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By V.P. Nandakumar
It’s well known that in recent years India’s banks have been grappling with high levels of non-performing assets (NPAs). This problem came to light in 2014-15 when the Reserve Bank of India, suspecting that NPAs were being under-reported over the years, introduced tougher norms for NPA recognition under an Asset Quality Review. The result was that NPAs in 2015-16 almost doubled over the previous year. With the consequent sharp increase in provisioning, many banks have suffered severe erosion of their capital base. This, in turn, constrained their ability to lend in tune with the requirements of the growing economy. Since credit is the lifeblood of the economy, India stood to suffer badly under these circumstances.
However, as things turned out, it was not as gloomy as one would have feared, only because the non-banking financial companies (NBFCs) stepped up to the plate. Consider these figures. The lending book of India’s NBFCs has grown at a rate of 18 per cent in the last five years, while the sector’s contribution to total credit has increased from 15 per cent to 20 per cent in just three years. The NBFC sector has played a pivotal role in meeting the financial needs of individuals and businesses that have traditionally remained un-served or underserved by banks. NBFCs are now recognized as last-mile financiers with proven ability to lend to those marginalised sections of society that commercial banks would not have deemed credit-worthy. Also, most of them are niche players who approach their business with focused attention and unique insights which allows them to devise innovative ways to address the special needs of their target segment. And innovation allows them to generate profits out of businesses that mainstream players would dismiss as losing propositions.
The funding challenge for NBFCs
While NBFCs are seen as a segment distinct from the banks, the fact remains that the major source of funding for NBFCs even today is the banks. This is especially true for the non-deposit taking NBFCs. In FY2017, borrowings from banks made up 21.2 per cent of NBFC borrowings, which jumped to 23.6 per cent in FY2018 and 29.2 per cent in FY2019. This reliance on banks for meeting a large share of their funding requirement comes at a price. It has meant that NBFCs have often had to face difficulties in lending to even their deserving customers because of inadequate funding arising from the weakening credit profile of the banks.
The reliance on bank funding was not without its blessings as it was easier for NBFCs to raise money at lower costs when the going was good. However, whenever the tide turned, it would become difficult and costly. The fact is, banks have acted mostly as fair-weather friends, lending an umbrella in clear weather and taking it back when it rained. This kind of risk-averse behaviour is perfectly understandable because banks are, after all, custodians of the depositors’ money. And so, after the 2018 default by one of India’s largest NBFCs (IL&FS) highlighted the problem of asset-liability mismatches across the sector, banks have generally turned wary of lending to NBFCs. Matters were not helped when the leading NBFC engaged in housing finance, Dewan Housing Finance Ltd., also went under subsequently.
Given the risk aversion of the banks, over the last two years there has been a change in the funding scenario for NBFCs. The days of banks being the primary source of funds for NBFCs may well be coming to an end. These days NBFCs are raising funds in the markets at ultra-cheap rates even though the banking system sits on a huge surplus while still reluctant to lend to NBFCs.
Bond market as the alternative to banks
India’s financial markets are still a work-in-progress and there’s a dearth of alternatives to bank funding, especially for the long-term. The solution, therefore, is to deepen India’s bond markets that would free NBFCs from excessive dependence on banks to make the occasional failures like IL&FS less traumatic for the banking and financial system. The development of an active and liquid corporate bond market will greatly help in the transparent and efficient financing of business and industry, especially NBFCs.
The question may now be asked, ‘What prevents the growth of the bond market in India?’
Well, factors such as the dominance of banks in lending, the limited risk appetite of individuals, requirement of higher credit ratings, tax arbitrage, and prescriptive regulatory limits on investments have all played a part. Also, retail participation in debt markets is minimal even though the psyche of the Indian investor is skewed towards fixed income instruments (as much as 47% of the annual household financial savings flowing into bank deposits.)
And so, India’s corporate bond market’s penetration or outstanding corporate bonds as a percentage of gross domestic product is abysmally low (around 15 per cent) compared to many of its emerging market peers, like Brazil and Turkey. In Turkey, non-government bond issuances jumped from less than $1 billion in 2010 (0.2 per cent of government issuances) to over $18 billion (12.82 per cent of government bonds) in 2020.
There is, thus, an urgent need to deepen the bond markets with larger participation from the retail investors so that NBFCs can shift from banks to the bond market for the bulk of their funding needs. A good start may be made by having the on-tap public issue of bonds directly to investors, enabling corporates to raise funds regularly at lower issuance cost. The main challenge faced by the investors is the illiquidity of bonds, as each issuance is a new instrument, unlike equity shares where all the follow-up issues are part of the same instrument. It may be worthwhile to explore the issuance/ re-issuance of perpetual debt securities (to be traded on a clean price mechanism, just like G-Sec) allowing higher liquidity and larger participation of investors.
For borrowers, it would lower the funding cost with transparent price discovery. The bond market also requires a functional trading platform with a central counterparty facility like that for government securities. We also need insurance products like credit default swaps for an active secondary market for corporate bonds. The bottom line is to do away with opacity when it comes to underlying assets. The Indian bond market is reasonably large in Asia. However, it is dominated by government securities. Attention should be given to bringing about further growth and diversification in the corporate bond market since it is currently lagging relative to peer countries.
Why it matters for NBFCs
NBFCs have been at the forefront of innovations in financial services which banks go on to adopt later. The culture that produces innovations thrives best under a light-touch regulatory structure. Regulations are a product of rational thought, whereas innovations emerge from out-of-the-box thinking. Innovations cannot thrive under a heavy hand as encouraging the innovation culture requires a higher tolerance for failure. Innovations are like start-ups where the failure rate is high, yet the one that survives and flourishes, goes on to redefine the sector. If India’s NBFCs have succeeded against the odds so far, it’s because they have been lightly regulated all these years compared to the banks. In the banking sector, failures come at a high cost and hence the need for rigorous regulations to prevent downsides.
In the post IL&FS scenario, there is pressure on the regulators to tighten up their oversight of NBFCs.
Indeed, as long as NBFCs depend primarily on banks for their funding (considered as money belonging to the public), the regulators will be under pressure to tighten their grip as any default involving public funds is bound to be controversial. And that, as we have seen, would be detrimental to the innovation culture of NBFCs. That’s why a shift in the funding pattern of NBFC’s towards the bond market and away from dependence on banks would be hugely positive for the financial sector, as it would also help NBFCs retain their innovative edge.
Published in Unique Times Magazine, December 2020
(The writer is MD & CEO of Manappuram Finance Ltd. Views are personal.)