NBFCs now make up a much bigger part of the ‘credit industry’…



…driven by the rise of new asset classes…

…fast-growing consumer portfolios…


…and structured lending


Project finance is not a natural fit…


…and competition has risen

Bond markets are hard to tap…


…and many NBFCs suffer from asset-liability mismatches

The roots of the NBFC crisis…

• NBFCs have seen a period of rapid asset growth, with their market share in overall credit from 14% in FY14 to 22% in FY18. In part, this is due to a slowdown in bank lending, the result of a growing political and financial focus on bank NPAs.
• The rise of new asset categories such as affordable housing, developer financing, consumer finance, personal loans, and two-wheeler loans, has also contributed to this shift.
• Consumer portfolios (CPs), which made up 7% of total lending in 2014, are now 16%, with housing finance alone rising to 13% of the total. The long average tenure of housing loans points to future problems in this space.
• NBFCs have also moved into structured lending, driven by the fact that banks are either reluctant or barred by regulation from certain types of transactions. Often, such lending is not backed by assets or cash flows but based on equity prices or on events such as IPOs and SBU sales, which are intrinsically unpredictable.
• The liability mix of NBFCs makes them less suitable for project finance. As a result, companies have had to opt for the quick-fix alternative of short-term financing, opening them up to a basket of risks and regulation.
• Competition in the NBFC space has intensified with the emergence of new players. This has squeezed margins and driven cost-cutting.
• Finally, the absence of a mature bond market prevented many NBFCs from accessing long-term finance. Few but the most reputed companies – those with strong parentage, good track records and lower NPLs – are able to directly access longer-term funds.
• The net result is a big increase in assets, especially those of longer tenure, but also a huge increase in short-term borrowing, heavily skewing the liability profiles of many NBFCs.

Hasty downgrades created panic, causing liquidity to dry up…




…which is now slowing asset growth

…and its immediate triggers

• The near-term trigger for the crisis was that, in multiple cases, ratings were downgraded from AAA/AA to default status in a matter of days. This revealed to investors that ratings do not always reflect the intrinsic character of assets, and are sometimes based on flawed pricing or the incomplete recognition of risks.
• Perceptions of deteriorating asset quality created panic, and subsequently impacted funding costs and supply, severely squeezing liquidity.
• Today, many NBFCs are unable to grow their assets in the absence of liquidity, while even the more liquid NBFCs have been affected by the asset quality scare, which has triggered extreme risk aversion within the industry.

The sector remains buoyant in parts…


…but funding costs are up…


…consumer lending has slowed…

…ratings are under greater scrutiny…


…while volatility has also declined…

…and market cap has declined

Current conditions…

• The NBFC sector remains buoyant, in areas such as two-wheeler and car loans. In contrast, areas such as real-estate, wholesale and infrastructure lending, as well as structured credit are seeing a big decline, which is likely to continue.
• Funding costs have gone up as NBFCs have struggled to correct their asset-liability mismatches. In the post-September aftermath of the IL&FS crisis, rates have risen by 0.5-1.2%, partly because of margin compression. The bond spread between NBFC and AAA-rated corporates has gone up by about 50 basis points during this time.
• Consumer lending, even for the best-performing NBFCs, is below pre-IL&FS levels.
• Rating mechanisms are under greater scrutiny. At the same time, banks are giving NBFCs more competition given their pricing power.
• Volatility has reduced somewhat since December, but could go up again in March as liquidity tightens.
• Market capitalisation has taken a hit, with NBFC share prices correcting by 60-70% over the last two quarters. As costs increase, the percentage of NPLs goes up and asset build-up slows. This prompts analysts and brokerages to re-rate earnings and price multiples.

Fresh equity issues might be considered…

…and buy-outs are likely





Several potential sources of new funding…




…but asset quality remains a concern…


…and regulatory oversight could increase

…and a medium-term outlook

• While NBFCs could potentially benefit from raising fresh equity at this point in time, their capacity to do so has been dented by market conditions.
• Banks, stronger NBFCs, as well as non-NBFC investors could potentially buy out distressed NBFCs.
• NBFCs may also consider diversifying their funding sources by tapping into retail NCDs and deposits. Volumes, however, might get constrained by the significant distribution, acquisition and servicing costs involved.
• Other new sources of funds, while not dramatically large, could include insurance companies, provident funds, and pension funds. The RBI has also helped infuse liquidity by temporarily raising the liquidity coverage ratio and sector exposure limits, allowing banks to lend to NBFCs.
• Asset-quality problems are likely to persist, especially with regard to real estate and property loans. It will be difficult for smaller NBFCs to pick up 5- or 10-year money unless the bond market strengthens.
• Further regulatory tightening is likely, with the RBI seeking to increase its supervision over NBFCs, bringing it on par with banking oversight. This could encourage NBFCs to search for long-term funding, intensifying the liquidity crunch in the short-term but eventually helping them to stabilise. The RBI might also revisit the fact that NBFCs do not face CLR requirements and have lighter SLR requirements than banks.

Funds have become scarcer for certain borrowers

Investors are re-evaluating risks in debt mutual funds

Re-ratings are underway in other areas, too…


…but equity remains a viable option

Key takeaways for investors

• For the NBFC-dependent manufacturing sector, and for those who require structured credit or one-off financing, funds have become expensive and scarcer.
• Investments in debt mutual funds, which have long been misperceived as being risk-free, were hit by potential defaults and downgrades a year ago. While these will continue to be a source of corporate liquidity, a re-evaluation of risk is now justified.
• Direct investments in other NBFC paper, such as CPs and NCDs, have also seen changes in risk perception. As the market capitalisation of NBFCs and banks has fallen, there is greater pressure on equity markets. Re-rating is likely to increase volatility and make it more difficult to raise money in the equity market.
• Even as raising money in the equity markets has become more difficult, and despite the negative cost of carry today, it remains a viable option.