To solve the liquidity crisis, RBI should make banks lend more to NBFCs
In the immediate liquidity crisis, good Non-Bank Financial Companies (NBFCs) should be able to raise debt capital, but this is not always happening. The good NBFCs, who are unable to raise debt capital, should signal to the debt market by having their promoters put skin in the game. Longer term legislative reforms are necessary for the sector to be regulated properly.
Lending by NBFCs continues to contract. At the same time, the real effects of the NBFC crisis are visible, for example, in the auto sector, in which both showrooms and customers depend on NBFC financing. Car sales have been declining for some months. Now a slowdown is also visible in the automobile components industry and in some parts of the Micro, Small and Medium Enterprises (MSME) sector. The effect of the crisis on the real estate sector has similarly been visible for some time. Downstream industries like cement might be next. The domino effect (for example, automobiles to automobile components) shows that the problem is not over.
The business model of an NBFC is one in which it raises money from some creditors and then lends it to others. If, say, the NBFC has raised money and lent it to a real estate company, but the real estate company is unable to sell flats and pay back on time, the NBFC will soon fail on its repayment obligations to its own lenders (for instance, the mutual funds that it borrowed from). If the real estate company is itself under financial stress, and does not have the money to complete its project, the assets on the balance sheet of the NBFC start looking bad.
The liquidity stress of NBFCs is turning into a solvency issue. A liquidity issue is one when a company has good assets but is unable to borrow against them due to conditions in the market. A solvency issue is one in which the value of the underlying assets against which it has borrowed is less than the value of the debt. In other words, even if it sells off the assets, it will not be able to repay the debt. A liquidity issue can turn into a solvency issue through delays, the accumulation of interest, and tough business conditions.
Suppose the real estate company needed a flow of money to complete the project, but the NBFCs and banks from which it has been borrowing shut off that tap due to their liquidity issues. This may hit its construction plans and its half-built flats may not have as much value as it had expected. A decline in the value of the project then reflects on the portfolio of the real estate company and on the NBFC portfolio. This is the kind of vicious cycle that we are seeing today: financial stress that makes banks and NBFCs wary of lending, and then their borrowers (the real estate firms) get into distress, and this distress feeds back into the asset quality of banks and NBFCs.
There is a lot of heterogeneity among Indian NBFCs. There are more than 9000 of them. Only a handful are public sector, infrastructure or deposit-taking. The rest are a diverse bunch. They are often small, local and often cater to the consumer, go the last mile and lend for consumer durables, houses, transport equipment, automobiles, etc.
The best NBFCs are getting plenty of funds but most are facing difficulties. Of the stressed NBFCs, many have suspect financials but many are actually healthy firms. Lenders are unable to discern the good NBFCs from the bad ones, because many traditional tools for this kind of understanding have become less reliable. Lenders worry about whether financial statements that are signed by auditors can be trusted; they worry about ratings assigned by credit rating agencies. Lenders are unable to read the credit spread of the NBFC bonds on the bond market, and interpret wider spreads as greater risk, as the bond market does not work too well.
What are the possible responses to the problem?
In the short run, the industry argues that to solve the liquidity crisis, the Reserve Bank of India (RBI) and government should make banks lend more to NBFCs. Banks are themselves frail, they find it difficult to choose which NBFCs are healthy, and they are already lending to NBFCs and buying out healthy assets which assists the downsizing of NBFCs.
How can lenders learn to trust the quality of an NBFC? The owners and the management can help by showing their own faith in the business. If promoters will bring in additional equity into the NBFC, this will send a powerful signal of their belief in their own business. Since the promoter has the most information about who it has lent to, which borrower is in trouble, which loan may go bad, this is perhaps the best way to signal to the market. An alternative way is to have a private equity firm invest in the NBFC. Private equity funds, particularly those that take up a substantial stake, do a thorough job of studying the firm before investing. Lenders can feel safer when they see large stakes by private equity funds in an NBFC.
The regulation of NBFCs has been falling through the cracks. Under the present laws, NBFCs are regulated by the RBI. The RBI does not have the regulatory capacity to perform these functions. The Financial Sector Legislative Reforms Commission, 2011, had proposed a unified regulatory agency for NBFCs, equity and bond markets, insurance, pensions, mutual funds, etc. It is time to revisit this proposal.
Ila Patnaik is an economist and a professor at the National Institute of Public Finance and Policy
The views expressed are personal