After the notoriously opaque financial conglomerate Infrastructure Leasing & Financial Services (IL&FS) collapsed last year, there was fear all around of a wider conflagration in Indian financial markets, the country’s own mini Lehman Brothers moment. It did not happen, but a firestorm is waiting to explode.
Engulfed in it will be not only non-banking finance companies (NBFCs) but all entities in the financial sector in one way or another—mutual funds, rating agencies and the usual suspects, accounting firms that have been accused of looking the other way when it mattered most. Connecting all these are, of course, borrowing companies, many of which have borrowed recklessly and sowed the seeds of the grief that has enveloped the sector.
And, as is characteristic of every major financial crisis, there is a growing chorus now audaciously demanding a bailout. As the Finance Minister Nirmala Sitharaman prepares her maiden Budget, she faces not only the pressures of a powerful lobby but also competing demands on a fisc that is stretched taut.
The problem of NBFCs defaulting on payments running into thousands of crores became grave ever since IL&FS Financial Services announced last September that it could not meet its massive loan obligations.
In 2019, four more large NBFCs have defaulted on payments. The Reserve Bank of India (RBI) realises that the ramifications of this liquidity crunch could lead to a massive financial crisis. However, financial analysts and economists ask whether a bailout is a solution and whether it is even justified. After all, are NBFCs, acting in collusion with other players, responsible for the mess they are now in?
NBFCs play a vital role, lending mainly to the infrastructure, real estate and auto industries. Known as shadow banks, NBFCs fill a space in the lending arena which is not always serviced by commercial banks. In fact, the tightening credit situation, triggered by the massive and mounting non-performing asset (NPA) burden of banks, left a vacuum that these NBFCs filled, often acting recklessly. Mutual funds, in turn, lent to the NBFCs, encouraged by the happy-go-lucky ways of rating agencies and accounting firms. Investors in mutual funds now fear for their investments.
NBFCs are far from being the Good Samaritan lending when the banks do not. The IL&FS Financial Services situation exposed a seamy arrangement which involves credit rating agencies, mutual funds, moneylenders, auditors and, of course, borrowers. “When you look at how they operated, you will realise why they do not deserve a bailout. They should be allowed to go under and be charged with a crime,” says an investment banker. “Until a company goes belly-up, we do not know what is going on. There are fundamental flaws in our system that need immediate addressing, and this does not include bailouts.”
When the chain of lending and borrowing is examined, it is obvious that this crisis is the result of complicity between several players. An NBFC insider explains: Auditors of an NBFC give the company a clean chit so that it can earn a good credit rating.
The rating procures the NBFC crores worth of investments, mostly via mutual funds. Typically, fund managers look at credit rating before investing. The NBFC borrows on a short-term basis but lends for long-term projects, returns from which may be some time in coming. Most of the time the NBFC does not recover its loans from the projects, but it needs to pay back its lenders. So it uses the funds coming in from mutual funds and other lenders to roll over its loans.
Because NBFCs keep getting a good credit rating as they are complicit with the auditors (who want to keep their clients and get more contracts), they keep getting the money. As much as NBFCs are culpable, so are the others.
After the IL&FS debacle, the government asked the National Company Law Tribunal (NCLT) to bar the company’s auditors—Deloitte; and BSR, an affiliate of KPMG—for five years on charges of lapses in auditing the company. The matter is under review. Meanwhile, both auditors are under investigation by several agencies, including the Serious Fraud Investigation Office.
The culprits
The rating agencies downgraded IL&FS’s credit rating only after it became clear to everyone that it was on the verge of a collapse. What was the point of having a rating agency that could not foresee a collapse? For instance, in the IL&FS case, trouble started brewing in June 2018 when one of its companies defaulted on payments. It was in August 2018 when a few more IL&FS companies defaulted, that the rating came down. IL&FS’ outstanding loans reportedly amount to Rs.91,000 crore (“Road to Ruin”, Frontline , October 26, 2018).
It was well known that NBFCs were in trouble, but it was in June 2019 that the situation became dire. Dewan Housing Finance Limited (DHFL), another NBFC, reported debts of approximately Rs.1 lakh crore.
When this came to light, the rating agencies CRISIL and CARE downgraded the A4+ graded NBFC to default status. DSP Mutual Funds, an investment house, sold DHFL’s commercial paper at a discount a few weeks after the IL&FS crisis broke; soon problems at DHFL began to compound. In seven months, the company slid to the verge of bankruptcy.
In January 2019, the Essel group, another big player, said it was suffering from payment issues to the tune of Rs.1,029 crore. A month later, Anil Ambani’s Reliance Capital and Reliance Infra confessed to Rs.35,000 crore worth of outstanding debt. Ambani has appealed to the RBI to help the “gasping NBFCs”. He has also gone out of his way to say he is servicing the debt against “insurmountable odds”.
Bankers estimate that close to three trillion rupees are locked in real estate, construction and infrastructure projects. While it is difficult to estimate the exact default amounts, they believe the collapse of big names has led to a liquidity freeze, and the fear of the contagion spreading has hit markets.
To understand why these particular companies are critical in the NBFC space—Credit Suisse says up to 15 per cent of debt mutual funds’ assets under management are accounted for by four stressed companies—DHFL, Essel group, IL&FS and Anil Ambani’s ADAG. These four companies together owed Rs.3.6 lakh crore to lenders at the end of March 2018. To put this in perspective, one only needs to recall that the entire NPAs of public sector banks are a little over Rs.10 lakh crore.
A Mumbai-based mutual fund analyst told Frontline that unless the problems of liquidity and solvency were settled quickly the uncertainty in the market would remain. “It does not appear that the government is in a hurry to bail out or provide a safety net as it sees it as a moral hazard,” said the analyst.
Currently, the loans outstanding at NBFCs stand at Rs.17.2 lakh crore, according to the RBI. To keep afloat, meet payment commitments and bolster investor confidence, defaulters are trying to sell company assets. The Essel group, for instance, is looking for a buyer for 50 per cent of the promoter holdings in Zee Entertainment Enterprises Ltd, one of its flagship companies.
“These are private corporations and it isn’t fair that due to their bad judgements and shady arrangements the government has to pay. On the other hand we cannot neglect those who will be affected by the negativity towards NBFCs,” said the Mumbai-based analyst.
Genesis of the crisis
The genesis of the crisis was demonetisation, said an economist with a multinational investment bank. At that time a flood of cash got deposited in the banking sector. This found its way to the debt mutual fund market. Unfortunately, lending happened without much collateral. In fact, during this crisis one needs to question the actions of mutual funds and their systems on risk assessment capabilities and processes, he argued.
Speaking of mutual funds, Chetan Pandey, a consultant who was earlier with ICICI Prudential, says, “Portfolio managers have gone way ahead of their mandate, maybe because they were super confident that money will keep coming. In fact, many of them should be pulled up for their lack of better judgement.”
Pandey reckons that the exposure of mutual funds to NBFCs is about Rs.76,000 crore. Mutual funds with exposure to debt were particularly negligent in investing in NBFCs. Two marquee players, HDFC Bank and Kotak Bank, have delayed redemptions recently. “This is unacceptable. An investor should get back his money as and when he wants it. These are not good signs,” says Pandey.
The way forward
The bailout clamour rests on the assumption that the new government cannot afford a major financial crisis so soon after assuming office. There are some who believe that the RBI’s Rs.3 lakh crore reserve, which belongs to the Government of India, ought to be transferred to public sector banks to stem the downward spiral. But for this to happen, the RBI needs a credible external signal mechanism, which can best be provided through an asset quality review of the NBFC sector, said the economist.
NBFCs claim they can sell assets and recover some of their outstanding. But analysts and economists believe these are not long-term solutions. A fundamental problem with NBFCs is that unlike commercial banks they are not subjected to the same stringent regulations. Analysts say the RBI and Securities Exchange Board of India’s light-touch approach towards NBFCs is also responsible for the current situation.
For now, the RBI appears to be telling NBFCs: “You have made your bed, now lie in it.” RBI Governor Shaktikanta Das has said the central bank will step in only if required, suggesting that it does not view the crisis as a systemic one, just yet. At its policy meeting in June, the RBI indicated that it viewed liquidity conditions as broadly sufficient and would improve transparency around how it assesses this.
Currently, there are about 11,400 shadow banking companies in India with a combined balance sheet worth Rs.30,400 crore and with loan portfolios growing at nearly twice the pace of banks. All eyes will be on the government and the central bank as they struggle to fend off a crisis that looms large over the Indian financial sector on the eve of the Budget.
