After CRB Capital, one of the biggest Non-Banking Finance Companies (NBFCs) collapsed in 1996, RBI came out with a long list of dos and don’ts that forced hundreds of NBFCs to shut shop. Those were the days when long queues of depositors outside bankrupt NBFC offices were a familiar sight. It raised a hue and cry, made headlines and often forced the local MP (who could also have been a member of the Parliamentary standing committee on finance) to call up RBI and ask, “What’s this all about?”
It was a social issue, political embarrassment and a pain for the regulator who, after a point, felt enough was enough. Rules of the game were changed: NBFCs were asked to chip in with more capital, while raising deposits from the public — up until then the main source of NBFC finance — became almost impossible and within a few months, a large number of NBFCs surrendered their licences. The few that survived were big enough to take care of themselves.
Everyone thought NBFCs were history. Now, more than a decade later, NBFCs have returned to haunt the regulator. No one is willing to lend them money, and few have the cash flow to clear old loans that are coming up for repayment.
How did they get into this mess? Before that, why did they flourish? A cleaner or a truck mechanic, who graduates to become a driver and five years later decides to buy a used truck to build his own dream fleet, will not get bank finance. But an NBFC knows exactly what he wants — how much loan he can sustain, how he will repay it and, more importantly, how best to recover the money if he fails to pay. An NBFC did what a high-street bank couldn’t. It was also smarter than a bank in regular businesses like consumer loans for auto, two-wheeler, washing machines and televisions. The NBFC model was also a window for big banks, many of which floated finance companies, to enter into businesses the parent couldn’t due to stringent RBI rules. So, if a bank couldn’t generously lend against shares beyond a point, the NBFC did; if the bank had reached its exposure cap to a particular business house, the NBFC gave the additional loans; or, if a promoter was looking for money to raise his holding through a creeping acquisition, he turned to NBFCs for money. Bankers have a word for this: regulatory arbitrage.
It went on beautifully. The problem arose when the money market went into a tailspin. Almost overnight, it exposed the touch-and-go business model of NBFCs, which was giving five year loans with two-year or one-year or even six month money. Hardly any NBFC today relies on public fixed deposits. Instead, they borrow from banks and most importantly, place debentures with mutual funds (MFs). It’s quicker, simpler, cheaper and, unlike an FD default, bad loans don’t necessarily mean bad press (There are instances where the promoter of a failed NBFC had morphed into the owner of a new software firm; or the shareholders of a pharma company quickly distanced themselves from the NBFC they had once backed. Few complained, too).
Raising money from MFs was even more attractive. With banks, the NBFC had to give a minimum 25% margin — meaning, it had to pledge collaterals worth Rs 125 for a Rs 100 loan. With MFs, there was little or no margin; besides, there were savings on stamp duty as long as the debentures you placed with the fund were secured — even if that security meant that a Rs 500-crore debenture issue is backed by Rs 5-crore office space in Ahmedabad or anywhere in Gujarat — the state which offered such a duty exemption.
Most MFs didn’t care whether the NBFC was in a position to service the loan. Instead, they left the job to credit rating agencies. So, as long as an NBFC debenture had a good rating, there were takers. But what has deepened the crunch is the duration mismatch between the money raised and the money lent. Banks and MFs had no interest in buying five-year or 10-year bonds of NBFCs. They were game for six months to three years, while NBFCs gave loans which were for five years. So, at the end of six months, the NBFC had to raise new money to repay the previous six month loan. This is fine when things are hunky dory, but not when the credit market has frozen and banks choose to hoard cash and not lend. NBFCs were also reluctant to float long-term debentures where the interest rate was higher and credit rating lower. Cheaper, short-term money was far too tempting (Bankers also have a word for this: interest arbitrage).
There was also a little symbiosis between MFs and NBFCs: NBFCs drew their full bank lines to park with MFs, helping them prop up the monthend asset under management number; in return, MFs bought NBFC papers. Today, this model is under scrutiny. It’s generally agreed that NBFCs have a role to play in capital formation, fostering entrepreneurship, backing SMEs and fuelling the consumption boom. Perhaps, they can do it better than banks. But they aren’t banks — they can’t borrow from RBI, can’t raise low-cost funds through savings or current accounts and can’t run a mismatch for years the way banks can.
If they are lucky, a few of them will eventually get a banking licence, or merge with a bank. Till then, they will have to stick to financing less volatile assets (say, trucks and cars rather than stocks), and find cheaper source of funds, like floating tier-II bonds or placing long-term papers with insurance companies. All this will take time. While new rules can be framed to quicken the change, the immediate need is bank loans to keep them afloat. The market today cannot afford defaults by NBFCs — it’s just not a few thousands of depositors losing money; it can impair the financial system. Bankers ought to know best.
It was a social issue, political embarrassment and a pain for the regulator who, after a point, felt enough was enough. Rules of the game were changed: NBFCs were asked to chip in with more capital, while raising deposits from the public — up until then the main source of NBFC finance — became almost impossible and within a few months, a large number of NBFCs surrendered their licences. The few that survived were big enough to take care of themselves.
Everyone thought NBFCs were history. Now, more than a decade later, NBFCs have returned to haunt the regulator. No one is willing to lend them money, and few have the cash flow to clear old loans that are coming up for repayment.
How did they get into this mess? Before that, why did they flourish? A cleaner or a truck mechanic, who graduates to become a driver and five years later decides to buy a used truck to build his own dream fleet, will not get bank finance. But an NBFC knows exactly what he wants — how much loan he can sustain, how he will repay it and, more importantly, how best to recover the money if he fails to pay. An NBFC did what a high-street bank couldn’t. It was also smarter than a bank in regular businesses like consumer loans for auto, two-wheeler, washing machines and televisions. The NBFC model was also a window for big banks, many of which floated finance companies, to enter into businesses the parent couldn’t due to stringent RBI rules. So, if a bank couldn’t generously lend against shares beyond a point, the NBFC did; if the bank had reached its exposure cap to a particular business house, the NBFC gave the additional loans; or, if a promoter was looking for money to raise his holding through a creeping acquisition, he turned to NBFCs for money. Bankers have a word for this: regulatory arbitrage.
It went on beautifully. The problem arose when the money market went into a tailspin. Almost overnight, it exposed the touch-and-go business model of NBFCs, which was giving five year loans with two-year or one-year or even six month money. Hardly any NBFC today relies on public fixed deposits. Instead, they borrow from banks and most importantly, place debentures with mutual funds (MFs). It’s quicker, simpler, cheaper and, unlike an FD default, bad loans don’t necessarily mean bad press (There are instances where the promoter of a failed NBFC had morphed into the owner of a new software firm; or the shareholders of a pharma company quickly distanced themselves from the NBFC they had once backed. Few complained, too).
Raising money from MFs was even more attractive. With banks, the NBFC had to give a minimum 25% margin — meaning, it had to pledge collaterals worth Rs 125 for a Rs 100 loan. With MFs, there was little or no margin; besides, there were savings on stamp duty as long as the debentures you placed with the fund were secured — even if that security meant that a Rs 500-crore debenture issue is backed by Rs 5-crore office space in Ahmedabad or anywhere in Gujarat — the state which offered such a duty exemption.
Most MFs didn’t care whether the NBFC was in a position to service the loan. Instead, they left the job to credit rating agencies. So, as long as an NBFC debenture had a good rating, there were takers. But what has deepened the crunch is the duration mismatch between the money raised and the money lent. Banks and MFs had no interest in buying five-year or 10-year bonds of NBFCs. They were game for six months to three years, while NBFCs gave loans which were for five years. So, at the end of six months, the NBFC had to raise new money to repay the previous six month loan. This is fine when things are hunky dory, but not when the credit market has frozen and banks choose to hoard cash and not lend. NBFCs were also reluctant to float long-term debentures where the interest rate was higher and credit rating lower. Cheaper, short-term money was far too tempting (Bankers also have a word for this: interest arbitrage).
There was also a little symbiosis between MFs and NBFCs: NBFCs drew their full bank lines to park with MFs, helping them prop up the monthend asset under management number; in return, MFs bought NBFC papers. Today, this model is under scrutiny. It’s generally agreed that NBFCs have a role to play in capital formation, fostering entrepreneurship, backing SMEs and fuelling the consumption boom. Perhaps, they can do it better than banks. But they aren’t banks — they can’t borrow from RBI, can’t raise low-cost funds through savings or current accounts and can’t run a mismatch for years the way banks can.
If they are lucky, a few of them will eventually get a banking licence, or merge with a bank. Till then, they will have to stick to financing less volatile assets (say, trucks and cars rather than stocks), and find cheaper source of funds, like floating tier-II bonds or placing long-term papers with insurance companies. All this will take time. While new rules can be framed to quicken the change, the immediate need is bank loans to keep them afloat. The market today cannot afford defaults by NBFCs — it’s just not a few thousands of depositors losing money; it can impair the financial system. Bankers ought to know best.
