic financial crisis a decade ago when, heading into the crisis, most large financial firms had leverage ratios in excess of 20, with several above 30: Even 3 per cent of the loans going bad would have eroded their net worth.
There appear to be a few pockets of potential problems in asset quality, starting with real-estate. The loans to real-estate developers from the top 25 banks and NBFCs grew 53 per cent between 2016 and 2018 to Rs 5 trillion, and seem to have grown further in the first half in this financial year. As this was a period of sluggish sales and weak prices, a justifiable concern is that a lot of this growth was ever-greening of bad loans. Some comfort though can be drawn from the fact that about a third of these loans are borrowings against a reasonably assured stream of future rental receipts on existing properties.
The contagion risk to the overall real-estate market and the economy may be contained by the fragmented nature of the industry, the fact that the top 8 cities are only 6 per cent of the total housing stock in India, and the small market share of organised real-estate (many houses are self-built). This too is notably different from the situation in Japan, the US or Spain seen in recent decades, which commentators often get tempted to refer to.
A second potential source of problems could be the smaller NBFCs, on which there is no aggregate data available, but which, based on anecdotal evidence, have grown rapidly in the last few years. In an environment of low appetite for lending to NBFCs, many of these new firms may not be able to survive. Unsecured financing to small and medium enterprises (SME) has also grown rapidly in the last few years, but this being a relatively new product defaults are unlikely to be large in absolute terms.
Though the size of the potential problem may be small in aggregate, the inability to identify the few firms at risk and the inter-linkages between them and other entities are the root cause of the prevailing uncertainty that has frozen funding access to all these firms. As NBFCs are lightly regulated, there is a paucity of aggregate data almost by design — only deposit-taking NBFCs and those with assets greater than Rs 5 billion are required to submit returns to the Reserve Bank of India (RBI). The details of their sources of funding, and the end-markets they lend to, are hard to decipher.
Further, unlike in the prolonged resolution of stressed assets in the banking system, where the public ownership of affected banks obviated the risk of a default, most of the NBFCs are private, and the markets are understandably jittery about solvency. A speedy resolution of suspected problem cases therefore becomes necessary: The stalled Financial Resolution and Deposit Insurance (FRDI) Bill (which deals with bankruptcy of financial firms) may have been handy in this environment, though probably not sufficient.
A sustained slowdown could generate its own victims and worsen the damage: Slowing disbursement of home loans, for example, can cause cash flow problems for developers, triggering defaults on construction related loans. Further, while many firms may have been irresponsibly chasing growth, many others have also driven product innovation, creating and growing new markets and helping the spread of formal credit. Their failure would not only slow down formalisation, but also impede access to credit for SMEs.
Tightening of the short-term funding markets began in September, and turned to a freeze after the Infrastructure Leasing & Financial Services (IL&FS) default. The markets have thawed a bit since then, with commercial paper (CP: short-term funding for a few months) issuances picking up, and even financial firms are beginning to tap the market. For non-financial firms the situation seems to have normalised.
Funding for one- to three-year periods though is still not easy, possibly because markets are still unsure of the solvency of some firms. While the market attention currently is on seeing through the large amount of refinancing needed for NBFCs over the next few months, attention over time will probably turn to their asset quality. In particular, as the inability to grow their loan books exposes the ever-greening cases: Real-estate developers and SMEs being the probable candidates.
To get the markets moving again action may be necessary on multiple fronts. A primary driver of the liquidity shortage has been the Balance of Payments (BoP) deficit: The recent sharp increase in open market purchases of bonds (OMOs) by the RBI should help, but more may be necessary, particularly as many NBFCs may undergo forced deleveraging. This, too, may not suffice in sectors where the market has concerns on solvency — allowing greater market access could help the solvent ones get more funding. There should also be an attempt to reduce the uncertainty — through provision of credible information (particularly as trust in ratings is low currently), and also on what may happen should a firm fail.
Development of an alternative to a state-dominated banking system and deeper penetration of formal financing channels have long been objectives of financial policymakers. This episode, challenging as it is to navigate, could also be an opportunity to set the stage for the next ten years of growth.