Earlier this week, a top government official, Corporate Affairs Secretary Injeti Srinivas, flagged an imminent crisis in the Non-Banking Financial Companies (NBFC) sector. Specifically, he pointed to a credit squeeze, over-leveraging, excessive concentration, a massive mismatch between assets and liabilities, coupled with some misadventures by some large entities, as primary concerns in the sector.
What are NBFCs? How are they different from banks?
An NBFC is a financial institution that gives out loans and advances, involves in the acquisition of shares, stock, bonds, hire-purchase insurance business or chit-fund business. NBFCs lend and make investments. But, unlike banks, an NBFC does not issue demand deposits, does not form part of the payment and settlement system and cannot issue cheques drawn on itself nor Demand Drafts. Both banks and NBFCs are regulated by the Reserve Bank of India (RBI), but under different laws. Banks are subject to the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970; NBFCs to the Companies Act, 1956.
Why do we have NBFCs when we have banks?
NBFCs of various types fill in roles that the banks generally don’t. There are NBFCs that give out loans to small entities and individuals that are unbanked, thus increasing financial inclusivity; other NBFCs give out long-term loans to large infrastructure projects and for commerce and trade. Banks, on the other hand, expect timely, scheduled and short-term repayment of loans that may not be feasible in some industries.
So, what is the crisis that the Corporate Affairs Secretary was warning about?
NBFCs, also called ‘shadow banks’, are reeling under a liquidity crunch – they don’t have enough funds to lend. The financial system has been facing this situation for over seven months now. The estimated liquidity deficit last week was Rs 39,810 crore. The liquidity deficit starts a vicious cycle. NBFCs borrow money from banks to lend to their customers. In turn, their cost of lending goes up. Demand for these loans fall, and investments and spending decline. Projects get stuck, repayments are hit, the lender’s liquidity crunch increases.
What has led to this?
The shadow banking crisis started off when the NBFC behemoth Infrastructure Leasing and Financial Services (IL&FS) defaulted on payments on its Rs 90,000 crore debt to various banks. Since then, the sector has been reeling under stress. Market insiders say there are five other big NBFCs in crisis that have been kept afloat through RBI’s open market operations (OMO) to prevent any more bad news until elections are over. The buzz is that at least two of these NBFCs will bite the dust shortly after elections. The Corporate Affairs Secretary coming out in public on the NBFC crisis has made that buzz more credible.
How did these large NBFCs come to this situation?
By injecting liquidity into the NBFCs, the government is treating only the symptom. The disease is the business model of NBFCs. They raise short-term funds and lend them out as long-term loans, thereby causing an asset-liability mismatch. For example, an NBFC borrows a sum of Rs 1 lakh through a debt paper that is to be repaid in six months’ time. In turn, the company lends this amount, say, in the form of a car loan repayable over five years. When this happens on a large scale, with thousands of crores involved, it results in a liquidity crunch and a repayments crisis for the NBFC.
Is the NBFC crisis cause for worry over the larger economy?
The NBFC crisis has already hit consumption. If the impact worsens, we could be heading into an economic downturn. Since the IL&FS fiasco, banks have raised the cost of funds to NBFCs by about 1.5%, in turn pushing up their lending rates to customers. There is already a reduced flow of car and personal loans, reflected in the fall of car and two-wheeler sales to an eight-year low. Analysts expect this dip to continue and further engulf some other sectors, like consumer electronics. That is a bad signal for India’s growth story.