NBFCs are facing a liquidity crunch. In other words, they don’t have money to lend or
are facing enormous difficulties in raising funds. NBFCs typically borrow money
from banks or sell commercial papers to mutual funds to raise money. They on-lend
these money to small and medium enterprises, retail customers and so on. When
NBFCs don’t have money to lend, that reduces the credit flow to the economy, hits
economic growth and causes many borrowers to default on loans.
What led to this?
There are a couple of things to consider here. One, the NBFC business model itself is
flawed, to begin with. It relied on raising short-term funds which were then lent out as
long-term loans. This leads to a situation called an asset-liability mismatch. For
example, an NBFC raises money by selling 6-month debt papers and on-lends this as
a car loan with a tenure of 5 years. This leads to a situation where the NBFC has to
roll over (or renew) the 6-month debt paper or raise fresh loans to repay the debt
paper. In good times, this happens as a matter of course. But when times are tough,
this cycle is broken.
That leads us to the second factor. The cycle was broken by a default of some firms of
the IL&FS group. There were fears that this would turn out to be a contagion. Simply
put, banks, mutual funds and their investors were afraid that more such entities
wouldn’t default. As this fear took hold, many institutions refused to give money to
NBFCs. The cost of funds rose by as much as 150 basis points for NBFCs.
Were the fears of contagion real?
In the last few years, especially after demonetization, there was excess money
sloshing around in the system. That is because a lot of cash was deposited with banks
and investors parked more money with mutual funds. As fund managers of debt
schemes deployed the funds in money markets, NBFCs were able to access cheap
funds easily. They were able to grow their loan portfolios at double the pace of banks.
But on the flip side, note that mutual fund managers were chasing high returns for
their investors and so too were NBFCs and banks. This led them to take risks and put
pressure on the quality of their underwriting standards. Note that this excess money
was given not only to NBFCs but also to other companies such as infrastructure
players -- as loan against shares -- which have come back to bite now.
Why is the crisis a big deal?
As explained earlier, NBFCs are playing an increasingly important part in the
economy. Their share of credit has increased because they were lending in sectors
where banks refused to go or did not want to go. The used commercial market is a
good example here.
Now that NBFCs are finding it difficult to raise money or having to pay a huge cost
for doing so, this will choke the flow of credit to the economy. It will hit the MSME
sector which is already suffering from the twin blows of demonetisation and the goods
and services tax.
More importantly, it will hit consumption demand in the economy. With investment
demand yet to pick up and exports flagging, consumption was the primary engine
driving the economy. A reduction in credit further adds to economic slowdown
pressures, which are already visible.
Besides, a slowdown in credit could lead to another pile of non-performing assets in
sectors such as commercial real estate and infrastructure, which could have economywide knockdown effects.
Consider this example, an infra project needs working capital funds for completion so
that it can start earning. When funds aren’t available or come at a higher cost, this
undermines the feasibility of the project and puts the money already sunk in at risk.
This adds to the stressed assets; mutual funds lending to such projects will have to
mark down their net asset values; this leads to investors taking money out of mutual
funds and in turn mutual funds won’t be able to give money to NBFCs/ other projects,
setting off a vicious cycle.
The spate of recent downgrades in NBFCs, housing finance companies and
infrastructure projects highlight the problems caused by the crisis.