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A Moment Of Truth For NBFCs...

And For The System

Harsh Vardhan

Published: Oct 02 2018, 11:00 AM

Last Updated: Oct 02 2018, 11:56 AM

Indian financial markets have been going through a turbulent period over the last
couple of weeks. Stock markets have slipped and shares of banks and non-banking
finance companies have taken a big hit.

Questions like “Is this India’s Lehman Moment?” have been raised. The government
and the regulators have made statements to assuage the markets and restore
normalcy. On Monday, the government moved to supersede the board of
Infrastructure Leasing & Financial Services Ltd., which had roiled financial markets
due to a series of defaults. The Reserve Bank of India, too, has stepped in with
liquidity support.

While the actions of the government and the RBI may restore some degree of calm to
the markets, we must use this moment to recognise the deeper problems in the
Indian financial sector that this episode has exposed.

The defaults by IL&FS and the panic it created, even if short-lived, should
force discussions on deeper, systemic issues.

Also Read: Can A Satyam-Style Rescue Work For IL&FS?

How Did We Get Here?

NBFCs and housing finance companies have seen dramatic growth over the last four
years, in part, due to some peculiar circumstances in the Indian financial system.

Most public sector banks and some large private sector banks, facing high levels of
bad loans, had become averse to lending to riskier segments of borrowers such as
small and medium enterprises and lower income borrowers within the housing loans
segment (so-called “affordable” housing loans). These banks, however, were willing
to lend to NBFCs, whose capital base provides a sort of first default guarantee to

Contemporaneously, the Indian economy was seeing greater financialisation, with

both households and corporations moving their savings into financial assets, chiefly
mutual funds. Demonetisation, announced in November 2016, fast-tracked this
process and led to unprecedented levels of inflows into mutual funds. This
groundswell in domestic capital flowing to equity and debt markets, in turn, led to a
sharp rise in share prices and fall in interest rates.

On the back of increased valuations, NBFCs could raise equity capital easily. The
larger and better rated ones (those rated AA and above) could also easily issue debt
paper to mutual funds and insurance companies. They could also raise debt capital at
interest rates that were comparable or even lower than those offered by banks.
NBFCs, thus, grew rapidly, essentially taking on credit risks that banks were
avoiding. A large number of new NBFCs were established. The number of HFCs went
up from around 50 in 2013 to nearly 100 now. New NBFCs and HFCs have lower
ratings – typically BBB or below – and hence cannot access mutual funds or
insurance companies for debt as these institutions typically invest in papers rated AA
and above.

This started a game or rating arbitrage where large, better-rated NBFCs

would borrow from banks and funds and lend to smaller, lower-rated
NBFCs. The entire NBFC sector started getting intertwined.

When The Winds Turned

These tailwinds for NBFCs began to change course earlier this year.

Driven largely by global factors – chiefly rising crude oil prices, rising interest rates
in the U.S., and trade tensions – Indian interest rates started to rise. The yield on the
benchmark 10-year government bond moved up from around 6.8 percent to over 8
percent in a period of about three months.

Fresh inflows into mutual funds, especially into debt funds, slowed, and debt fund
managers began to adopt a “wait and watch” policy on deploying fresh funds.
Liquidity supply to NBFCs began to dry up rapidly. Fresh bond issuances by NBFCs
declined and the costs of borrowing rose.

All this preceded the spate of defaults by IL&FS.

And then the news of IL&FS defaults broke. It had two immediate implications.

First, there was a fear of large scale redemptions in debt mutual funds. So some
funds resorted to panic selling of debt securities which sent a negative signal to
the entire market.
Second, the defaults shattered faith in ratings of debt securities. IL&FS debt had
the highest rating just a couple of weeks before the default. The rating was
revised to the lowest default grade (“D”) after the default occurred. This raised
doubts about the quality of other issuers assigned similarly high ratings.

The reaction in the market was vicious. Yields on corporate bonds went up and the
debt market almost stalled.

The RBI acted quickly and took steps to inject liquidity via open market operations.
Since then calm has returned to the market for securities of less than one year but
the market for medium-term securities remains tight.

Even so, the long term structural issues of the debt market still exist. The
actions taken so far don’t do anything to address these structural
liquidity issues. In fact, these actions highlight the limited options the
central bank has in addressing such issues.

A Five-Point Structural Agenda

If policymakers are serious about avoiding such accidents in the future, they need to
focus on a few aspects of the financial system and work towards making changes.

Point 1: NBFCs have a wholesale-funded model and the wholesale funding market is
underdeveloped, illiquid, and founded on ratings of questionable quality. These
features make the funding market and, by consequence, NBFCs vulnerable to
liquidity shocks. All those who thought that the withering away of public sector
banks will not matter much as their space will be filled by NBFCs as debt providers,
must pause and think again.

As long as primary liquidity, via access to household savings, is with banks (and
predominantly with PSU banks), their health is of paramount importance to Indian
financial system. RBI can add liquidity at the shorter end of the yield curve as it did
over the last few days, but its ability to inject liquidity at the medium and long end is

Some have argued for open market operations on the lines of quantitative easing
that was followed in the U.S. and Europe as a means to structurally inject liquidity.
But that would require the entities needing liquidity to hold tradable securities that
can be bought by the central bank. That is not the case with NBFCs, who have loans
on their balance sheets and not bonds or asset backed securities.

RBI can inject liquidity into banks who hold large amount of government
securities, through OMOs but the only institutions that can inject structural
liquidity into NBFCs are banks. They need to start lending again.

Point 2: Debt mutual funds that are invested in illiquid bonds but promise their
investors redemption in a day or two, need access to a liquidity window on the lines
of the Liquidity Adjustment Facility that the RBI offers to banks. In the midst of the
global financial crisis, the RBI had opened its repo window to money market funds
for a short time. There is a repo window run by Clearing Corporation of India Ltd.
called the Collateralized Borrowing and Lending Operations but it is too small.

Now that the size of debt funds has grown significantly, we need a more
formal, institutionalised liquidity support for them so that they can withstand
sudden redemption pressures that may arise from time to time.

Point 3: We must encourage large scale securitisation of NBFC assets so that the
resulting asset-backed securities can be traded imparting liquidity to otherwise
illiquid balance sheets. This is especially critical for housing finance companies.

This would require a relook at the regulations governing securitisation and there is a
case for setting up a government backed institution to facilitate such large scale

Point 4: We must demand greater accountability from the rating agencies. The
entire edifice of the corporate bond market stands on credible ratings. If the market
loses faith in ratings, then it cannot exist. Regulators need to take a hard look at the
functioning of the rating agencies. In India, even banks use ratings provided by
rating agencies for loans. So, the issue of credibility of ratings impact both banks and
bond markets.
Point 5: Easy licensing and light touch regulation of NBFCs should be seriously
questioned. Most NBFCs depend on banks for funding and hence the risks they
underwrite ultimately impinge on the banking system.

Long Debated Depth Of Bond Markets

Finally, the much discussed topic of development of bond markets. While the bond
markets in India have grown in size, as measured by value of bond issuances, they
have not developed depth. A hundred crore trade in bonds of an issuer with
thousands of crore worth of outstanding bonds spikes yields higher, demonstrating
the lack of depth in the market.
Liquidity develops when a large number of diverse investors, diverse in their risk
appetite, participate in a market. In the bond markets, this can be achieved by
opening up pools of capital other than mutual funds and banks such as provident
funds, pension funds, trust funds, etc. Provident funds, insurance, and pension funds
in India have a debt corpus of around Rs 50 lakh crore, which is almost entirely
deployed in government securities. Even allowing a 2 percent increase in the corpus
that can go to corporate bonds can inject Rs 1 lakh crore.

Managers of the Indian financial system – regulators, managements, policy makers,

and investors – should learn the lesson from the episode that just played out and
work towards strengthening the system.

Else, we shall bumble our way out of this challenge until the next one hits us.

Harsh Vardhan is executive-in-residence at the Centre of Financial Services, SP Jain Institute

of Management & Research. He has more than 20 years of experience in consulting to the
financial services industry.

The views expressed here are those of the author’s and do not necessarily represent the views
of Bloomberg Quint or its editorial team

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Vibha 40 points
a month ago

Long Debated Depth Of Bond Markets

Clearly mutual funds and insurance companies have failed to add depth to the market as their
own understanding is rather shallow. Adding another layer of Govt investors to bond market will
do no good.
However, Govt can really widen the base of debt investors by giving tax benefits and promoting
vehicles other mutual funds. There is a merit in have special category of AIFs, targeted at middle
income investors. Further, If interest on bonds is subjected to only 10% tax, large family offices
and corporates may investment in understanding these credits to give depth to the market. This
alongwith a solid liquidity facility, whereby haircuts are predefined basis the credit rating and
tenure can give real boost to the debt market. A stronger debt market will give more resilience to
the liquidity of large NBFCs, which in turn would enhance the financial inclusion agenda of the

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