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

Nervousness around credit quality of India’s non bank financiers along with tighter liquidity and higher interest could continue to sour the sentiment around these firms. That’s according to Suresh Ganapathy, head of financial sector research at Macquarie.

While there is no direct comparison between the troubles at Infrastructure Leasing & Financial Services (IL&FS) and the broader NBFC sector, the risk of contagion is "very much there," Ganapathy said in an interview with BloombergQuint. He, however, notes that for the broader sector the concerns are related to liquidity rather than solvency.

"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," Ganapathy said.

IL&FS has defaulted on some of its debts over the last two weeks, leading to nervousness in the credit markets and a sell-off in the equity markets. On Friday, shares of Dewan Housing Finance Company Ltd. plunged as much as 60 percent after reports that DSP Mutual Fund sold its bonds at a higher yield. This prompted investors to fret about the reason behind the debt sale.

Also read: India Needs to Stop the IL&FS Rot From Spreading

'Rana Kapoor Was Important For Yes Bank’

Commenting on the RBI’s recent decision to give Yes Bank CEO Rana Kapoor only four more months at the helm of the bank, Ganapathy said that Kapoor's departure from the lender will weigh heavily on its performance. "Rana Kapoor was important for the firm I think." It will now be critical to see if Kapoor will remain a part of Yes Bank's board member or not, he added.

Ganapathy, however, agreed that in the long term the RBI’s zero-tolerance towards compliance lapses is positive for the health of the sector.

Edited excerpts of the interview below:

What have you made out of NBFC nervousness? IL&FS started it, but do you see broader concerns?

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.

Also read: RBI, SEBI, SBI Step In To Assure Nervous Credit Markets

Is it fair to draw a direct comparisons between IL&FS and the NBFC space and housing-finance companies. The portfolio of the latter is more predictable?

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.

On the funding side, there is one issue of tight-liquidity and there is a trust deficit, both of which will probably lead to higher rates at least for the lower-rated NBFCs. Is it the spread issue now?

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.

What did you make of the statements that came from RBI, SEBI and this morning the finance minister saying that we will ensure money flows through the NBFCs sector. Is it calming the nerves?

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.

What is your broader call on the NBFC space?

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.

Lot of small NBFCs have diversified their sources away from wholesale markets to bank lines of credit etc. Does that provide for any comfort?

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.

Bunch of management changes this year at private banks. Yes Bank being the latest. What did you make of Yes Bank in particular. Will it be a complicated transition from here on?

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.

Would the market prefer Rana Kapoor to stay on the board because that means the transition would be that much tougher right? If you are hoping to transition to a clean new start, that would make it much tougher.

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.

It’s quite possible that the trajectory of the bank changes now, right? We have seen very high growth at least in advances over the last couple of quarters. They also have to secure funding via a pending QIP issue.

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.

Why did the market not attach importance to things like the distribution of key man risk. Should we be equating a CEO with a banking institution?

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.

What do you think is the message that has come through the RBI for both Axis and Yes Bank . What is the message you are taking away from these actions from the RBI?

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.

Whether it’s the PNB fraud or the compliance fraud which happened during the demonetization scam in certain banks. The divergences are also an issue of compliance of many banks .

The RBI is very clear that there is zero tolerance for lack of compliance and going ahead they want to ensure that at least the private sector banks, which are within their powers, are as clean as possible, the governance structures are put in place and also the compliance procedures are put in place. The message that they are sending across the banks is that you can grow at 30 percent but then that cannot come at the expense of compliance issues.

That should be a comforting message to the investors right?

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.

Watch the full interview here: