Sometime in 1996, a high-profile non-banking finance company, or NBFC, that had grown meteorically over the past few years started defaulting on payments to lenders. When the first few cheques bounced, thousands of depositors landed up at its branches to demand their money. But CRB Capital founder Chain Roop Bhansali had flown the coop. Various stakeholders lost an estimated Rs 1,200 crore in the CRB scam.
Bhansali, from Rajasthan, belonged to a middle-class jute traders' family and, as a chartered accountant, had a reputation for using innovative ways to move money around. In Mumbai, he had a successful run between 1992 and 1995 and set up a slew of companies, including an asset management company (mutual fund) and a merchant banking outfit to help companies tap stock markets. Just before the defaults started, he had even managed to get a banking licence from the Reserve Bank of India of RBI.
Initially, he did well, as bull market and easy liquidity and a penchant for making friends with businessmen with cash to invest helped him grow. As the slowdown hit in 1996, his investments took a beating. The South East Asian crisis, and the real estate slump that followed it, added to his problems. He hoped things would turn around and borrowed money to pay back old loans. Eventually, he could not borrow further. CRB collapsed. Bhansali was eventually found in Hong Kong and brought back to the country to face trial in 2013.
Though it was a high-profile NBFC scandal, and the amount of money involved was high for the time, it did not create much turmoil in the financial sector. It just showed up the lacunae in the regulatory system.
That was then. The impact of the recent Infrastructure Leasing & Finance Services (IL&FS) crisis, triggered by bond defaults by the shadow bank, is being felt across the financial sector. The reason is simple - it involves a much bigger debt of Rs 91,000 crore-plus. (NBFCs are often called shadow banks as they function a lot like banks but with fewer regulatory controls. Barring a few, they cannot accept deposits from people and so raise money from bonds or borrow from banks). The crisis, which looked big but one-off when it started, is spreading fast, infecting even institutions that were till only recently considered perfectly healthy.
After the first set of IL&FS defaults in June 2018, a large and reputed housing finance company, Dewan Housing Finance Ltd, or DHFL, found itself in trouble because of squeeze in liquidity triggered when a fund house sold Rs 300 crore of its commercial paper (CP) at a discount to raise funds. Though the fund house later said it was a routine exercise not triggered by concern over DHFL's health, the damage had been done. The DHFL stock fell more than 60 per cent intraday, roiling other NBFC stocks too (they are yet to recover). The panic has triggered a liquidity squeeze for the entire NBFC sector, leading to downgrades, further impacting their ability to raise capital. And the downward spiral is really hurting. A couple of months later, the contagion spread to Reliance Capital, which is also facing a cash crunch and may have to delay some payments. Two of its entities have been downgraded (for details, read Back to the Wall on pg 32). Somewhere in between, the Zee Group, which never had financial troubles before, also found itself beseeching lenders for more time to pay investors in its bonds.
While many financial analysts and bankers are confident that the contagion will be controlled, what is making markets nervous is that over the next three months, about Rs 1 lakh crore of CPs raised by shadow banks are coming up for redemption. NBFCs, except a few, do not have access to deposits, and depend on short-term instruments to raise funds that they then have to keep rolling over.
India has 10,190 NBFCs. They are lenders of choice for companies and people who cannot get loans from banks and had loans outstanding of Rs 17.2 lakh crore at the end of 2017/18 compared to Rs 92.1 lakh crore outstanding bank credit. They are involved in commercial and passenger vehicle finance, consumer durables finance, housing finance, housing project finance, loans to small and medium industries, loans for infrastructure projects (like IL&FS) and even microfinance. Their aggregate balance sheet size was Rs 28 lakh crore at the end of September 2018. A collapse will be Indian policymakers' worst nightmare.
NBFC defaults - or even a liquidity squeeze that forces them to increase rates sharply - affect debt mutual funds and banks and others from whom they have raised money. The higher cost of funds also affects borrowers, especially housing finance companies, commercial transport companies and SMEs. The troubles in the financial economy could create problems for the real economy too, creating a vicious cycle where the two feed off each other. That is why the government moved quickly to stabilise IL&FS by constituting a new board. Experts are talking about tightening regulations to prevent such events in future.
The Seed of the Crisis
Many experts say as the Indian economy slowed down and a number of sectors - from small and medium enterprises hit by demonetisation and goods and services tax to real estate firms - got into trouble over the past couple of years, the NBFC crisis was just waiting to happen. "All these things have happened as we have been having a bear market for the last 12 -14 months. I always believe bear markets are great cleansing agents as they bring out all the hidden problems in the system," says Shankar Sharma, Co-Founder and Chief Global Strategist at First Global.
In a bull market, because of rising equity values, money is available easily. "This hides the core problems of the business. The moment that easy money flow stops, and it stops always in a bear market, skeletons start tumbling out," he says. Two-third BSE-listed stocks are down 20 per cent or more in the last one year even as benchmark indices, the Nifty and the Sensex, have held their ground.
IL&FS and its subsidiaries were the first ones to default, possibly because they had been hiding their problems for long. The infrastructure sector has been in doldrums for a long time and IL&FS, as both a lending institution and an executing organisation (its 200-plus subsidiaries bid for road projects), has deep exposure to a sector that faces a classic asset-liability mismatch problem. Projects can take up to 20 years to pay back while money raised by the financing entity is at best for four-five years and sometimes even less.
Ravi Parathasarathy, a former Citibank executive who had used his contacts in the financial world to raise money and set up IL&FS in 1989, and then grew it by hiring retiring bureaucrats, is on the surface a very different character from the flashy Chain Roop Bhansali. But in many ways, not too different either. In spite of having big investors - LIC, Japan's Orix Corp and Abu Dhabi Investment Authority sat on the board - he could hide the problems at IL&FS for a long period. When it was no longer possible, he resigned and left for the UK for medical treatment.
How This Fell Apart
In 2015/16, when public sector banks stepped back from lending due to rising non-performing assets, or NPAs, and lack of capital, companies and NBFCs began borrowing heavily from mutual funds by issuing short-term CPs. Total CP issuances jumped from Rs 1.3 lakh crore in April 2017 to over Rs 3 lakh crore in August 2018. Pure issuances by NBFCs tripled from about Rs 50,000 crore to Rs 1.5 lakh crore in the last five years, says Bhushan Kedar, Associate Director at Crisil.
But there is an inherent flaw in this kind of lending - NBFCs borrow short-term money using CPs of three to six months and finance long-term assets like real estate, commercial vehicles, passenger cars, construction equipment and infrastructure projects. This means new CPs are issued at regular intervals to repay the previous ones. This can continue in good times. But when the demand for CPs falls due to a temporary liquidity crunch or any other problem, the cycle breaks, and defaults start. "If you cannot take deposits and are over-dependent on wholesale funding, when the rate cycle turns, you will be caught short because of high funding costs," says Abheek Barua, Chief Economist and Executive Vice President, HDFC Bank.
Kajal Gandhi, Research Analyst at ICICI Securities, says NBFCs are suffering from liquidity stretch. It is a vicious circle. "You don't have money, so you cant lend and, therefore, can't earn income. But you have to repay borrowings and need to keep reserves for that. This continues. Those who can surpass this will be great companies but those who do not manage well will get stuck. Sometimes, liquidity crisis can turn into insolvency crisis." The Chief Economic Advisor in the finance ministry, Krishnamurthy Subramanian also said in a newspaper interview that the issue is one of insolvency of a few large players and added that the asset liability mismatch of the firms needs to be closely watched.
This seems to be the case with IL&FS, which was dependent on short-term wholesale paper to meet its requirement for funds that it used to lend for projects whose payback period was long. However, when funding costs started going up, it found it difficult to roll over funding. Once it failed to repay, mutual funds took a hit. The resulting liquidity squeeze made it difficult for other NBFCs also to keep their commitments or raise fresh funds.
Barua says NBFCs run asset-liability mismatches as the bond market in India is not deep. "For investing in a 15-year project, there has to be a corporate bond market that allows you to issue a 15-year bond," he says. These investors are able to price the risks and have the associated instruments like bond options to hedge them. "We don't even have a proper yield curve," says Barua.
Unrated Rating Agencies
In its absence, investors rely on rating agencies, which have not been able to assess risks adequately, including in IL&FS. Gandhi says rating agencies mostly use only historical numbers - balance sheet, profit and loss account and return ratios. So, a downgrade takes place only in the last stages of default. "Historical numbers don't necessarily give an idea of future performance," she says.
Also, there is an inherent flaw in the revenue model of rating agencies, as companies being rated also pay the agency. This can impact objectivity. "Moreover, it is not easy to understand risk in complex special purpose vehicles or SPVs (IL&FS has over 250 subsidiaries)," says Gandhi.
Barua agrees the situation is dire. "I think it has to be looked into in great detail as people are losing faith in ratings," he says. He favours an asset quality review to bring out all the problems to the fore which, he says, cannot be done through rating agencies or plain auditing.
Rating agencies are monitoring companies closely after the IL&FS fiasco. ICRA recently downgraded to junk grade 'D' the short-term ratings on two Anil Ambani group NBFCs - Reliance Home Finance and Reliance Commercial Finance. Lenders may find it almost impossible to recover their money as they are on the brink of default.
Some promoters who had pledged their shareholding in companies to raise money for expansion or diversification are also in trouble. They run the risk of losing control as valuations are down and stakes will have to be sold at low rates to repay lenders. Essel group founder Subhash Chandra is among those feeling the heat.
PSBs - The Biggest Casualty?
A bigger hit may have to be taken by banks. More than Rs 53,000 crore bank loans to IL&FS will be added to their book as bad loans as the NCLAT has allowed lenders to declare accounts of IL&FS and its defaulting subsidiaries as NPAs. "This will be a new overhang over public sector banks (PSBs) and previous recapitalisation estimates will be inadequate. Otherwise, PSBs will keep hobbling," says Debashis Basu, Founder, Moneylife.
So far, IL&FS agreed to sell its wind energy portfolio of 874 MW to GAIL for Rs 4,800 crore. The debt of Rs 3,700 crore on books of wind power SPVs will be fully repaid. "Only one project has been sold. The list of lenders is long. Realising Rs 91,000 crore is a long process. A part will be debt securities issued by IL&FS and subsidiaries to which mutual funds and other institutions have subscribed. Slowly, it will have to be written off," says Basu.
PSBs have already written off Rs 7 lakh crore in last ten years. During October to December 2018, it was Rs 64,000 crore. No amount of recapitalisation can help PSBs. "Growth will be taken over by private banks and PSBs will remain hobbled even after recapitalisation," says Basu.
Doom and Gloom
India's debt market looks gloomier than ever is because macroeconomic indicators are in a bad shape. Collection of direct taxes fell short of target by Rs 50,000 crore in 2018/19, household savings to GDP was 17.2 per cent in FY18, the lowest since 1997/98, FDI contracted 7 per cent to $33.49 billion in April-December 2018. "There is a big slowdown in growth and the macroeconomic picture remains tepid. So, companies have problems as lenders don't want to give capital in the absence of growth. If the economy continues to be in this shape, there can be more defaults," says Sharma.
NBFCs, meanwhile, are busy setting the house in order. The level of securitisation (conversion of loans into debt instruments) reached a 10-year-high of Rs 1.9 lakh crore in 2018/19, according to CRISIL. In securitisation, NBFCs bundle their retail loans (individual loan accounts) into debt instruments and sell to investors who want a steady stream of interest income that these bundled loans generate. NBFCs recover their capital tied up in these loans.
CRISIL's Kedar says after August, owing to limited appetite and NBFCs' intent to realign their asset-liability management, CP borrowings went down significantly. "Securitisation helped NBFCs free up cash flows to create immediate liquidity by channelising loan assets to new investors," he says. Securitisation will reduce the dependence of NBFCs on short-term funding sources.
Where does it leave companies or NBFCs? "Many NBFCs are unable to get adequate funding from wholesale debt market due to perceived balance sheet concerns," says Ashish Gupta, Managing Director, Head of Equity Research for India, and Head of APAC Financials, Credit Suisse.
Barua says a fresh round of NPAs could emerge. "More worms could come out of the woodwork. It will be a slow burn, with one bit of bad news following another. While no systemically important entity will go down, bad news flow will keep people away from the bond market," he adds.
More importantly, the development of the corporate bond market has taken a few steps backwards. "It will take time for faith to return to the market. The overhaul has to be systemic and system wide," says Barua. Gandhi suggests a new revenue model for credit rating agencies in which they can be paid independently and not clients getting themselves rated. "Rating agencies should be watchdogs and not be doing business," she says.
Gupta believes an asset quality review of NBFCs will restore credibility to balance sheets. "Even in cases where there is a shortfall, more capital can be raised to plug the gap in the balance sheet, which will allow them to access the debt markets," he says.
But, these are only prescriptions. How well the patient is administered the medicine will decide his recovery. For now, this seems to be a long time away.
Meanwhile, there are those who predict this story will not end well, no matter how hard government tries to fix it. Many debt funds are stuck with paper they cannot sell - spooking retail and institutional investors (see Stuck in Quicksand on pg 28). "NBFCs always have a terrific three-year window of run as whatever they are lending is high margin and they book those earnings for the first three years. After that, those loans start to go bad. This movie has played many times in the last 20-30 years," says Sharma. The bottom line: for jobs growth, the cycle of investments has to stimulated.