India’s Bank-NBFC Divide Has Never Been Clearer

Life is coming full circle in the Indian financial sector.

There was a time when banking licences were coveted. The eventual game plan of many non-bank lenders was to get a banking licence. 25 applicants lined up for one in 2014 when a new round of licences—then given out in spurts—was opened up. Things changed in the few years after 2014. Mutual funds were gathering more money, which was flowing through the debt markets. There was hope that the long awaited ‘depth’ to India’s debt market was finally becoming a reality.

Suddenly being a non-bank lender didn’t look so bad. Money was available at reasonable rates. The business opportunities were wider than what banks could undertake. Public sector banks were stressed, leaving market share up for grabs. Regulatory requirements were lower. Returns were higher.

Wanting a bank licence was passe. So when the RBI put bank licences on tap in 2016, no one rushed to the application window. Instead, NBFC licences were in vogue. Many a retired banker was seeking one.

A few years later, things are looking very different once again.

The collapse of Infrastructure Leasing & Financial Services in August 2018 was the first blow. It alerted debt markets to the liquidity risks that lay dormant within some NBFCs. For a while all NBFCs, with a handful of exceptions, paid the price. In about a year, things started to settle down. And then came Covid-19, leaving NBFCs in the midst of another liquidity squeeze.

Rashesh Shah, chairman of the Edelweiss Group, who built a large financial conglomerate structure without a banking licence, summed it up well in a recent interview with BloombergQuint. “Just when you feel it is safe to go back in the water, the shark comes along again,” he said describing the second bout of liquidity pressures being faced by NBFCs in less than two years.

A Peculiar Situation

NBFCs are indeed in a tough spot.

They are among the lenders who are allowed to offer a moratorium to their clients. They are not being forced to do so but they can if they want to. Given that the alternative is a surge in bad loans, these lenders are offering the moratorium selectively. Two large NBFCs—Bajaj Finance Ltd. and Edelweiss—have suggested that about a third of their loans are under moratorium.

But since NBFCs fund most of their lending via banks or the markets, they need to match the moratorium on their assets with one on their liabilities.

For some peculiar reason, banks, at the start of this moratorium decided not to extend the relief to NBFCs. While they have relented partially on this stance, confusion persists. Some banks are offering fresh credit to help NBFCs meet repayments, others are offering a moratorium. Decisions are taking long.

RBI’s Cautious Support

The RBI’s first instinct appeared to be to allow market forces to play out.

Banks were given Rs 1 lakh crore in funding via long-term repo operations. Since banks had full discretion on where to invest the first round, funds went to larger corporates and a few strong non-bank lenders. But a large part of the NBFC sector was left out. So the RBI tried a second targeted long term repo operation, aimed at NBFCs. Banks were barely interested and only half the Rs 50,000 crore available under the facility was used.

In both these facilities, the idea was that RBI provides liquidity to banks, who then determine the final allocation of those funds based on their judgment of credit risk. But it didn’t work. Banks were simply unwilling to take the credit risk, particularly on NBFCs, as evident from the partial success of the targeted LTRO.

Finally, this week, the RBI stepped in as lender of last resort for NBFCs but in a manner that kept it away from any credit risk associated with non-bank lenders.

The design of the relief facility is similar to what was used in 2008-09. A special purpose vehicle is being created, under a public sector bank. The SPV issues government guaranteed securities. The RBI subscribes to Rs 30,000 crore in these securities, thereby providing the SPV funds to on-lend to NBFCs. The funds provided are for a short duration of 90-days to help meet immediate liquidity needs and are not intended to help the non-bank lenders create fresh assets.

The structure helps do two things. First, the RBI Act says allows the central bank to buy government securities and also “securities fully guaranteed as to principal and interest” by the government. As such, the design of the facility allows the central bank to stick to the letter of the law.

It also keeps the central bank away from solvency risk of any entity other than banks. For banks, the RBI is willing to step in directly as lender of last resort, as it did when it provided a liquidity line to Yes Bank Ltd.

The RBI has chosen to use this previously tested route despite the clamor in favor of the central bank accepting corporate debt as collateral. Had it chosen to work with the government to bring about necessary legislative changes, it could have provided both non-bank lenders and other entities like mutual funds direct support in times of stress.

Message Between-The-Lines

Reading between the lines, the message in the RBI’s actions is clear. Banks are different.

Banks are allowed to accept customer deposits. Yes, some older non-bank lenders accept public deposits as well, but the RBI has stopped giving out deposit-taking NBFC licences freely for some time now.

In return for the ability to accept public deposits, banks are subject to regulation and supervision that is far more intense than what non-bank lenders face. They have to set aside a portion of their deposits as cash reserve ratio. They have to hold a higher level of liquid assets. Accidents still happen but presumably the likelihood is lower than in the case of NBFCs regulated with a ‘lighter touch’. And that is why the RBI is willing to provide banks direct liquidity relief via its many windows.

Large NBFCs have already been seeking a separate, more strongly regulated category in the hope that they will get access to public deposits and direct central bank liquidity.

If the RBI doesn’t yield, don’t be surprised if the sector comes full circle to a place where, once again, banks are king.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.