An employee of Muthoot Finance, counts Indian one hundred rupee banknotes in a branch in New Delhi, India. (Photographer: Anindito Mukherjee/Bloomberg)

What The Post-NBFC Crisis ‘New Normal’ Looks Like

BloombergQuintOpinion

We are in the middle of a non-banking financial company crisis. Triggered by the IL&FS defaults, the supply of liquidity to NBFCs has evaporated creating an existential challenge for many. It is quite likely that actions of regulators, the government, and collective action by NBFCs sees us through this crisis without a mishap – without another NBFC defaulting on its obligations. Given the liquidity situation, the next two months are crucial.

Even if we get past this crisis without much further damage, it is likely to leave a lasting imprint on the sector. NBFCs saw scorching growth over the last few years when banks were on the retreat.

Their share of overall credit within the system went up from about 18 percent to 22 percent.

NBFCs were the providers of credit to many segments of borrowers, that banks had shunned, such as construction and real estate, SMEs, affordable housing, etc. This crisis will reverse the trend. Given the important role that NBFCs have come to acquire in the Indian financial sector, it will be worthwhile to think about what the ‘new normal’ post this crisis would look like.

Credit In Fewer, Stronger Hands

Funding to NBFCs both from banks as well as non-bank sources will decline. Lenders will become more conservative and lend only to larger and more established players.

This is exactly what happened in the microfinance business after the 2010 crisis.

Bank lending returned but was skewed towards larger microfinanciers. Bank lending will follow the same trajectory with NBFCs post this crisis. Even mutual fund managers will be far more cautious in buying debt papers issued by NBFCs.

Also read: NBFCs Creating Liquidity Cushion To Tide Over Next Few Months, Says Rashesh Shah

New Rules

There will be regulatory steps to avoid a similar crisis in the future. Some kind of liquidity requirement—along the lines of the liquidity coverage ratio for banks—could be imposed. It is interesting to note that when a bank borrows money from another for a period longer than a fortnight, it has to maintain a statutory liquidity ratio on such borrowing. When an NBFC borrows from a bank, it does not! It is also likely that the norms for income and asset quality recognition will be matched with those for banks.

Any perceived regulatory arbitrage between NBFCs and banks will be removed.

Easy licensing for NBFCs is unlikely to continue.

Also read: RBI Allows Partial Credit Enhancement Of NBFC Bonds

Lower Growth And Valuations

The result of lower levels of funding and regulations will be slower growth and lower margins for NBFCs. From an equity valuation standpoint, the sector could get re-rated downwards. The stratospheric valuations NBFCs enjoyed have already begun to come down, and could move significantly lower in most cases. Lower valuations will make raising equity capital much harder.

An indiscriminate flow of private equity capital into all kinds of NBFCs, that was witnessed over the last few years, will slow down.

The virtuous cycle of higher valuations driving easy capital raises, followed by cheap leverage and hence high growth, will come to a halt and will reverse in some cases.

A Credit Gap

Slower or no growth for a large share of NBFCs will create a system-wide credit shortfall. This will be especially acute in segments that NBFCs’ financing dominated: real estate and construction, commercial vehicles, affordable housing, consumer durables, construction equipment, etc. Some of the shortfalls will be met by banks, especially private sector banks. But banks will be far more selective in their lending and hence, these segments will see a reduction in credit.

Also read: NBFCs Moved Back Towards Bank Borrowings In September, Shows RBI Data

A Rise In NPAs

As growth slows down, overall asset quality of NBFCs will decline. Rapid balance sheet growth tends to camouflage asset quality. As growth slows down, the average vintage of the loan book increases quickly and NPA ratios go up. Since NBFCs tend to be competitive in relatively higher risk segments, there could be a really sharp increase in NPA levels. Segments such as real estate and construction were kept afloat by NBFC lending over the last three years as banks stopped lending to it. Lower credit from NBFCs may push such customers into financial troubles, further aggravating the NPA problems for NBFCs.

Business Model Recast

Lack of funding and poorer economics would push some NBFCs to adopt the ‘originate to distribute’ model where they recast themselves as originators of loan assets for other lenders—primarily banks—and do not develop large balance sheets of their own.

We could see a significant increase in the sale of NBFCs’ securitised loan books to banks.

Even mutual funds could be open to buying high-grade securitised paper.

Expect M&A

Slower growth, asset quality deterioration, and poorer economics will push to consolidation. Private equity payers that own NBFCs will try to squeeze value from their investments under challenging market condition through mergers of small, sub-scale NBFCs. Such mergers are likely to be between small NBFCs or through acquisitions of small NBFCs by large ones.

The scale of consolidation, however, will not materially alter the concentration of the NBFC sector – there are over 200 NBFCs with a balance sheet of over 1,000 cr.

GDP Growth Impact

Overall, the ‘new normal’ will be much more challenging for NBFC growth and profitability. In the short run, the reduction in credit will have a negative impact on the gross domestic product. The extent of the GDP impact will depend on how deep and long the challenging conditions prevail and on how quickly banks move in to occupy the space left vacant by NBFCs. Public sector banks will have to get back to health quickly if the GDP impact is to be contained. That may require additional capital infusion in PSU banks.

The current crisis will result in the system credit getting more evenly balanced between banks and NBFCs. All those who had hoped that the weakening of public sectors banks has been compensated by the emergence of NBFCs, would be disappointed.

Harsh Vardhan is the Executive-In-Residence at the Centre of Financial Services, SP Jain Institute of Management & Research.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.