Trust Deficit Casting A Shadow On Indian NBFCs, Says Suresh Ganapathy

There are liquidity concerns but I don’t think there are insolvency concerns in these NBFCs. The last couple years have been pretty good. NBFCs benefited out of the fact that cost of funds was low and they could grow their balance sheets aggressively. In the last few months, liquidity has been very tight. IL&FS contagion risk is very much there and it has spread to other companies. Also, investors are definitely taking a call when it comes to subscribing to relatively low-quality papers. There is a lack of trust or trust-deficit. Sometimes, that can cause a lot of problems and that is what we’re currently seeing in the markets.

That’s true. But we have heard concerns that many of these finance companies do commercial real-estate lending which is disguised at housing loans. If you look at some of these housing finance companies, they do have a reasonable 30-40 percent of the portfolio, which is not exposed to pure residential forms of financing. There could be some cause of concern there - be it loan against property or lending to residential developers, especially the smaller one which have been in a bad shape after RERA.

I think RBI is also concerned about lending to NBFCs, which has picked up significantly specifically housing-finance companies. RBI is always wary about banks having an exposure to the real-estate sector. We have seen time and again RBI coming out with rules to curb or curtailing lending to the commercial real estate sector. Taking an exposure to the housing finance companies is an indirect way to get into the commercial real estate play. I’m not sure how good banks are when it comes to the managing the end use of funds. An NBFC can borrow but they can deploy it for non-residential housing finance projects. That’s where the worry is emanating from. So it’s not as serious as IL&FS but there are some causes of concern about NBFCs.

Yes, of course. What we believe specifically is that in some of these segments, like housing finance, where the banks compete pretty heavily and the pricing power is still not there with anybody in this system, there could be severe compression in margins and reduction in growth. There will be a compromise for NBFCs on how calibrated your growth should be. There will be an impact on growth and on spreads and margins, not only on housing finance companies but also NBFCs.

Yes, if you look at the regulator’s responsibility, they have to ensure that the confidence remains in the debt markets and equity markets. Considering the inter-connectedness of the financial sector, they really cannot afford any large financial institution to go under. It is obvious that the regulator and the government will have to step in and soothe the markets so that the contagion risk does not spread across all other financial institutions. I think what they have done is obviously right but that does not necessarily mean we are looking at a easy interest-rate scenario for these NBFCs.

We would remain underweight on the NBFC space. Except, few quality housing-finance companies which are rated AAA like HDFC Ltd.  Historically, whenever liquidity has tightened in the markets, they (HDFC) have shifted their focus towards retail deposits. They are one of the very few NBFCs who are in a position to raise retail deposits. Even last quarter, they managed to raise almost their entire funding requirements from the retail depositors. Some of the NBFCs can manage the tight-liquidity conditions very well and that’s the reason if you were to take a slightly longer-term view of two to three years, the return ratios will be pretty comfortable. For most of the other NBFCs, especially the ones trading at higher valuations, the margin of safety or room for comfort is very low at these prices.

Actually, diversification really helps in these circumstances. But if liquidity tightens, remember even banks will ensure their lines of credit are also frozen a bit. We can’t say they are completely insulated.

All said and done, whatever the NBFCs say, in the course of last two to three years, the bond markets were very conducive. The rates in the bond market were lower than that of banking markets. I’m pretty sure that exposure is still sitting in the books of some of these NBFCs. In fact, some of the reasonably well-rated NBFCs have almost 60-70 percent of the incremental funding from non-banking sources. Banks alone would be less than 25-30 percent for most of these NBFCs, at least the larger ones.

Rana Kapoor was important for the firm I think. Purely from the fact that this engine of high growth and good asset quality and reasonable spreads was headed by him. That institution is not as institutionalized as banks like HDFC Bank or IndusInd Bank. So clearly Rana Kapoor not getting an extension will weigh heavily on the performance of the bank.

Now it’s pretty critical to know whether he will be a part of the board because there are some sections in the Banking Regulation Act, which will raise questions about his ability or rather the possibility of him staying on the board. Clearly if he is not going to be a board member and you are getting someone from the outside, it needs to be someone with a very good credible track record.

The situation becomes more complicated because it’s not very clear if the new appointee will also need Madhu Kapur’s (wife of co-founder Late Ashok Kapur) approval. So with all these things, how it’s going to play out is very uncertain at this point of time. And markets hate uncertainty.

The broader issue is not necessarily with respect to Yes Bank but with respect to all other banks in the country because leadership transition issues are a serious issue in all these institutions and that’s even the case in non-banks.

That’s true. I mean Rana Kapoor being on the board and still controlling quite a lot of stuff would definitely make it difficult for the bank to find a new CEO, to be very honest. So the way I would look at it is, ideally speaking, the market would want Rana Kapoor to have executive powers but I think that is ruled out for the time being.

The new person who comes on board should set somewhat similar terms and conditions to what Romesh Sobti did when he joined IndusInd Bank. He very clearly told the promoters that you are not going to interfere in my operations and this is what I’m gonna do. I’m going to bring in my own set of management team and run the bank. I think that kind of independence needs to be given and needs to be assured. Whether Rana Kapoor can do it, really depends upon the kind of person who is joining and the bargaining power they have.

Of course, no doubt about it. Not only the uncertainty, their capital levels are actually not as strong as any of the other private sector banks. If you look at their common equity, it’s about 9.5 percent and it’s much lower compared to other private sector banks, which are at 12-13 percent. So growth is definitely going to be lower. They are not going to grow at 40-50 percent. I think without capital at best they can grow at around 20-30 percent. That, too, beyond a certain point I think they will have to come to the market and raise money. So yeah capital remains a big challenge.

Also any new person who comes on board will also have a pretty calibrated growth strategy because a part of these high divergences is also because of the fact that their growth is very aggressive.

Yeah. But then to be honest the markets really thought Rana Kapoor would have another 10 years tenure because you can be CEO till 70.  Markets underestimated, or rather didn’t really exactly estimate, the amount of risk that a single individual carries because of the assumption was that the person would be there for another 5-10 years. And 10 years is a long time frame for the markets.

But you raise a very important point and going ahead the key-man risk is something which is going to be very seriously watched. On Friday, when Yes Bank was down 30 percent, even Kotak Mahindra Bank was down 4 percent, so people were extrapolating the fact that this could be some promoter related issue. And what happens if the same is applicable to Kotak? So you are clearly seeing some of these worries cropping up.

You never know what happens even at HDFC Bank or IndusInd Bank but at least these organisations are far more institutionalized and in a better position to find a right candidate. But yes it’s a big issue and going ahead the markets will be keenly watching management transitions in private sector banks.

That I’m the boss.

Look , one of the major issues in some of these private sector banks, which has been debated time and again, is the independence of the board. People thought they can get away doing whatever they want. Clearly that’s not the case. Though you may have technically independent board , most of the shots were called by the CEO who had indomitable powers. So, the RBI is very clearly saying that the functioning of the board is very very important and that the involvement of the board in taking commercial decisions is very important.

For example, the quid pro quo in ICICI Bank is yet to be established but there are issues with the independence of the board at the time. So, one area where they are very clear is the fact that board governance is something which is really they are looking at.

Secondly there is zero tolerance for lack of compliance. It’s pretty evident. So RBI is saying that I’m not going to allow banks to get away with compromising on their processes and systems.

Of course. Over the longer term that’s right. In the interim there would be a churn across some of these organisations with respect to the management, processes. Over the longer term it is good for the system but then you know there is a fine line you need to be very careful about . What is the level of independence these organisations have and the extent of regulatory interference on every little thing that RBI is trying to do. So yes, that fine balance needs to be struck to be honest. But yes, over the longer term if it helps in bringing about a much more cleaner financial system, then I’m all for it.