How Can the NBFC Sector’s Ongoing Slide be Reversed?

The slide continues
In its recent report ‘Trend and Progress of Banking in India’, the RBI has said that the asset quality of the NBFC sector has continued to deteriorate in the first half of FY2020. The banks are also suffering a similar fate; the RBI in its Dec, 2019 financial stability report stated that “the gross NPAs of scheduled commercial banks may increase from 9.3% in Sep, 2019 to 9.9% in Sep, 2020 due to a change in macroeconomic scenario, marginal increase in slippages and the denominator effect of declining credit growth.” This seemingly unsolvable problem of persistently high NPAs in India’s lending ecosystem has been further compounded by low credit growth (7.1% in 2019 – this is the second slowest pace of growth in the previous decade).  This has led to a unique situation – on one hand, the excess cash in India’s banking system is at Rs. 4 lakh crores – the highest since the post-demonetisation period and on the other hand we are seeing the second lowest credit growth (the lowest again being the post demonetisation period) in a decade.

How did we get ourselves into such a mess?
At the heart of India’s economic slowdown is a failure of its financial system. This failure has two distinct drivers:

1. The surge in crony capitalist lending by banks (public and private sector) which started around 12 years ago and which continued until 3-4 years ago. NPAs arising from this lending have amounted to nearly 15% of the Indian banking system’s assets and have destroyed the risk appetite of all Indian banks (public and private sector) for funding capex.
2. The surge in NBFC lending in 2017 (driven by cheap availability of debt in the money market which in turn was a consequence of the excess liquidity generated by the events of Nov 2016) resulted in NBFCs financing low quality residential real estate developers along with pilferage of cash by the promoters of these NBFCs. The unravelling of IL&FS in 2018 and Dewan Housing in 2019 was a symptom of this slipshod lending in 2017 & 2018. With other NBFCs teetering on the brink, the money market has stopped financing all NBFCs barring 3 or 4 marquee names. The AA rated NBFCs and Housing Finance Companies (HFCs) are now paying a 400-430 bps premium over benchmark yields compared to 300bps a year ago to access bank funding. As a result, the NBFCs have started shrinking their balance sheet size which in turn means that auto loans and home loans have been curtailed severely with obvious consequences for the Indian economy. For a more detailed account of this unravelling, read: https://marcellus.in/blogs/the-rbi-can-reverse-the-nbfc-crisis.

As a result of the above, credit disbursal in the Indian economy is down 90% YOY i.e. the economy is running on minimal credit disbursal. For a more detailed account of this slowdown, read: https://marcellus.in/blogs/marcellus-dissecting-the-economic-slowdown-in-india/

How can we get out of this mess?
Given that at the heart of this slowdown is the cancer in India’s lending ecosystem, it follows therefore that remedies must address this cancer. Given the multi-headed nature of the problem, multiple lines of attack must be pursued:

1. Privatisation of Indian public sector banks: Whilst the Indian government has repeatedly recapitalised public sector banks (injecting nearly US$50 billion over the last 5 years), it is still not clear whether: (a) the PSU banks’ balance sheets are in good shape with considerable doubts remaining on whether they have properly accounted for their lending to shaky NBFCs (post the ILFS crisis, credit to NBFCs as a % of overall banking credit has grown to almost 9% vs. 5.5% in the pre ILFS era as banks have replaced the CP and CD borrowing of these NBFCs) and other shady business houses; (b) barring a couple of high quality PSU banks, these banks have limited ability to hire adequately trained personnel and build high quality risk management systems. Whilst private sector banks have also suffered from high NPAs, the talent deficit is not as glaring in the private sector. For the banking system to move forward, the government must allow privatisation of PSU banks. The first step forward would be to privatise IDBI Bank. Interestingly, IDBI Bank was NOT nationalised by an act of Parliament and hence is a unique public sector bank whose privatisation does not need to be approved by Parliament. Furthermore, because it is a corporate bank – albeit with a challenged balance sheet – it will be an easier bank to privatise provided the government is realistic about what valuations such a sale might fetch. Once, IDBI is out of the way, the Government can try to see if a better-quality PSU bank like Bank of Baroda can be privatised at a superior valuation. In parallel, the Government needs to expedite the recently announced BPCL privatisation and the long-delayed privatisation of Air India. Without letting go of Government owned assets, it will be difficult for the Government to find the money required for the next steps outlined below.
2. A “bad bank” for NBFCs: Barring 3 or 4 prominent NBFCs, the rest of the sector is suffering from the money markets’ lack of faith in their balance sheets as evident from the fact that CPs of NBFCs and HFCs used to account for 23% of the investments of mutual funds and asset managers in the Sep, 2018 quarter, that number has now almost halved to 12%. Loaded up as these balance sheets are with loans to real estate developers, loans to homeowners whose flats have not been delivered (and probably will never be delivered), loans to SME owners whose collateral (shops, factories & warehouses) is highly illiquid. By all accounts, NBFCs’ balance sheets are continuing the deterioration on a monthly basis – see https://www.livemint.com/industry/banking/nbfcs-asset-quality-continues-to-deteriorate-11577210758437.html. The RBI Governor has said that the central bank is doing a deep dive into the balance sheet of NBFCs to identify such rotten assets. Identification alone however won’t be enough. These rotten loans then have to be disposed off to a bad bank (or a “bad fund”). The Govt announced last month such a “bad fund” but gave it a corpus of only US$3.5billion and strangely asked for the monies to be directed towards beleaguered real estate developers rather than for the purchase of bad assets (https://economictimes.indiatimes.com/wealth/real-estate/have-a-house-in-a-stalled-project-heres-all-you-need-to-know-about-nirmala-sitharamans-realty-und/articleshow/71953951.cms). This fund needs far more capital and that capital needs to be used to purchase weak assets which are in workout mode. The question is how much more?

   NBFCs’ NPAs which have remained doubtful for over 2 years (i.e. loans which are highly likely to be a 100% write-off) amounts to nearly 2.5% of their loans outstanding. That amounts to around US$10 billion. To our mind, this is the minimum corpus this fund needs to be able to absorb the lowest quality assets from the balance sheet of weak NBFCs. Ideally, the fund needs to have twice this corpus because it is highly likely that the NBFCs’ current balance sheets understate the scale of the bad loans sitting on their books. Ideally, therefore the “bad fund” needs US$20 billion. In return for being willing to buy these bad assets, the “bad fund” should have a backstop arrangement with the Government that: (a) these bad loans will NOT be subject to the IBC process as that process does not seem to work for lenders (more details given below); and (b) the Government will provide a minimum assured rate of return to investors in the fund. Subject to these two criteria and subject to appropriate oversight of the Investment Committee of the bad fund, foreign investors would be willing to provide capital to the bad fund.

3. Clarifying the bankruptcy process for NBFCs and for real estate developers: So far, the IBC process even for conventional borrowers has had mixed success at best. As described by Arvind Subramanian and Josh Felman in their recent paper “whereas the law specified that cases should be resolved within 270 days, completed cases have actually taken an average of 409 days so far. And progress is even slower in the larger cases, which account for the bulk of the bad loan amounts. More than two years after the RBI referred 12 large debtors to the IBC only half of these cases have been resolved, mostly in the steel sector. Consider the big picture. Only Rs. 2 lakh crore has been resolved through the IBC so far (with recoveries of just Rs. 83,000 crore), a small fraction of the initial stock of NPAs. At this rate, it will take a very, very long time to solve the bad debt problem. And the current rate of resolution actually overstates the prospects, since most of the bankruptcies processed by the IBC so far have been relatively straightforward cases, such as steel producers caught out by downturns in global steel prices….More complex cases, especially those of the independent power producers, which account for a large portion of stressed assets, are still far away from any resolution.”

   For the Financial Services sector, the IBC situation will be even more complicated as it is not clear from a legal perspective how the rights of a bond holder (who has lent money to an NBFC with specific loans being offered to her as collateral) can be overridden by the waterfall structure mandated by the IBC. This lacuna looks likely to result in prolonged litigation as secured creditors (bondholders), unsecured creditors and depositors fight it out in court. India cannot afford to get into this sort of prolonged legal mess. The Government must step in and in collaboration with the appropriate regulators clarify the law rather than letting the courts establish the case law through trial & error over the next several years. Without legal clarity on this matter, it is not clear that the first two panaceas identified above will work and without the first two panaceas it is not clear, we will get out of the economic mess we find ourselves in.

Saurabh Mukherjea and Tej Shah are CIO and Portfolio Counsellor respectively at Marcellus Investment Managers (www.marcellus.in).

Note: the above material is neither investment research, nor investment advice. Marcellus does not seek payment for or business from this email in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.