NBFCs: Defusing the ticking time bomb

India’s vast, mostly unregulated and fast-growing shadow banking sector is in the midst of a crisis. This is a fire that threatens to engulf much more than the sector in which it has started and carries the potential to burn down important segments of the Indian economy. The government is understandably concerned. It would want to navigate the crisis with a minimum of disruption. In the process, all kinds of solutions are being offered on the simple logic that a full-blown crisis and its possibly horrible spin-off effects must be avoided at all costs. Some reports said that banks may be asked to pick up some of the top-rated loan assets of the troubled NBFCs. While resolving the crisis should be a priority, any attempt to signal that the government is here to help, caught as it is by the collar in the midst of a serious meltdown, would be a wrong signal. Good money of the people cannot be and should not be spent on supporting bad projects and bad loans that have come on the books not only because of bad decisions but also bad practices and malfeasance. All help is welcome but it must come with the caveat that those who have contributed to making this disaster will be held to account and brought to justice.

The pressure to act is of course growing by the day as the crisis unfolds in all its misery. Over the weekend came the announcement from Deewan Housing Finance Corporation Limited (DHFL), which has total assets under management of almost Rs. 1,20,000 crores, that it may not be able to survive. As DHFL put it: “The Company's ability to raise funds has been substantially impaired and the business has been brought to a standstill with there being minimal/virtually no disbursements. These developments may raise a significant doubt on the ability of the Company to continue as a going concern.” Its results for March 2018, which were released July 13, showed additional provisioning of Rs. 3,280 crore to come up with a net loss of Rs. 2,223 crore for the quarter and net loss of Rs. 1,036 crore for the whole year. There is no indication of how and why this huge provisioning amount has come up now. Can assets deteriorate in quality quite suddenly in a quarter, or is there something afoot? There is more. As much as Rs.20,750 crore of loans have problems with documentation, and this process will take to September to resolve!

Meanwhile, at the Infrastructure Leasing & Financial Services Limited (IL&FS), which has a total outstanding debt of about Rs. 94,000 crore, the Enforcement Directorate has broadened their probe and the Serious Frauds Investigation Office has filed a criminal complaint against 30 parties, including the auditors of IL&FS, according to reports.

As the bad news continues to emerge, and as lenders and regulators scramble to find a temporary fix, somethings must be clear: We are in the midst of India’s very own subprime crisis. It has ballooned out of control. Housing is a good part of the crisis. But housing prices strangely aren’t particularly in decline though the number of transactions have come down. Standards of governance are weak. Growth has come at the cost of sound lending practices and the management of the short term with no concern for long-term fallouts. 

Ideally, the prescription for these kind of entities should be the one offered in the US by Mitt Romney, who famously wrote in the New York Times: “Let Detroit go bankrupt.” The argument simply was that any support given to a collapsed order (at that time, the auto companies in the US, centred in Detroit) that has not lived up to changing market forces will only reinforce the bad system. It’s like good money after a bad project. Instead, allowing the auto giants to slip and take their natural course of collapse will make the conditions for the rise of a new way of doing that business. That argument is tempting in the case of NBFCs, save that the amounts involved are huge, there are allegations of wrongdoing flying thick and a lot of what is at stake is the money of the public.  In that sense, this is a mirror of the banking crisis, which has eventually forced the government to fork out funds and help recapitalise banks.  As the RBI said in its Financial Stability Report: “Solvency contagion losses to the banking system due to idiosyncratic (Housing Finance Companies) HFC/NBFC failure show that the failure of the largest of these can cause losses comparable to those caused by the big banks, underscoring the need for greater surveillance over large HFCs/NBFCs.”

How long and in how many sectors can this go on?

NBFCs are just like banks but with a few key differences:  NBFCs cannot accept demand deposits; they are not a part of the payments and settlement system and so cannot issue chequebooks; and the deposit insurance facility is not available to depositors of NBFCs, where NBFCs are (only in rare cases) allowed to take deposits. Mostly, these are companies in the business of loans, acquisition of shares, bonds or securities, leasing, hire-purchase, insurance business, chit business. In short, the word shadow banking aptly describes these companies that have grown dramatically and are seen to have played a positive role in supporting lending and growth activities because they came in just when banks were reluctant to lend. Typically, NBFCs have gone in for short-term borrowing to fund long-term assets leading to asset-liability mismatches.

As is typical in these cases, some of the issues do not come to the fore when growth is good, or seemingly good.  To look at haphazard growth and how this also is a growth of the problem before it bursts open, consider these insights from the RBI Financial Stability Report:

• NBFCs depend largely on public funds, which account for 70 per cent of the total liabilities of the sector.
• The share of bank borrowings to total borrowings of NBFCs (the rest come from debentures and Commercial Papers)  have increased from 21.2 percent in March 2017 to 23.6 percent in March 2018 and further to 29.2 percent in March 2019.
• During the same period, dependence on debentures declined from 50.2 percent in March 2017 to 41.5 percent in March 2019.
• This indicates that banks are compensating for the reduced market access for NBFCs in the wake of stress in the sector.

In other words, this indicates that the markets have lost confidence in the NBFCs while banks are filling in the hole. This is in effect a case of banks financing markets rather than markets financing markets, defeating the very purpose of NBFCs. 

The total funds under discussion are of the order of Rs. 2.88 lakh crores during 2018-19. The number of NBFCs have swelled to 9,659 (as on March 31, 2019), of which 88 were deposit-accepting NBFCs, and 263 are large enough to be categorised as “systemically important”. What is this if not a ticking time bomb that must be defused now, and then investigated with rigour, speed and the firm resolve to check the kind of practices that have brought us to this sorry place?

(The writer is a journalist and a faculty member at SPJIMR. Views are personal)