Think Tank

An Impending Financial Sector Crisis: Implications for CFOs

Ramesh Venkat, Founder and Managing Partner, Fairwinds Asset Managers

India’s financial sector, which was already grappling with NPAs to the tune of 12-13% of assets before Covid-19 hit, is likely to see these ratios worsen in the coming months. In an extreme scenario, NPAs may touch 18-20% as borrowers struggle to fulfil obligations. Effectively, this would wipe out the equity base of the entire financial system. The trouble has now spread to the mutual fund sector, as evidenced by the recent experience of a prominent fund house. The RBI’s liquidity enhancing measures appear to have had only a marginal impact and credit availability remains highly constrained. At a recent all-India CFO Forum session, we invited Ramesh Venkat, Founder and Managing Partner of Fairwinds Asset Managers to take stock of the current turmoil and explain the implications for CFOs.

The last 5 years have been marked by dramatic changes and policy upheaval in India’s financial sector…

Lurching from one crisis to another
In the last five years, India’s financial sector has witnessed major policy and regulatory changes that have either directly or indirectly impacted NBFCs. A regulatory overhaul in 2015 reshaped balance sheets and changed how these businesses conduct themselves. Demonetisation affected the entire financial services industry – mostly SMEs and other small borrowers – as did the introduction of the GST and the new NPA rules.

…coupled with the NBFC crisis, bank failures and a slowing economy

In 2018, the IL&FS crisis broke out and Ind-AS was made applicable to NBFCs, forcing them to rejig their balance sheets to reflect their true assets and liabilities, which in many cases triggered dramatic changes in ratings. Consequently, it emerged that most lenders had serious asset-liability mismatches, poor or deteriorating asset quality, and governance and management issues. 2019 saw the Insolvency and Bankruptcy Code (IBC) being extended to NBFCs, as well as the Yes Bank saga and other NBFC-related scams. A trifecta of rising borrowing costs, the recalibration and de-risking of the loan book and a slowing economy caused credit growth to decline to 7-8% in FY20, compared with over 15% a year ago. While retail lending continued to grow, corporate loan growth was flat.

Covid-19 will impact the BFSI sector

Current conditions: the impact of covid-19….
Covid-19 and the ensuing nationwide lockdown will have a significant negative impact on the economy and the banking and financial services sector in particular.

Repayment ability will be severely impaired…

  • On the asset side, the repayment ability of both corporate and retail borrowers will be severely impaired. However, this will vary hugely by the type of lending (corporate loans are less susceptible to impairment than retail ones), by sector (mortgages tend to have lower levels of impairment than unsecured loans) and by region/state.

…while collection systems remain broken

  • With operations coming to a standstill and many employees moving back to their hometowns, the collection mechanism, particularly for NBFCs that rely on physical repayments, is broken. In places, this has also affected the overall credit culture.

Access to funds is restricted

  • On the liability side, banks – which were already limiting access to funds, particularly longer-duration ones – have become even more risk-averse. Barring the top banks and NBFCs, most institutions are having trouble accessing funds. With falling interest rates and the rising risks of bank failure, CASA (current account, saving account) deposits are also likely to dry up. Finally, recent developments in the mutual fund industry will prevent lower-rated companies from accessing funds.

High levels of uncertainty will affect ALM strategies….

  • Given volatile markets and high levels of uncertainty, it is extremely difficult to predict the timing of recovery which will significantly affect firms’ asset and liability management (ALM) planning and strategies.

…and the pandemic will extend the AQR cycle

  • Lastly, the asset quality review (AQR) cycle of banks and NBFCs which was in its final stages, will get extended to FY22 on account of the pandemic.

An array of monetary and liquidity measures announced by RBI…

…..and response measures
Monetary stimulus
In the wake of Covid-19, the RBI has come out with an array of monetary and liquidity measures to ensure a continued flow of funds, particularly to the worst-affected sectors. These include cheap long-term repo operations (repo rates have come down by 1.15% and 10-year G-secs are now priced well below 6%); infusing liquidity through open market operations (it has purchased over Rs 1.5 trillion of bonds in the secondary market since March); and exempting banks from including the incremental credit disbursed to specific sectors in their cash reserve ratios. However, these measures will have a limited impact. The benefits of lower rates do not get transmitted widely, and in an environment of poor market sentiment, interest rates alone cannot spur loan demand. Credit growth has stayed flat despite the system being flush with liquidity.

…and multiple fiscal measures…

Fiscal stimulus
The Finance Minister announced four sets of fiscal measures around the financial sector: 1) Rs 3 trillion of guaranteed loans for MSMEs; 2) Rs 300 billion of liquidity support for NBFCs; 3) Rs 450 billion worth of partial (20%) first-loss guarantees for lower-rated NBFC paper; 4) A 6-month moratorium, which is essentially a working-capital interest deferment.

…will have only a limited impact

These measures are unlikely to have a ‘big-bang’ impact, given that many issues around the financial sector remain unaddressed. There are also anomalies in the fine-print. For instance, additional lending will be available to the extent of the outstanding balances to date, implying that the more efficient MSMEs (those with lesser or no loans) will have no access to these funds. Also, these loans are to be administered by the banking sector, which is subject to local vagaries and procedural bottlenecks that could impact the speed and efficiencies of disbursements. Further, the liquidity support available to NBFCs is short-term in nature (only 3 months), limiting its utility and falling short of the longer-term funding needs of NBFCs. The partial, 20% first-loss guarantee scheme is probably a non-starter, given the extreme risk aversion among banks and mutual funds.

The extended moratorium will add to the pain

The six-month moratorium is likely to cause added hardship for NBFCs, especially the smaller ones. They typically operate on limited short-term liquidity, which will become even more strained if customers start defaulting after the moratorium. In general, the moratorium book ranges from 20-100% for NBFCs, 90% for some small finance banks, and 25-35% for large banks. Although banks are relatively better placed, smaller NBFCs could see serious asset-liability mismatches post August 2020, especially if the current risk aversion and restricted market access persist.

A one-year pause on the IBC proceedings is hugely negative

Regulatory tweak: IBC on hold

In a bid to provide relief to companies defaulting on loans due to the stress from Covid-19, the government announced that no fresh insolvency proceedings will be initiated for one year under the IBC. Further, all coronavirus-related debt will be excluded from the definition of default. In terms of impact, this measure is hugely negative for the resolution of corporate delinquencies, requiring lenders to revert to inefficient, bank-led resolution mechanisms such as SARFAESI, inter-creditor agreements and ARC. Further, putting such regulation on hold is negative for private lenders and operational creditors, and could provide unintentional protection to fraudulent promoters. Moreover, the definition of ‘Covid-19 related debt’ is wide enough to open the flood-gates for litigation.

High risk of a spike in NPAs and bank failures

The way forward

The government and the RBI have swung into action with targeted interventions, but the financial sector must brace for a hugely negatively impact. In the coming months, a spike in NPAs is inevitable, and by the end of FY21, they could be in the range of 18-20%. Access to liquidity will remain constrained even as borrowing costs will stay low, exacerbating the stress on both the asset and liability sides of the balance sheet. Consequently, there is likely to be another round of bank failure – though this will be confined to the regional, cooperative and small-banking space – and a wave of consolidation in the second half of the year. New-generation NBFCs and Fintech lenders that focus on unsecured lending will find it extremely difficult to continue their operations, and VCs may pull the plug on many of them.

Debt mutual funds will find it hard to raise funds

In the absence of a robust bond market, new bond issues will remain subdued, resulting in a shortage of funds for debt mutual funds. Longer-tenure and lower-rated paper, on which debt funds rely to earn better yields, will hardly see any takers. However, companies in the digital payment space will see greater traction, with the stronger players gaining market share.

Household balance sheets to remain stressed but will get repaired quickly

Household balance sheets are likely to come under stress in the near-term due to job losses, and made worse by a fall in the savings rate over the last few years. By next year, however, they are likely to be in much better shape as income levels return to normal, the savings rate edges up, and households deleverage on a large scale.

Needed: more reforms, and direct government support for certain sectors

In terms of stimulus/policy measures, many have called for the direct government financing of certain categories of companies, including NBFCs. To that end, some experts recommend that the government directly buy equity in stressed sectors, including airlines and auto. This would be a huge morale booster, lending direction to industry, and ensuring access to funding. Other suggested measures to boost consumption and cash flows include changes in the GST laws, a reduction in income tax rates, and other deferrals. The government could also consider initiating bold reforms in the corporate bond market; tweaking the IBC to allow for ‘promoter triggered insolvency’; limiting the reverse-repo window to stimulate lending; and increase the hold-to-maturity limits for banks.

CFOs should raise money when opportunities arise

Issues for CFOs

In the short- to medium-term, CFOs should not look to NBFCs as a major source of finance. Given the recent defaults in debt mutual funds, most surplus funds are likely to gravitate towards bank deposits or low duration funds. Few companies or institutions will have much appetite for other NBFC papers, such as CPs and NCDs. However, fears of a systemic meltdown are overblown. For the most part, equity markets have been robust and debt markets are also likely to hold up, albeit with a few hiccups. Timing the market is therefore a futile exercise, and CFOs should raise money whenever such opportunities arise.