NBFCs | What can we pick up from the recent crisis

NBFCs/HFCs contributed significantly towards financial inclusion, reaching out to the last man standing in the line, financing needs of the small & medium enterprises & towards providing timely funds for infrastructure projects. But with all the impressive contribution that the space has made towards the economy- it also lately started becoming a little too aggressive & somewhat reckless in its desire to grow too fast; which ultimately cooled off with the recent liquidity/corporate governance driven crisis in the sector.

Before some of the NBFCs/HFCs came to a screeching halt & the rest of them woke up to reality, there was a long period of unprecedented buoyancy & heady optimism in the space; sometimes defying basic business intelligence; ignoring primary underwriting requirements; sidestepping any questions on liquidity risk; & all this combined with an absolute disregard of all the impending risks, by the capital markets- led to some NBFCs/HFCs becoming too complacent & kept taking the initial cues of impending risks lightly. The capital market remained so bullish on this space for the last few years, that even on a 100/150 bps long term bond yield escalations during the last FY it did not rationalize the valuations of the most of NBFCs/HFCs accordingly- unlike how it responded in 2013, when it cut the valuations of NBFCs/HFCs anywhere between 20-30% as a result of 100 bps bond yield escalation. We witnessed such behavior in the US just before the sub-prime crisis where the escalation in defaults rate in the underlying loans of various securities did not lead to any change in the yields of the securities- in fact the prices of some securities went up with an increase in the underlying loans default ratios.

The NBFCs/HFCs currently constitute around 20% of the total system loans & before the recent concerns on liquidity, asset quality & corporate governance hit the market- they were contributing 30% of the total system lending in the preceding 3 years & almost 40% of the system lending in the preceding 12-18 months.

The fairly high lending growth of NBFCs is predominantly funded by the CPs & NCDs (<1 year) - during the last 4 years, the share of the two short term instruments in the funding mix has increased from 12% to approx. 22% - the incremental borrowing mix was even higher at almost 35% coming from CPs/NCDs (<1 year).

The CPs & the NCD (<1 year) are primarily bought by corporates, MFs & HNIs, the investor group that is comparatively more prone to changing positions frequently & selling at a discount on a possibility of any risk, thereby escalating the yield & making it both difficult & expensive to issues fresh papers by the FIs. And hence dependency on such instruments always keep you exposed to significant ALM risk.

While the deposits & bank loans are more reliable & assured channels of funding, closely followed by long term NCDs. Last year when the bond yield escalated by 100-120 bps the bank MCLR increased by just 10 bps & the public deposits by just under 50 bps. The short-term profile of the borrowing puts immense risk on the asset liability management & poses significant risk of a default even during normal course of business- even if there is absence of any untoward event or any governance issue by FIs. 

The long-term asset creation using short term liability can only sustain in the times of ample liquidity & benign interest rate environment. Just before the recent liquidity challenge many leading NBFCs/HFCs had almost 15-18% of their liabilities maturing in less than 3 months, while the asset maturity for most of them was less than 8%, making defaults almost inevitable without the flexibility of easy refinancing of the liability. Most NBFCs/HFCs cut their fresh lending & sold down assets to cover for the borrowing coming for maturity to avoid the default.

The long-term asset creation using short term liability can only sustain in the times of ample liquidity & benign interest rate environment.

Thanks to the default by IL&FS that the market ultimately woke up to the risk, otherwise it could have ended in much bigger a mess- the mutual funds that were subscribing to all kind of papers hitting the market, started cutting their positions. Some of the NBFCs/HFCs went back again to the board rooms & looked at their operating model, business strategy & growth expectations.

Even if we park the corporate governance issues for the time being, there were a few things that were not completely right with the operating/business strategy of many NBFCs/HFCs, except a few like HDFC, STFC, Repco & Gruh.

Lending, essentially, is a business of trading risk- one must measure the credit risk, the collateral price/recoverability risk & liquidity risk adequately & then price the product right. Some of the fast growing NBFCs/HFCs were less than alert in either recognizing the risks or in looking beyond the immediate.

The recent crisis in sometime will be behind us, but we can take away a few lessons from it:

Define Your Universe: There are HDFC & the likes that have a very stable & competitive liability profile & basis that they can create assets at a very competitive rate attracting the super prime customers. There is another HFC, say an XYZ that has a liability profile that is neither stable nor competitive- why then should it try to attract & acquire an HDFC customer? And this is what precisely has been happening with so many of fast growing NBFCs/HFCs. Their cost of funds- even in the best of the times- was 75-100 bps higher than the rate at which they were lending to this super prime segment of customers. You allocate marginal operating cost of around 20 bps & add another 50 bps as the credit loss & voila- you start from the point of making loss of almost 150-175 bps on every such case. But for some reason some of the marquee NBFCs were so eager to grow at 30-50% that it was inevitable for them not to target these profit-eating-segments; this got reflected in their high book growth not resulting in similar operating profit growth (net-off fee & other income).

Your asset profile cannot be independent of your liability profile, rather your liability profile should dictate your asset profile too- please define your universe- what profile of customer & what profile of property/asset you want to finance & at what rate! There are certain asset finance types- like auto finance, consumer durable finance etc, where you can easily pass on any increase in the borrowing costs- NBFCs operating in such spaces can deal with sudden cost-of-funds escalation better than the low margin housing finance business- where the balance transfers can happen even at a 50 bps rate difference. 

Measure Risk: Broadly the HFC/NBFCs have 3 risks; credit risk, collateral recoverability risk & liquidity risk. Before you can manage the risk, are you even measuring it right:

I. Credit Risk: Once in a meeting with one of the leading NBFC that was put on block- which had a decent book (in terms of size) consisting of largely (~80%) self-employed profile & extremely compromised credit quality- when the management was asked on how do they measure the credit risk of some fairly informal self-employed customers- the answer they gave was that they charge +14% rate on home loans & +16% on LAP & that will cover for the risk that they take. We stopped our discussion at that point- the NBFC is still on the block. A credit scoring model combined with defined guidelines for PDs can help in measuring & pricing risk better for self-employed customers.

II.    Collateral & Recoverability Risk: Measure collateral price risk & the recoverability risk- quantify it & add the expected recovery costs to price the product & decide on LTV accordingly. Most of the not-only-focused-on-growth NBFCs/HFCs are doing it anyways.

III.   Liquidity Risk: Let your liability profile dictate the asset profile as much as possible. Identify the potential triggers & the portfolio pools that can be sold down quickly in the case the situation arises. Ensure the ALM committee actually meets & actually discusses the A-L profile basis the real time scenario. 

Rationalize Growth Expectations: Ultimately it is the bottom-line that derives the valuations & not the book size. If the additional business is leading to cut in the profitability, that continues beyond a very short-term, its alright to rationalize the growth targets. Ultimately a Gruh Finance with almost one fifth of the book size of some other HFCs is valued almost five times of them.

Organization Structure: No, 10 different zones with each zone having 3 regions- all vertically separated across credit, sales, operation & collection/recovery starting from the branch- is no org. structure. Its good to be lean. It is even better to decide on an organization structure & persists with it for a reasonably long a time, instead of changing the org structure every alternate year.

Define Product Bucket: Its alright for a financial institution to be conservative. Unnecessary innovations don’t help much- for example an innovative product like double-whammy where institutions consider a combination of both LTV & IIR to somehow reach higher eligibility for the customer, is inherently flawed & that can be seen from the portfolio performance of this product. If you reach 90% IIR, by keeping the LTV at just 40%- you have higher probability of a default, but with the LTV comfort that ensures that you will recover the entire outstanding through resolutions- something that most of the NBFCs/HFCs ideally would want to avoid to get into.

Negative Amortization Risk: is the case where the EMI is not able to cover for the interest due & hence leading to a situation where if the EMI is not increased the loan principal will keep on increasing with time. The NBFCs/HFCs were not even looking at this risk until last year- though almost all of them faced this same situation sometime around 2013 too. If, for any reason, the cost of funds suddenly escalates by 150/200 bps in a short time of 3-6 months, almost all your recent book can fall in the negative amortization- if you have not sanctioned cases at a very high IIR, you still can navigate this challenge by increasing the EMI- but what if the loans are given at +70% IIR?

Wholesale/Retail Mix: The market is punishing those NBFCs/HFCs more that have higher exposure to wholesale loans. Please don’t go entirely by what the market is telling you today. The builder financing portfolio might not be doing that well today because of comparatively sluggish pace of sales- but the wholesale portfolio is the one that best resemble your liability profile, most of these loans are also self-liquidating & this is the portfolio that keeps the average NIM beyond 1.5% for most of the NBFCs/HFCs. The temporary stress in the portfolio should be short-lived & over the next 12-18 months the shock of DeMo, RERA & GST should be over. The recent stress seen in the smaller developer segment is the result of the crisis in the NBFC/HFC space & is not the cause of it. So continue keeping a healthy mix of wholesale & retail.

The dependency on financing support by NBFCs/HFCs for the Indian economy is higher than ever before, hence it is imperative that the management of the NBFCs, regulators & the government reach to a common ground & provide some temporary relief to the sector- until the NBFCs adjust themselves to the changed market reality. The regulators can also create better framework & relax certain regulatory requirements like CRR, SLR, for a possibility of merging NBFCs with some old private banks- which can balance the asset liability profile of the combined entity. 

NBFCs now play an important role in providing support to infrastructure, self-employment, tractor/CV/PV financing, housing finance, rural & micro financing-& thereby making the engine of the economy run. The health of this sector has significant impact in terms of, increasing inclusive development of the country, reaching out to henceforth-not-catered-to-customer segments & innovating the financial products & distribution - & hence it is in the interest of all the stakeholders including the investors, government & the regulator to help the NBFCs navigate the current liquidity & trust deficit crisis.