The Indian NBFC Crisis

Galileo Galilei once said, "All truths are easy to understand, once they are discovered; the point is to discover them." In 2009, when the world markets were reeling from the after-effects of the global financial crisis, a financial columnist for the New York Times authored a book titled Too Big to Fail: Inside the battle to save Wall Street, based on events surrounding the mortgage crisis. The book went on to become a best seller but what's particularly riveting is the recurring theme of the story. The "too big to fail"theory asserts that certain financial institutions are so large and so interconnected that their failure would be disastrous to the greater economic system, and that they, therefore, must be supported by government when they face potential failure. India is currently grappling with one such crisis.

Our story is an attempt to put together a coherent version of the fiasco which is now being dubbed as "India's own Lehman Moment"

The Boom of Shadow Banking

Our story begins with shadow banks or more precisely Non Banking Financial Companies (NBFCs). It is perhaps a bit disingenuous to brush aside all NBFCs as shadow banks. Shadow Banks are legally defined as entities that work with little to no regulation. NBFC's, on the other hand, are well regulated, albeit not held to the same standards as private and public sector banks. But they are and continue to be an essential cog in the Indian economy. When public sector banks were reeling under pressure from bad loans and withdrawing from the lending space, NBFCs were the first to answer the call. They plugged the funding gap and helped continue to propel growth and yet, for all their contribution to the Indian economy very little is known about these intermediary institutions.

While regular banks take deposits from people and cover a wide gamut of responsibilities including providing payment and settlement systems, savings accounts, cheques, credit lines etc. NBFCs specialise in particular fields. Mannapuram finance specialises in gold loans, Bajaj Finance in automobile loans and this specialisation allows NBFCs to occupy a special place in the banking industry. Considering most NBFCs are non-deposit taking, they are not subject to the stringent RBI regulations and this has allowed them to grow at a blistering pace over the course of the past few years.

Currently, there are about 11,400 shadow banking companies in India with a combined balance sheet worth $304bn and with loan portfolios growing at nearly twice the pace of banks. But this story isn't about all NBFCs instead it's about the principal architects of the crisis and there is none bigger than the leading Infra Finance company IL&FS or Infrastructure Leasing and Financial Services

The Big Daddy of the NBFC space

IL&FS was set up in 1987 when a consortium of banks decided that there was an urgent need for a financing institution in the infrastructure space that could double down as a technical consultant as well. In a bid to fund and profiteer from the infrastructure boom of the 90's, IL&FS grew to be one of the prominent players in the financing industry with powerful backing from a rich set of institutional shareholders.

Over the subsequent decades, the company morphed and evolved into a gargantuan behemoth with over 300 group companies. With a slower-than-expected growth in the Indian economy, stalled projects and payment delays to the firm, the financier had to rely increasingly on debt funding until the burden ballooned to over 90,000 crores at which point, IL&FS was proving to be a major liability to the financing industry.

DHFL and the Asset Liability Mismatch

The second central figure in the story emerges from the confines of the housing finance space to highlight a problem that is now seen as endemic to large parts of the NBFC industry, a problem that is more pronounced in the housing finance sector. A housing finance company like DHFL disburses loans that have repayment periods of about 20 years. Despite the unusually long repayments periods, the loan is a rather safe bet. The company generates reasonable interest income and if the consumer were to default on his payments, DHFL will still have a house they could liquidate to help recoup a part of their investment. So there is little concern on the lending side. It's the borrowing bit that's slightly more complicated.

In an uber-competitive scenario, DHFL would want to make an extra penny by trying to borrow at cheap rates. But as the great economist, Milton Freidman often said: "There ain't no such thing as a free lunch." Borrowing at cheap rates comes with a caveat - You can't take 20 years to pay back the loans. DHFL's lenders will gladly offer cheap rates if they promise to repay the loan sooner. How soon? 3–6 months would be optimal. But DHFL is poised to receive its funds over the course of 20 years. How then could you expect it to pay back its dues within 3–6 months. This is a problem characterized by what many people like to call an Asset Liability Mismatch.

But this problem has a rather simple workaround. DHFL borrows funds with short repayment periods by issuing a contract note. In banking parlance, they call this a Commercial Paper (CP). Once the repayment period is complete and the CP is due to mature i.e. expire. the company simply issues a new set of commercial papers and borrows once again. This way the company can "roll over" funds to meet their short-term obligations. Some naysayers have equated such manipulation to Ponzi Schemes, a fraudulent investment operation that offers returns using money paid by subsequent investors, rather than from any actual profit earned. While there are similarities, in that both schemes require new investment from other sources to keep working, NBFCs, unlike Ponzi schemers, have the capacity to earn income from their usual lending operations. And so NBFC's get around this little inconvenience rather easily until that is they can "roll over" the funds no more i.e. the lenders refuse to invest in Commercial Papers.

The Stage is Set

And finally, the moneylenders of the industry form the final piece of the triumvirate responsible for the crisis. These elusive folks deal in such complicated instruments as Commercial Papers that they often slip under the radar because of the sheer complexity involved in buying them. Well, that is not entirely true. You could get your hands on one of these if you were determined enough to push through. But not a lot of people are into bonds and commercial papers and so the only prominent actors include large corporates and fund houses who buy and trade these bonds in large volumes. Our story today will focus on Mutual Fund houses in particular - the good people who pool money from the general public and then invest them elsewhere to offer what they claim are better returns than the market average.

While most people think of mutual fund houses as institutions that buy shares of publicly listed companies they also happen to buy bonds and commercial papers so long as the fund managers believe CPs offer better avenues for generating higher returns. The fund managers also make another tacit assumption in that the amount will be paid back. If the fund Manager were to grow suspicious of the borrower's ability to repay, all funding stops.

With the lending industry in the bag, the stage is now set. The perfect storm is just about to hit Dalal Street

. . .

The Perfect Storm

On September 4th 2018, IL&FS breaks the cardinal rule of the Finance Industry. It defaults on a series of repayments. The corporates and the fund houses who generously granted loans to the behemoth were stunned. After all, this was unexpected. The rating agencies responsible for evaluating the company's ability to pay back its debts had rated the bonds AAA, meaning the likelihood of default was near negligible and yet IL&FS was now poised to default on thousands of crores worth of loans. It was time for a thorough reevaluation. The credit rating agencies changed their rating on these bonds from AAA to junk overnight. Other IL&FS bonds were significantly downgraded, meaning the likelihood of default was now much higher - an obvious conclusion but long overdue. Fund Managers and Chief Financial Officers across the board were making provisions of their own in the event of a catastrophic failure. It did not take long for tremors to reach Dalal Street and NBFC stocks took a pounding the next few days. The investor community was now on red alert.

Far from the eye of the storm, DSP, a mutual funds investment company was making preparations of its own. The company was already exposed to IL&FS after having lent 629 Crores worth of loans and it was about to do something that would further compound the problem. On September 21st, a full 16 days after the first IL&FS default, DSP sold 300 Cr. worth of commercial paper. The deal in itself wouldn't have raised eyebrows if it hadn't been for 2 important details. The commercial papers belonged to DHFL, a solid growth prospect in the housing finance space and the papers were sold at a discount. The discount in itself wasn't steep and considering the large volume (300 Cr.), you could argue that the discount was indeed warranted. But in times of fear, rationality takes a back seat. Over the course of 5 trading days, DHFL's stock price tumbled from Rs. 613 to Rs. 273, a precipitous fall of 55%. The investor community had taken the signal - DHFL was going the route of IL&FS or was it?

The capitulation was complete but it wasn't very apparent to the general public as to why the stock took a beating. On the face of it, it seemed like all of this was a massive misunderstanding. The management team at DSP stated that the sale was a purely routine exercise to raise some extra cash and that DSP still held DHFL papers in bulk. This, by all accounts, was a statement of intent - it trusted DHFL to pay back its debts. The credit rating agencies had reaffirmed the AAA rating on the commercial papers and the DHFL management had made no qualms about their ability to repay all their obligations and still be left with more cash.

The Rumour Mill of Dalal Street

However, word on the street was that with the IL&FS crisis unfolding the way it did, several lending institutions were likely going to go under and that DHFL was going to be first on the roster. There were also rumours about DSP being under sustained pressure to meet its own payment obligations. Running a mutual fund means you ought to be wary about customer withdrawals - financiers call this redemption pressure. With depleting cash reserves it seemed the DHFL Commercial Paper sale was imperative. The discounted sale also marked a loss of trust in NBFCs they said. The assumption was that with the eroding trust, the inflows from mutual funds were likely to stop and when they did NBFC's would have nowhere to go.

Investors were also picking apart the finances of NBFCs, including DHFL and the numbers suddenly didn't look all that rosy. The asset liability mismatch, which was only a passing concern for much of DHFLs existence suddenly looked like a gaping hole in the balance sheet despite the company stating otherwise. There was also a commitment from the board to move away from short-term commercial papers to long-term bonds in a bid to minimise the asset liability mismatch but all this fell on deaf ears as the stock continued to tumble.

RBI vs the Government

Meanwhile, the Reserve Bank of India was making temporary concessions in a bid to halt the calamitous fall. While it was indeed true that mutual funds had become extremely conservative in funding NBFCs, banks were now ready to take the mantle. RBI for its part relaxed restrictions that would enable them to further boost this much-needed funding operation. However, it was rather uncanny that the government believed otherwise. There were reports emerging about a possible rift between the RBI and the government on how best to tackle the crisis.

According to the Department of Economic Affairs, a whopping Rs 2 lakh crore of NBFC/HFC debt is due for redemption or 'roll over' by the end of December 2018. The government believes that based on current estimates, the system could see a funding gap of as much as Rs 1 lakh crore and in the off chance that this gap isn't bridged, some of the largest NBFC and HFCs may default on a significant amount impacting the whole financial system and in turn the economy as well. Now I am no expert on policymaking, but if I were the government looking at these numbers, right at the precipice of an election year, I'd be concerned.

The government wants to avert such possibilities. But RBI seems to be in no mood to change the status quo. It continues to believe that the current predicament does not warrant any further action and it is quite content to sit back and watch. Between the government and the RBI, retail investors seem to be caught between a rock and a hard place. While we can't tell you who's making the correct call we want to remind you that the RBI's mandate is to safeguard our economy from collapsing, not propelling growth at the risk of collapse. So for all of RBI's shortcomings, maybe there is some merit in heeding to their advice, for the advice does not seem to originate from a place of malice.

Back to the Stone Age?

So what happens to NBFC's now? Well depending on who you ask, this could be a minor blip that ought to last another couple weeks or this could potentially be the moment of reckoning for everybody in the industry. Its quite likely that growth will stay muted, in a scenario where institutions are conservative with their cash and profitability of such banking firms is probably going to take a hit as borrowing becomes more expensive. But beyond this, it is anybody's guess how this crisis will play out. One feature that has been consistent, however, is the conspiracy theories - "All NBFCs have stopped lending" " We are all going back to the stone age" " This is a devious plan by the Congress and Rahul Gandhi."

Please stop paying attention to this nonsense. We urge investors to exercise discretion and carefully dissect opinions to separate the wheat from the chaff for when this is all done, we hope that NBFCs still continue to hold an important place in the banking industry and that the fallout is limited to facts and not fiction.

Fellow reader, I ask you, Where is your bet?

. . .

Disclaimer: No content on this website should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. The author accepts no liability for any actual investments based on this article.

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Review & Analysis by Pawan, IIM Ahmedabad

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