Brewing crisis in Non-Banking Finance Corporations

• NBFC sector facing tightening of liquidity
• Mutual funds reducing exposure to NBFCs
• IL&FS and DHFL default signals a bigger crisis in the making

In the past year, the Indian corporate world has been marred with huge banking and liquidity crisis, while issues regarding fraud and bankruptcies added to the wounds. The fallout of the same has been catastrophic, with ballooning public sector banks NPAs touching ~INR 10 lakh Cr., the disintegration of the Infrastructure Leasing & Financial Services (IL&FS) and the Anil Ambani Reliance group. Currently, the brunt being faced by Dewan Housing Finance Corporation Limited (DHFL) on the back of the liquidity crunch and allegations of malpractices to the tune of INR 33,000 Cr. as reported by the Cobra Post in Jan. 2019. All this has badly shaken investors’ confidence in shadow banks (non-banking finance companies [‘NBFCs’]) and has led to a more stringent stance from regulators (introducing harsh, inflexible rules), credit rating agencies (taking a very conservative approach), and fund managers (reducing exposure to securities in the NBFC space).

NBFCs account for ~19.2% of the total credit extended by the Indian financial system. These intermediaries have helped plug the funding gap by lending to borrowers deemed too risky for the commercial banks and in-turn helped propel the economic growth by making credit availability to people at large. Ironically, the NBFC sector gets a majority of its funding from mutual funds and commercial banks (indirectly making them a party to the risk, which they were not willing to take directly). It is pertinent to note that unlike commercial banks, NBFCs do not have ready access to cheaper public deposits and they raise debt from outside (commercial banks, or issue corporate debts, commercial paper, foreign currency debts, etc.)

The biggest risk faced by the NBFCs today and in the past has been related to their asset and liability mismatch. On the asset side, they usually lend to borrowers for a longer term (typically 20-30 years), however, on the liability side, they source these funds for a shorter term (typically 2-4 years) and at the maturity roll over these debts. Moreover, until the time, the NBFCs were paying their dues, rating agencies ignored this inherent risk and gave them high ratings, while mutual funds (seeing high ratings) readily bought these debt securities. Things became complicated when NBFCs faced the short-term liquidity crunch (owing to the timing differences in the receipt and repayment of dues), thus, initially leading to stress in working capital and eventually leading to a default on dues for some. As things turned murkier, rating agencies rushed to rate these debts as junk grade and pushed the interest yields on bonds and other tradable debt securities upwards. Mutual funds did write-off to the tune of 75-100% of their exposure (as required by SEBI), leading to their selling of other securities to meet the redemption demand from investors. All this led to a full-blown liquidity crisis in the recent past as these NBFCs were unable to secure fresh funds (even if they could their cost of funding rose dramatically) leading to a few defaults on other borrowings as well. This highlights an important point that these debt securities not only carry interest risk but also default risks.

In September 2018, IL&FS was the first large NBFC (deemed too big to fail) to default on its debt obligations, triggering a liquidity crisis in the financial services market (the debt portfolio stood at INR 99,354 cr. at that time). The issue here was more than just the asset and liability mismatch, the company’s balance sheet structure was opaque (with over 200 subsidiaries and SPVs [special purpose vehicles]), which masked the liquidity problem for a long time. The government stepped in to replace the IL&FS board with hand-picked nominees in October 2018. The findings by the chairman Kotak were outrageous, almost 90% of the receivables were NPA (including arbitration cases), the valuation of the assets was inadequate, and multiple instances of round-tripping/ever-greening involving third parties, circular rotation of funds between group entities were found. This also has led to a host of allegations on the auditors of the firm.

Furthermore, having been hammered by the IL&FS fiasco, the capital markets have not been very forthcoming for others, making a contagion issue and this has impacted the general perception about the industry. The mutual funds have offloaded over INR 67,000 Cr. of NBFC debt securities since September 2018. Although NBFCs still account for ~12.5% of their overall assets under management.

On June 4, 2019, DHFL (an NBFC with a focus on housing finance) delayed on its scheduled debt obligation worth INR 950 Cr. On June 5, Crisil and ICRA downgraded its commercial paper outstanding worth INR 8,500 Cr. to ‘D’ (Junk Grade). This led to mutual funds having a total exposure of INR 5,236 Cr. in DHFL (spread across 163 schemes) to take a 75% to 100% write-down. UTI took 100%, while Reliance took 75% hit. The ball is now in the court of banks, which hold a substantially larger chunk of DHFL loans (~INR 38,000 Cr.), which might want to enter into a lending freeze.

Further, in January 2019, the company has been accused by an investigative media outlet ‘Cobra Post’ of distributing huge loans without any security (~INR 31,000 Cr.) to shell companies allegedly linked to the promoters.

In order to tackle the allegations of Cobra Post, DHFL had been looking to rope in a strong strategic investor to ease concerns, while Kapil Wadhawan (Charmain and MD of DHFL) had agreed to step down from active management once such an investor is roped in. In this regard, the company has signed a definitive agreement with PE firm AION Capital to infuse equity capital (making AION the largest shareholder in the DHFL after a rights issue). Further, DHFL has taken multiple steps to tackle the above liquidity issues. The foremost is the securitisation of its loan portfolios and selling assets to generate cash. It sold its affordable housing arm ‘Aadhar Housing Finance’ to Blackstone for roughly INR 2,700 Cr. and its stake in ‘Avanse Financial Services Ltd.’ (education loan business) to Warburg Pincus. Additionally, it is looking to offload its wholesale loan portfolio to Oaktree Capital (valued at INR 17,000-18,000 Cr.) and sell its entire 50% stake in the DHFL Pramerica Life Insurance Company.

The company was able to repay its complete dues of over INR 900 Cr. on 11 June 2019 with the above steps in place. It is a waiting game for the rating agencies as they are yet to respond whether there can be any upgradation against the junk status assigned to the company earlier this month (for ‘D’ rated papers three months waiting period is compulsory before any upward revision can be done as per the SEBI regulations).

The situation was not so grim a year ago and a missed debt deadline would not have had such catastrophic effects on India’s capital markets back then. However, IL&FS shock has pushed up financing costs and made it harder for NBFCs to access the bond market. In addition, the situation for NBFCs remains fragile following the DHFL downgrade, with potential defaults from other NBFCs as well on the back of tightening liquidity. Addedly, the impact will be seen in the end-user markets, especially the real estate and construction companies, which depend heavily on these firms as a source of funding. Further, there are possibilities of cross-defaults (lenders of DHFL defaulting on their obligations). The pain in the NBFC sector poses a serious challenge for the Indian economic growth that has already slowed to a five-year low.

Who is to blame here? The promoters who ran an opaque business or the auditors who did not flag the liquidity crisis and malpractices brewing in these companies, or the rating agencies, which did not perform the necessary due diligence and gave them high ratings, or the mutual funds and banks, which lend to these companies based on the high ratings without performing thorough analysis, or the regulators which waited for a self-fulfilling liquidity crisis to raise its head. As per the current stand, the government is playing a waiting game and is hopeful that tightening from SEBI and credit rating agencies would make the system cleaner for the future. Although RBI has taken a few positive steps like rate cuts, extra financial aid to the banking system among others. But nothing concrete was done especially for the NBFCs, which the investors were hoping to see from the regulator. The need of the hour is to bring more transparency into the system so that these issues are identified at the onset and avoid unnecessary penalizing of healthy NBFCs. Further, rating agencies have to be more diligent in their analysis, while the onus would also lie on the external auditors of the company to flag any irregularities in businesses. A positive step has been seen with increasing interest of mutual funds in purchasing NBFC securitised loans issued as pass-through certificates (PTCs), which are backed by a relevant pool of retail assets as against the earlier short-term instruments which were highly risky. It is not wrong to say, we are in a ‘once bitten, twice shy’ scenario with regards to NBFCs in the country, wherein institutions and investors would like to see how things unfold in the coming quarters and hoping not to face any fresh shocks.