The new (dis)order of our financial system

Some of our non-banking finance companies are staring at a Northern Rock moment if they do not put their house in order

Many analysts are defining the near-collapse of Infrastructure Leasing & Financial Services Ltd (IL&FS) as the Lehman moment for India. We need to wait as the scene is still unfolding but some of the non-banking finance companies (NBFCs) are definitely staring at a Northern Rock moment if they do not put their houses in order. In September 2017, the UK retail bank Northen Rock asked the Bank of England, as lender of the last resort, for a liquidity support after it found its access to short-term money market frozen, and a depositor run followed. 

Northern Rock built long-term assets largely by short-term market borrowings. Many of India’s NBFCs that have had a phenomenal run in recent past, have followed this path. They borrowed short through money market instruments such as commercial papers (CPs) and certificates of deposit (CDs) at low interest rates and kept on rolling them over to fund the loan assets. With interest rates rising, many of them are finding themselves in a spot.

Money is becoming expensive for them. That’s only one part of the story. Many of the investors in such instruments, particularly the mutual funds, may pull out as they fear that not all NBFCs will be able to pay back. Incidentally, the mutual funds’ investment in the CPs and CDs of NBFCs jumped from close to Rs 990 billion in August 2014 to over Rs 2.65 trillion in July 2018.

The volume of privately-placed debt over the last few years gives an idea how the NBFCs raised money. In fiscal year 2017, the private placement market recorded its highest-ever volume — Rs 6.41 trillion. It dropped to Rs 5.99 trillion in 2018 and, with rising rates, it has dropped further to Rs 1.69 trillion in the first five months of fiscal 2018 till August. The cost of borrowing for AAA-rated corporations has risen by 2 percentage points in the bond market. It’s not that only the NBFCs were raising money through private placement, but they were the major borrowers.

Besides, many bad debt-laden public sector banks were wary of giving loans to corporations but they were lending to this set of intermediaries. Now some of them may close the tap as they want to lend themselves, leaving behind the bad dream of toxic assets.

In the June quarter, the gross non-performing assets of India’s government-owned and private banks were to the tune of Rs 10.03 trillion. The phase of recognition of bad assets is almost over. As the banks recover money, slowly some of them will start lending and the NBFCs that ruled the roost in the past few years will have to take a step back. 

For the record, in 2016, the loan portfolio of NBFCs grew 11 per cent to Rs 13.17 trillion and in 2017, the growth was 12.73 per cent to Rs 14.84 trillion. I don’t have the 2018 figure. Bank credit grew at 10.3 per cent in 2016, 4.5 per cent in 2017 and 10 per cent in 2018, albeit on a higher base. With innovative products and superior delivery system, the NBFCs have made fast inroads in almost every segment of the credit business — vehicle financing, mortgage and even wholesale financing.

A November 2017 report by rating agency Crisil Ltd had said that NBFCs would see an 18 per cent compounded annual growth rate (CAGR) for the next two-and-a-half years and raise their share in the total credit to 19 per cent in 2020, from 16 per cent in 2017 and 13 per cent in 2015. The share of public sector banks in the credit market was reduced to 51 per cent in 2017 from 57 per cent in 2015 and it would shrink further to 47 per cent by 2020, Crisil predicted, as these banks battle with bad loans and capital constraints. 

The mortgage business, the largest business segment for the NBFCs, is expected to grow at 18 per cent CAGR till 2020 as they focus on self-employed customers and lower ticket size. The number of home finance companies in the past few years almost doubled, from 55 to close to 100. The NBFCs’ market share in the wholesale finance business is also expected to rise from 12 per cent in 2014 to 19 per cent in 2020. 

That’s the story of the NBFCs that were thriving on a turf where many banks were inactive. The mutual funds too will see a dent in the flow of money to their kitty. The growth in the mutual funds’ assets under management has been phenomenal in past few years. In 2017, it grew by 42.3 per cent to Rs 17.55 trillion; the growth was 21.7 per cent in 2018 and 18 per cent in the first five months of the current fiscal to Rs 25.2 trillion. In comparison, bank credit grew a paltry 4.5 per cent in 2017, 10 per cent in 2018 and 1.9 per cent till August. In absolute terms, mutual funds’ assets grew Rs 6.16 trillion between April and August 2018 while only Rs 1.64 trillion flowed into bank deposits. 

Facing redemption pressure, some of the funds have been selling their debt portfolio, booking losses, and this is bringing down the net asset value of their portfolio and return to the investors. Many investors may now shift to bank deposits. 

Essentially, the Indian banking system that has seen tardy growth both in its deposit as well as lending portfolios, is losing out to mutual funds, and NBFCs will now claw back. This will be the new order of the Indian financial system.

To be sure, the NBFCs do not compete with banks; they create a new credit market. And, we need them. Most of them do not take public deposits but that does not mean they cannot create systemic risks. The banking system has at least Rs 570 billion exposure to IL&FS. Haven’t the banks invested public money in IL&FS papers? 

Some of adventurous NBFCs and irresponsible mutual funds will learn their lessons but sadly, because of them, disintermediation in the Indian financial system will get reversed for the time being and the banks, particularly the efficient private banks, will grow faster.

The columnist, a consulting editor of Business Standard, is an author and adviser to Bandhan Bank Ltd