The IL&FS fiasco – the lesson for NBFCs
Recently, stock markets in India were thrown into turmoil after one of the largest NBFCs in India lending predominantly to the infrastructure sector, i.e. IL&FS or Infrastructure Leasing & Financial Services, was unable to make timely repayment of some of its borrowings. The default was attributed to the asset liability mismatch faced by the company and the episode drew attention to the asset liability management (ALM) practices of NBFCs across India.
What is asset liability management?What is asset liability mismatch? All lending institutions, be it banks or NBFCs, are essentially financial intermediaries who take money from those with surplus (i.e. savers) and lend it to those who need money (i.e. borrowers). The difference in interest paid to savers on the liability created, and the interest charged to borrowers on the assets booked, is the margin in this business. This is where the profits come from after accounting for expenses. Any rational entity will seek to maximise profits by reducing the interest expended and increasing the interest earned.
In this context, we must understand that the liabilities raised on the one side (say, deposits from public or borrowings from banks and the money market) and the assets booked on the other side (say, home, vehicle and personal loans, loans to infrastructure or SMEs, or gold loans), all have a maturity profile. In other words, they fall due for repayment or recovery in different time spans, ranging from the short term to the long term. Asset liability management is about ensuring that when your liabilities fall due for repayments, you also have assets maturing at the same time so that you are in a position to honour your commitments, without default.
An asset liability mismatch typically arises when short term liabilities are deployed into longer term assets, which is what some NBFCs did in the quest for more profits. After all, when you borrow short term, the interest rate payable is less than when you borrow long term. Likewise, when you deploy your funds into long term assets, you typically stand to earn more than when you lend short term. But the risk here is that it makes you dependent on your ability to manage the rollover of your own borrowings (from banks or money market) falling due for repayment or obtain fresh short term loans to keep the business running.
In a scenario where interest rates are falling and where loans are freely available, this may not present a problem. Beginning from 2014 and up to 2017, India went through a phase of falling interest rates with ample liquidity in the market. All those lending institutions who borrowed cheaper short term funds to create more remunerative long term assets enjoyed abnormal growth and profits during this period. However, when the scenario changed, as happened over the last year with interest rates tightening and liquidity under constraint, rollover of existing loans became more difficult and more expensive, creating problems for many of them. In the case of IL& FS, it led to an outright default.
In July, as the distress in IL&FS was intensifying, the company’s founder Shri Ravi Parthasarathy resigned. Five special purpose vehicles of IL&FS and its subsidiaries including the parent IL&FS defaulted on bonds and commercial papers outstanding to the Indian government owned lender Small Industries Development Bank of India (SIDBI) in August. The latter filled an insolvency petition against IL&FS after missing its repaymentssending shockwaves across the financial markets in India.
The default by IL&FS was mainly attributed to slow monetisation of long term infrastructure projects aggravated by complications in land acquisition (following the passing of the stringent Land Acquisition Act of 2013), which delayed projects or turned them unviable,thereby restricting cash inflows. Also, the company had resorted to borrowing through short term instruments to realise marginal funding advantage, and tried to gain higher profit and market share by lending to long tenure projects,leading inevitably to an asset liability mismatch.
Indeed, the success story of high credit growth and higher profits recorded by many NBFCsin recent years was driven precisely by increased reliance on short term borrowing with lower marginal cost of funding. Among the common sources of borrowings were banks, mutual funds, insurance companies and, to some extent, retail issue of bonds. The funding of NBFCs by mutual funds reached a high of around Rs 2.2 lakh crore as of March 2018, which is more than double the level of September 2017. The bulk of this funding was extended through short tenure instruments, mainly commercial paper (CP). At the same time, banks’ credit outstanding to NBFC also increased by 27 percent over the year, as compared to overall gross credit growth of 8 percent as of March 2018. The situation favoured NBFCs as the interest rate scenario was benign under an accommodative monetary policy.
Interest reversal impacting NBFCs
The higher borrowings from banks and the money market was advantageous to NBFCs so long as the cost of borrowing was falling under the gaze of an accommodative monetary policy. With liquidity tightening across global markets, it had its impact in the domestic market too with foreign institutional investors withdrawing money from India. The Reserve Bank of India (RBI) intervened to stabilise the market by gradual reversing its easy monetary policy stance. The central bank increased the policy rate over two consecutive policy resolutions and in the last meeting changedits stance on liquidity from neutral to calibrated tightening. The guidance by the monetary policy committee indicated that there was little possibility of a rate cut in the near future. The change in the policy stance will increase interest ratesacross the board which will also increase the cost of borrowing for NBFCs.
With interest costs heading up, the NBFC sector will likely face liquidity stress if new funding or renewal of credit lines are withheld by banks and mutual funds. Many of them are grappling with asset liability mismatches where short term funds have been deployed in longer tenure loans, especially in housing and vehicle loans, or in infrastructure financing. According to a recent report, NBFCs including housing finance companies (HFCs) have around Rs 78,000 crs worth of debt maturing between October and March 2019.
What about Gold Loan NBFCs?
The gold loan NBFCs present an interesting study in contrast vis-à-vis most of the other NBFCs. The highlight of their business model is their focus on gold loans which are short term loans that are given out for periods ranging from three months to one year. In this scenario, gold loan NBFCs have little to worry about regarding asset liability management or the risk of asset liability mismatches. When your assets are overwhelmingly short term, it does not matter whether your liabilities are short term or long term.
Of course, the question may be asked, what about gold loan NBFCs like Manappuram Finance that have since diversified into new businesses like microfinance, vehicle and home loans where your money is blocked for longer periods? The answer, quite simply, is that we have no worries on that score either. Out of our total loans portfolio of Rs.17,000 crore, gold loans account for 75 percent, while another 15 percent is contributed by microfinance. In microfinance, the typical loan is sanctioned for two years but gets repaid within 18 months. Thus, 90 percent of our total portfolio is accounted for by relatively short term loans, which is more than adequate to take care of all our short term borrowings from banks and the money market. Of course, our home and vehicle loans have a tenure ranging from 3 to 15 years, but thanks to our equity investors and the profits we have retained over the years, we also have Rs.4,000 crore of our own funds in the business. We are very well capitalised.
The IL&FS fiasco has demonstrated once again the pitfalls of chasing profits by diluting your standards in asset liability management. It also demonstrates, once again, the inherent strength of the gold loans business model that sometimes markets lose sight of. On our part, we are confident that this crisis is temporary and will soon blow over. In the meantime, it continues to be business as usual for us.
Dr. V.P.Nantha Kumar