It was dark September for India’s financial market when debt repayment defaults by Mumbai-headquartered Infrastructure Leasing & Financial Services Limited (IL&FS) on inter-corporate deposits and commercial papers worth Rs 4.5 billion came into light. There was a fear that all housing finance companies would get resultant liquidity crunch effect and Lehman Brothers- like condition will come back.
The IL&FS was a Non-banking financial company. These types of companies perform banking like services but don’t hold a banking license and cannot accept demand deposits. NBFCs were one of the segments giving high growth rate till last year (2018) and filling the gap created by the banking system due to high NPA issues.
Since the companies cannot accept deposits from the public, they borrow money from institutions like mutual funds, pension funds, banks, etc. in the form of long term borrowings like term loans or short term loans (CP) and use these funds for further lending at a higher rate.
The reason behind why banks lend to them are:
NBFCs are a quicker way to meet disbursement targets and have the exposure to meet their priority sector lending norms. Initially, this borrowing constituted 70% of total liabilities of NBFCs but increasingly was replaced by short-term market-based instruments in the past few years due to declining interest rates.
The domino effect
In March 2018, Net Debt/EBITDA, which is a measure of company's ability to pay its debt was hovering around the ratio of 11 (anything above 5 is a red flag) and further postponed payment of $350 million bonds due to higher yield demand from investors.
The 91,000 crore-bankruptcy cases of India’s leading infrastructure development and finance company wiped out Rs. 8.48 lakh crore of investor’s wealth and caused tremors in the market.
IL&FS owed Rs. 57,000 crores of debt to public sector banks and housing finance companies. Just before the default, credit rating agencies re-rated IL&FS bonds as “junk” from “AAA” and led to panic selling in the market due to questions on the credibility of credit rating agencies.
When information of the scam leaked, it affected the share prices and Domino effect triggered when DSP mutual fund sold Commercial Paper worth Rs. 300 Crores at a discounted price, which belonged to Dewan Hosuing Finance Limited.
The sale of DHFL commercial paper further raised concerns of tight liquidity and the possible risk of default on debt obligations from the home financier, which made mutual funds and banks cautious about lending money irrespective of their financial soundness. As a result, anxious retail investors started selling shares of other NBFCs and redeemed from mutual funds.
What’s the reason?
- Structural defaults: The structure of NBFC has a fundamental flaw. It exposes it to project risks as well as financial risks. In the case of IL&FS, where it all started, the parent IL&FS runs operations through its subsidiaries that means it invests in subsidiaries, which in turn invest in executing projects, and subsidiaries.
Generally, money is expected to flow back to the Parent Company as dividends, interest payments, etc. but during the crisis, these payments got backed up and affected the whole organization.
- Layer after layer of debt: the IL&FS group created a mammoth of Rs. 91,000 Crore debt against equity capital of just 9.83 Crore in the parent company. The parent company raises debt, which is infused as equity in each subsidiary. Further, the subsidiary uses the equity (which is a debt on parent’s books) to raise more debt.
- Assets-Liability Mismatch: The primary reason for this crisis is a negative assets-liability mismatch as the inflow of assets is less than the outflow of liabilities. The NBFCs investing in the projects with a gestation period of 10 to 15 years by borrowing for 8 to 10 years and then get refinanced.
But due to RBI guidelines on refinancing, companies were forced to borrow from the market by issuing CPs and debentures.
Borrowing money for a shorter duration but investing in long-term assets created a huge asset-liability mismatch.
- Unviable Projects: The NBFCs were investing in unsustainable projects, which has been a significant issue for the crisis. Nearly 60,000 Crore debt of IL&FS alone is at the project level, including road, power, and water projects. Complications in land acquisition, delay in environmental clearances and consequent delay in completion of projects, Cost escalation also led to many incomplete projects. Lack of timely action aggravated the problems are some factors that slowed down this project.
- Issues with Management: The management of the NBFCs over-leveraged the business. Despite RBI raising concerns, the management of NBFCs failed to take corrective action. This raised further concern about transparency, accountability, and corporate governance of such companies.
- The credibility of Rating Agencies: The credit rating agencies are given "AAA" ratings to the securities and failed to see the trouble due to weak research and evaluation of the business, pointing towards the credibility of such agencies.
- Regulation: unlike traditional banks, RBI or any other entity does not strictly regulate NBFCs. The IL&FS crisis has raised concerns over the management of such entities.
Effects of this entire episode
The cascading effects of the liquidity crisis worried the investors and traders. Default by IL&FS led to panic in the debt market and dried liquidity in the system. The liquidity shortage of 1 lakh Crore in the system intensified the fear that funding cost for NBFCs will zoom and result in a sharp deterioration of their margins.
With the liquidity situation tight in September 2018 due to factors like advance tax outflow and rush by banks to meet targets, problems for NBFCs compounded as mutual funds too looked to cut exposure to the sector.
Debt mutual funds started to write done the value by 3-5% on their portfolios. Following the IL&FS saga, volatility in stock market plunged in the stock market, the rumors about DHFL took the market by surprise and as a result, all other housing financing companies and infra companies stocks fallen up to 60% of its stock prices. In light of this, Sensex shed 2,000 points just in a week, sparking a bloodbath in the market.
The liquidity crisis not only points fingers at the inefficient corporate governance of NBFCs but also questions the role of public regulatory bodies. The liquidity crunch had severe effects on the economy as well as sectors such as automobiles, consumer durables, and commercial real estate, which are heavily dependent on financing by NBFCs.
If the liquidity crisis prolongs, consumption will go down further weakening the growth. The need is to restore investors’ confidences that are worried about leverage at other shadow banks, prompting a surge in volatility among financial stocks.