Some learnings from the NBFC stress
The sector has been a market leader in terms of delivering shareholder returns. It is unlikely this trend will continue
It has been about two months since IL&FS first defaulted. Since the default, we have been through a torrid period with debt markets freezing for certain issuers, the Reserve Bank of India (RBI) being forced to pump in liquidity and a general lack of confidence in the NBFC (non-banking financial company, including housing finance firms) sector. Stock markets have taken it on the chin, with many of the NBFCs down by 30 to 40 per cent. The damage has spread to other stocks and sectors as well, the mid-cap indices are down 35 per cent in dollars and small-cap stocks are down nearly 50 per cent.
Investor sentiment is clearly shaky, everyone wants to sell at the first sign of trouble, and ask questions later. Rumours are rampant. Everyone seems to have some scoop on the next big defaulter, and their principal lenders.
It is imperative that the markets and investors draw a breath and settle down. This is not the time to panic, this is not India’s Lehman moment and the whole financial system is not going under.
There have been some important lessons to be learnt for all investors over the last couple of months as this crisis of confidence has unfolded.
First, everyone has some exposure to IL&FS and/or its subsidiaries and special-purpose vehicles (SPVs). From IndusInd Bank, Federal Bank and Bandhan to Persistent Systems and HDFC, almost every financial institution which has reported earnings for this quarter has some exposure. This shows how deeply IL&FS was embedded in our financial system. It also shows the dangers of having a poorly governed, highly leveraged financial institution and the regulatory lacunae and ambiguous ownership structure, which allowed it to raise ~900 billion of debt. However, as the debt is fragmented and spread through the system, it will not cause a solvency problem to any one institution. We do not have the elephant exposure issue, huge concentration of debt exposures in just a few banks. IL&FS shows that forcing borrowers to use debt markets, over and above the banking system, does reduce chunkiness of debt exposures and reduces a systemwide risk. There will be haircuts on the IL&FS debt, at least 30 to 40 per cent, but these haircuts will be spread through the entire financial system.
Second, it was not obvious until one sits back and sees the data exactly how beneficial the demonetisation was for NBFCs. Liquidity in the system improved dramatically post demonetisation, with a surge in financial savings. Non-banks were the biggest beneficiaries of this financialisation of savings. They were finally able to access short-term and longer tenure funding from the markets at unprecedented scale. The NBFCs were in a sweet spot. Liquidity was easy, rates were low, and access to wholesale funds had never been easier or more cost effective. The space to lend was there as PSU banks were dormant. In hindsight, both investors and the companies may have got carried away in assuming that this environment would continue in perpetuity. Valuations reflected 30 per cent growth rates in perpetuity. Anyone with some experience was able to set up an NBFC and raise both debt and equity. This game has now come to an end. Valuations have corrected and for some of the undifferentiated players, it will never go back to a premium again. The undifferentiated NBFCs without either reach or specialist lending niches will once again be seen as high beta plays on liquidity and the macro. In a benign macro environment with ample liquidity, they will do very well and suffer when liquidity tightens.
A third point is the scale and significance of the whole NBFC sector. Till one sat back and looked at the numbers, it was not obvious that the NBFCs now accounted for about 18 per cent of system credit and were responsible for more than 30-35 per cent of incremental system credit in the last two years. Neither was it clear that debt and liquid mutual funds had more than 30 per cent of their AUM in NBFC paper. The Indian financial system has a unique arbitrage available. Our banks, largely the PSU, have excess liquidity but no capital. They have liquidity as PSU banks’ market share in deposits, especially savings and term deposits has been very sticky. They cannot lend either because they are under prompt corrective action (PCA), or lack the capital to do so. Our NBFCs lack liquidity, with no deposit base, but have lots of capital, and easy access to more from investors. This system worked with the transfer of liquidity from the banks to the NBFC sector. It was the most effective way for the system to utilise the excess liquidity of the banks, optimise the capital available and ensure maximum credit delivery for the economy. Banks, if they lend ~1 to, or subscribe to the paper of, an AAA-rated NBFC, specialised in niche areas like LCV finance or MSME lending, need only about 25 basis points of capital. The same ~1 if the banks were to lend to these niche areas directly, they would need 100 basis points of capital. This is the capital arbitrage. If banks now shy away from subscribing to AAA or AA-rated NBFC paper, this liquidity transfer will break down. We will see a reduction in credit availability, as PSU banks do not have the capital to effectively lend out their liquidity as credit into the real economy. This will have implications for economic growth.
Another takeaway is that the one sector which will be unambiguously in trouble will be real estate developers. The NBFCs have grown their exposure here at a 50-60 per cent CAGR over the past few years and account for most of the new credit to these developers. As certain NBFCs are forced to shrink their book, credit flows to many developers will come to a halt. The poor state of the high-end real estate market across cities makes it difficult for them to liquidate inventory quickly. Banks will not come to the rescue, as they do not want to increase exposure to real estate or lack the capital to do so. Weaker developers will come under intense stress and we could see more defaults here. This is what the market fears. Who will default, and where are these exposures? Those NBFCs with significant real estate developer exposure are under the most pressure and will be under intense scrutiny. The debt with the real estate sector is in excess of ~5 trillion, with about half being in construction finance. Any default here is a very big deal.
The final takeaway is that the NBFC sector has been a market leader over the past few years in terms of delivering shareholder returns. It is unlikely that this market leadership will continue.