For the past few days, some members of India’s financial services ecosystem have been demanding relief from the powers-that-be, while pointing a gun to their own head.
Ensure funding for the system, they say, or we could spiral down and drag the broader economy along with us.
The immediate trigger is a trust deficit around the true nature of
non-banking financial companies (NBFCs) balance sheet asset-liability mismatches, and more importantly, around the true quality of NBFC assets. In the post-monetary policy committee press conference earlier this month, RBI itself indicated that all is not well with all NBFCs.
In this context, the focus is on Rs 2.5 trillion of
NBFC debt that will mature with mutual funds by March 2019. There is a fear that a chunk of this debt may not roll over. While banks are looking to buy assets from NFBC, this might not suffice to bridge the funding deficit.
The suggestions and entreaties to prevent a vicious spiral, range from encouraging banks to fund NBFCs, to the government readying a financial institutions bailout fashioned after the extraordinary 2008 US troubled assets relief program (TARP).
It’s ironical that just months ago, NBFCs were the darlings of the capital markets.
How green was my NBFC
Per RBI’s last financial stability report (FSR), as of March 2018, all NBFC put together had 22.9 percent capital risk-weighted adequacy ratio (CRAR), 5.8 percent gross non-performing assets (GNPAs), and 3.5 percent net non-performing assets (NNPAs).
By comparison, banks as a class were much worse off, with only 13.8 percent CRAR, alongside high 11.6 percent GNPA, and 6.1 percent NNPA.
In fact, the RBI FSR devotes 20 pages to analysing how banks can impact financial stability, and barely one-and-a-half pages to NBFCs.
Not only were NBFCs ostensibly safer than banks, they were also growing their assets twice as fast. No surprise, therefore, that NBFCs were the stars of the capital markets till recently.
Why are we suddenly obsessing about NBFC balance sheet risks and asset quality now? Why have some large NBFC stock prices fallen by 20-40 percent in the past one month? Has the IL&FS default made such a big difference?
As ever, there is no shortage of arguments to explain market behaviour post-facto. Here are a few sound bites and factoids that we now hear.
- RBI’s asset quality review (AQR) process since 2015 focused solely on banks. As a result, reported GNPA of banks increased from 4.6 percent in March 2015 to 11.6 percent in March 2018. For NBFCs, which were not subject to the same AQR process, GNPA rose from the same 4.6 percent in March 2015 to just 5.8 percent in March 2018. Is this really believable?
- In fact, 15 percent of Rs 22.1 trillion of NBFC assets are real estate or capital market exposures. These are riskier areas that banks are restricted from lending to. Look at the mess in real estate, with all the unsold inventory and builder distress. How have NBFCs managed to lend more, at higher rates, and yet managed to keep NPA ratios much lower than banks?
- RBI’s regulatory oversight over the 405 key NBFCs —let alone the 11,402 registered NBFC as of March 2018 —is not of the same intensity as that of banks. It gets even worse with housing finance companies (HFCs) – the supervision process of National Housing Bank (NHB) is even less comforting.
- Of course, regulatory oversight is not the first line of defence. There is frontline management, internal risk management, the board, external auditors and credit rating agencies, which are each charged with keeping things honest. And we believe each one of them is doing a great job – yeah, right!
- Mutual funds now hold about Rs 12 trillion of debt securities, of which a significant majority is non-sovereign debt. Total traded volumes in corporate bonds are about Rs 1.5 trillion a month. Given this illiquidity of secondary markets, largescale mutual fund redemptions in any crisis of confidence can severely push up credit spreads.
Of course, all this begs the question – if this (and more) was or should have been well known, what were we doing all this while?
The trap – eyes wide shut
There are many excuses to shut our eyes to such signals.
As a first excuse, we believe forbearance (a more complicated word for closing one’s eyes) is a good way of letting the system naturally adjust to issues. After all, we argue, Basel III norms do not really apply in the Indian context – which is why we criticise RBI’s AQR drive, culminating in the February 12
On the contrary, history shows that besides coming back to bite us, forbearance has often delayed and postponed real reform – in our case, areas such full recapitalization of banks and true reform of the banking system (PJ Nayak Committee recommendations, anyone?).
As a second excuse, we argue that a growing ecosystem can never be perfect, and this will be a journey with its inevitable ups and downs. So why be the party-pooper, as long everyone is having a great time?
Ups and downs are of course inevitable – but the downs should come from the unknown unknowns, rather than from issues that are staring us in the eye.
As a third excuse, we also use a patriotic “greater good” argument. If we classify the power sector as NPA, what will happen to all the people employed there? If we value all corporate bonds in MF schemes adjusting for the illiquidity of the secondary markets, how will the Indian debt ecosystem ever grow? If rating agencies, auditors and boards start sticking to the rulebook, how will industry and commerce ever take off in India?
These are important questions – and there are genuine, core, difficult reforms that can answer these satisfactorily, and none of them call for anyone to play the ostrich, or wink and nod.
In the financial services industry, trust is all-important. Painful regulators, auditors, boards, credit rating and valuation agencies are true allies in fostering that trust. By sticking to their respective individual mandates, all stakeholders — frontline and support — fulfil both their patriotic and professional duty.
The regulators and the government need to do their own bit by undertaking true reform, addressing the core issues that check-and-balances highlight.
The government has done well in implementing the Insolvency and Bankruptcy Code, for instance. We now need to understand how recapitalization and reform of financial services and secondary debt markets can be speeded up.
The price of gun-on-head negotiations
We will get out of the current situation – notwithstanding the now public spat between regulators and the government.
Things are not as bad as feared – NBFCs do have good assets, and the financial ecosystem is not all bad. In any case, even if things start to go out of hand, we will find a way. We have ample intrinsic buffers, and we always get by.
But all of us guilty of willful blindness – whatever the pretext - will have to held accountable. There has to be a price to pay for pointing a gun to one’s head.
Going forward, we need a financial ecosystem that fosters trust with conservative, eyes-open checks and balances – alongside the willingness to undertake hard, true reform of institutions and markets.
Reforms are obviously difficult to undertake – but that should not justify us closing our eyes.
Ananth Narayan is Associate Professor-Finance at SPJIMR. He was previously Standard Chartered Bank’s Regional Head of Financial Markets for ASEAN and South Asia.