Non Banking Financial Companies(NBFC) Crisis

-A crisis that unfolds in layers

Gurman Singh,Vishal Vats,Saksham Jain,Arnuv Joshi and Shubham Jha

(BMS 2nd Year,Sri Guru Gobind Singh College of Commerce)

Abstract:A Non-Banking Financial Company (NBFC) is a company registered under the Companies
Act, 1956 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable
securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not
include any institution whose principal business is that of agriculture activity, industrial activity,
purchase or sale of any goods (other than securities) or providing any services and
sale/purchase/construction of immovable property. A non-banking institution which is a company and
has principal business of receiving deposits under any scheme or arrangement in one lump sum or in
installments by way of contributions or in any other manner, is also a non-banking financial company
(Residuary non-banking company).
A NBFC is really important for a country’s economy as it fills the void between unorganized financial
sectors and the banking sectors.Non-banking financial companies help in rotation of resources, asset
distribution and regulation of income to shape the economic development. They enable converting
saving into investments and thus helps in the mobilization of funds/resources in the economy.
These organizations usually works under the banking rules and regulations of the government but are
largely non monitored under the government rules to promote free flowing economies,but what will
happen if these large companies fall down.In this paper we are studying two cases of such large
corporations facing crisis-IL&FS and DHFL Ltd.How did their crisis begin,what were the reasons
behind their downfall and how is it gonna effect the economy
Keywords: NBFC,Economy,regulations,crisis

Introduction

What is IL&FS (Infrastructure Leasing and Financial Limited)

It is actually a shadow bank(a shadow bank is a financial institution which is mainly a non depository
bank , it does not receive money like other traditional bank) . it act as an NBFC (non banking financial
companies) and since it does not have any public dealing directly , so it always escapes from regulatory
oversight.It was formed in 1987as as RBI registered core investment companies , currently its
institutional include LIC , SBI ,ORIX(Japanese company) ,Abu Dhabi investment authority and some
small stake holders. It takes the major infrastructure work in different sector including
transportation ,area development ,e-governance , health initiative , cluster development, finance ,
power ports , urban infrastructure, environment education, tourism etc.
Funding source of IL&FS
 Long term borrowing –It includes loan from SBI ,PNB, SIDBI etc
 Short term borrowing-For it they issue debt instrument like bonds non convertible debentures ,
certificates of deposit , commercial paper, mortgages,leases etc.
Since ILFS is a listed company and commercial papers offers great profit margin to share holders in
comparison to that of mutual funds, FD , RD , people start investing in such NBFCs and this is how
they fund themselves by selling commercial papers. Credit rating agencies (CRA) like ICRA , CRISIL ,
FITCH, give them ratings like AAA(this is the highest rating) B , CC etc , to show to the world that
this company is not going to be bankrupt .

Dewan Housing Finance Corporation Ltd. (DHFL) is a deposit-taking housing finance company,
headquartered in Mumbai with branches in major cities across India. DHFL was established to enable
access to affordable housing finance to the lower and middle income groups in semi-urban and rural
parts of India. DHFL is the second housing finance company to be established in the country. The
company also leases commercial and residential premises. DHFL is among the 50 biggest financial
companies in India.
 Literature Review

Since the study is based on case studies our references vary from different media reports to articles
found on Internet.Also we have studied various reports published by the finance ministry and Reserve
Bank of India for the study.

Main Objective of the Study

1. What went wrong with the corporations/companies?

2. What are the various impacts on the economy?
3. What are the lessons to be learned with these cases so that further cases could be minimized?

The IL&FS case(Complete Analysis):

WHAT WENT WRONG AND WHERE DID ALL THE MONEY GO?
Funding long-term projects by short-term credit: Loans given by NBFCs are mainly to
infrastructure projects which have a longer gestation period. But, for themselves, NBFCs opted for
short-term borrowing by means of commercial borrowing to fund these long-term projects, which
widened the Asset liability gap.
The infrastructure lender has a total consolidated debt of close to RS.1 Lakhs crore, and it started to
miss deadlines on its debt obligations beginning August 27, 2018.
It had already defaulted on around RS.450 crores worth of inter-corporate deposits to Small Industries
Development Bank of India (SIDBI) and more defaults were likely.
However, in the recent case, the interest rates on short-term borrowing had severely impacted this cycle
of NBFCs and left them with a cash crunch challenge.
Too much debt in the company: This was the single most important factor that led to the fall of the
company. With a consolidated debt of around Rs 90,000 crores, the company was simply unable to find
resources to pay its debt, and found itself in an asset-liability mismatch, which refers to a situation
where there is a lot of liability on the entity in the form of loans (both short term and long term),
creditors, commercial papers (an unsecured form of short term money-raising instrument from the
market) as compared to fewer assets, in the form of receivables, cash or inward-investments.
Mounting losses in the infrastructure sector: Financial analysts believe that longer the gestation
period of the project (that is, the time taken for a project from the planning stage to final execution),
higher are the chances of risk. This proverbial prediction turns out to be true in case of the investments
made by the IL&FS. Traditionally, the company has begun investing in power, road and water projects
that have gestation periods of anywhere between 8 years and 15 years. The company would get the
project refinanced, that is availing fresh loans, but in the recent few years, with the NPA crisis
troubling most major banks, IL&FS was left to look for alternative sources of funding, as short term
loans from the market, which it naturally was unable to pay.
More than 60% of the debt owed by the company was in the road building, power and waterworks
projects. These projects have often been found to be plagued with several issues such as complications
in land acquisitions, perpetual disputes between contractors and the government leading to litigation
and arbitration proceedings, long project delays, huge escalation costs, shortage of availability of
labour and raw materials etc
Manipulation in credit rating: The fact that despite impending financial challenges and irregularities
in the financial statements of the company, most credit rating agencies gave a AAA rating to the
company is a huge surprise. Forensic audit investigations are done so far reveal that email exchanges
between credit rating agencies (such as CRISIL and CARE) revealed the poor financial health of the
company, but the final certifications revealed no downgrading, which was only done last year, in 2018.
DHFL Case(Complete Analysis):

Problems with DHFL

1. DHFL is a non-banking financial company, also known as a shadow bank. This means it doesn’t
have a banking licence or access to central bank liquidity, but is nevertheless involved in financial
services – in this case, primarily giving loans to home buyers in India’s tier 2 and tier 3 cities
2. The HFC's business model was based on lending for the long term using short-term borrowings. This
meant while home buyers or developers took a 20-year-loan, DHFL financed it by borrowing through
commercial papers of much shorter maturity of six months and kept issuing new papers when old ones
came up for maturity.
3. The company expanded rapidly to 570 branches across India, giving loans to middle- and
low-income households, most of which are usually not served by banks due to inadequate
documentation or income proofs. As long as there was abundant growth in demand and liquidity, the
world of home finance was fine.
4. After IL&FS went bust, banks became much more careful about lending money to NBFCs.
But this led to a liquidity crunch, since there was limited access to credit. Many NBFCs rely on
short-term borrowing to finance long-term lending, which puts them in a difficult spot when there is a
liquidity crunch.
5. DHFL has insisted that the underlying assets that it holds, a big chunk of which are house loans, are
valuable and have a very low non-performing asset percentage. But those underlying assets are worth
about Rs 1 lakh crore. If it's a solvency issue, it could be a huge blow to India's financial markets.
6. The failure of DHFL could have major repercussions across the economy. A proper default would
lead to a knock-on effect on numerous other industries.

Impacts on the Economy:

1. IL&FS:

Tracing impact on the Indian economy

On individual investors
Since IL&FS had begun raising huge amounts of money from the market by way of a commercial
paper, which is an unsecured debt meant for immediate financing needs, the worst affected are
investors that include mutual funds, individuals, banks and other companies, which offered loan by
way of inter-corporate deposits.
On infrastructure projects
The IL&FS crisis is likely to have a major effect on current infrastructure projects. For example, in
Maharashtra, the government officials believe that the refusal of banks to offer loans on continuing
work on the highway for the Mumbai-Nagpur Communication Expressway is a direct result of the
IL&FS crisis, which has made banks extremely wary of releasing funds for the road project. IL&FS’
existing projects have also faced a critical blow, some of these were in the form of a PPP model (Public
Private Partnership) for developing national highways and connecting roads.
On credit rating agencies
The lack of transparency, accountability and subversion of credit rating agencies which are supposed to
exercise principles of prudence, caution and utmost integrity, have been highlighted by the crisis. It is
likely that the government would tighten its grip over credit rating agencies and prescribe greater
punishments for frauds.
On NPA crisis and the spillover on the economy
Being an NBFC, the RBI did not exercise as much control over operations as in the case of traditional
banks. The default in payment of loans of Rs60,000 crores will only add to the current financial distress
that the banking sector is facing due to rising non-performing assets. As a result, the spillover on other
segments of the economy is undeniable.
2. DHFL Ltd.

What about the broader economy?

India’s economy currently faces severe challenges, both domestic and international. In better times,
with more money generally in the market, a number of these companies like Jet and DHFL may have
found it easier to dig their way out of hole.

But with India’s growth story in danger and a steep drop in consumption, the failure of DHFL could
have major repercussions across the economy, which is already struggling to deal with the twin-balance
sheet crisis – a high number of non-performing assets and heavily indebted corporates.

A proper default would lead to an even tighter liquidity crunch, further fears about the viability of
NBFCs, and a knock-on effect on numerous other industries. It will also command greater regulatory
attention, at a time when India’s policy makers and regulators need to be thinking about steadying the
ship.

Why do finance companies use short term funds like commercial papers (CPs)
and current/savings account (CASA) for giving long term loans and create an
asset liability mismatch and in turn increase insolvency risk?

1) The longest source of money is equity.

Therefore, indirectly, investors may believe that all the long term loans of financial institutions should
be funded by equity. In this manner the FIs can avoid asset liability mismatch altogether. However,
using 100% equity for giving out long term loans limits the growth prospects of the FI. Raising equity
whenever a FI has to give out long term loan is not easy and is a costlier and time-consuming affair.

Therefore, if the FI only relies on equity, then it will lose out on the business when compared to its
competitors. This is because the competitors would give out loans faster and cheaper using money
raised from debt rather than equity.

2) Other solution to avoid asset liability mismatch can be that the FIs give long term loans by
using funds raised from long term debt.

Investors would appreciate that most of the time, the long term sources of funds are costlier than the
short term sources of funds. This is simply because the probability of anything going wrong with the FI
is more in the longer term. As a result, the providers of money to the FI ask for more return when they
give long term money than when they give short term money to FI. Therefore, one would appreciate
that for a FI, giving loans to its customer by using long term debt/long term sources would be costlier
than giving loans using short term sources of funds.

To cumulate the learning from our above discussion, it comes out that the stability/risk less in giving
out long term loans and the cost of giving these long term loans varies on a spectrum but moves in
opposite direction. Meaning:

 To have the highest level of stability, financial institutions (FIs) should fund all the long term
loans by equity/long term sources. However, this makes lending a very costly affair as long term
sources of money are costlier than short term sources. This, in turn, decreases the profits of the FI.

 On the other hand, if the FI uses cheaper short term funds to give out long term loans, then it
increases returns/profits because the short term sources of money are cheaper than long term
sources of money. However, when the FI uses short term sources of money to give long term
 loans to its client, it exposes itself to the risk where providers of short term money may ask their
money back and it will not be able to repay them. This is called asset liability mismatch or
solvency/liquidity risk.

Therefore, the final decision to use what kind of funds (equity/long term funds/short term funds) to
give out long term loans is a tricky decision.

FIs use a mix of long term and short term funds depending upon their ability to convince the short term
funds (CPs and CASA) providers to give them cheaper money and keep rolling these short term funds
over and over again. This rolling-over facility provides an opportunity to the FI to give long term loans
at lower cost and in turn, increase its profits. However, if a FI is not able to give the confidence to short
term fund providers about its ability to repay them whenever they call their money back, then these
short term fund providers may not give the FI any money. As a result, the FI will have to rely on
costlier long term funds and give loans at lower profits.

As the aim of all the financial institutions (FIs) is to generate maximum profit, therefore, they tend to
use cheaper short term funds as much as possible whether by way of commercial papers (CPs) or
CASA. However, they also need to show the short term fund providers that the FI is financially sound
and can pay them back whenever they want their money back. The ability of best performing banks to
repay the short term fund providers (CASA) at any time, is reflected in their ability to keep such short
term fund providers stick with them/roll over their money.

Investors would appreciate that this best performing image for high CASA banks is not permanent and
if there is any doubt on the ability of the bank to repay CASA at short notice, then banks also face the
same fate like IL&FS. It is called “Run on the Bank”. In the past, many banks have faced it.

Therefore, we believe that instead of looking it as a Banks vs. NBFCs perception, investors should look
at it from the vision of the confidence that any financial institution (FI) provides to the short term fund
providers (CPs/CASA). If any FI provides high confidence to CP/CASA providers, then it will want to
and it will be able to fund its long term loans from short term funds and in turn, it will generate high
profits for itself/its shareholders. However, whenever, this confidence goes away, then the FI
irrespective of being a Bank or NBFC will face a run on it and will face bankruptcy.

Therefore, in summary, the market perception of the stability of a FI (Bank or NBFC) lets it use short
term funds (CPs/CASA) to fund long term loans. FIs want to use short term sources of funds like
commercial papers (CPs) and current and savings accounts (CASA) to give long term loans as short
term sources of money are cheaper. This increases profits for the FI. However, whenever any FI
overuses short term funds, then it faces stability (liquidity) risk and results in its bankruptcy.

Possible Solutions:
What can be done

 A stress test for the NBFC companies has become necessary to restore investor confidence,
particularly of foreign portfolio investors (FPIs), who hold 16-74 per cent stake in leading Indian
NBFCs. The diminishing confidence of investors has resulted in the wide divergence between the
credit spread of retail and wholesale NBFCs.

 Under the stress test, the banking regulator calculates capital ratio of the financial service
companies under several adverse scenarios. The US Federal Reserve conducted a stress test for
the banking sector after the financial crisis in 2008 to ensure banks have enough reserves.
 The latest disclosure by DHFL has raised doubt on the collection efficiency of NBFCs. This could
potentially show down banks buying loans from NBFCs under priority sector loans. The
securitization of loans from NBFC to banks rose to Rs 1.90 lakh crore in FY19 compared with Rs
0.83 lakh crore in the FY18, according to data compiled by Kotak Institutional Equities. If banks
slow down the securitisation portfolio, it will be detrimental to borrowing plans of NBFCs.

 A potential solution which can break this logjam is an announcement of a “Voluntary AQR”
scheme by the RBI). The RBI gave birth to the AQR when five years ago it announced that all
banks’ balance sheets will be scrutinised to assess if the banks are understating their
non-performing assets (NPAs). The six-month-long exercise found that several prominent banks
were indeed understating their NPAs by a significant margin. Several of these banks have since
raised fresh equity capital. Gradually, the financial markets are recovering their faith in the banks’
balance sheets.

 A voluntary AQR will allow the better run, cleaner NBFCs to signal their quality to the CP and
CD market; in simple English, it will separate the wheat from the chaff. This, in turn, will
encourage the MFs and large corporate treasuries to buy the CPs and CDs issued by the NBFCs
who pass the voluntary AQR. These NBFCs will then be able to resume lending activity, thus
arresting the ongoing decline in economic growth.

 What the RBI did to the banks can be called a compulsory AQR. At this juncture, NBFCs are in
no financial position to be subjected to a compulsory AQR. Instead, what should be considered is
a carrot-and-stick approach called voluntary AQR wherein NBFCs who opt to subject themselves
to the RBI’s AQR are given a lower regulatory capital requirement (RCR) once the RBI has
cleansed their balance sheet. More specifically, the RCR can be lowered in a targeted manner by
giving the lenders lower regulatory risk weights for lending to economically sensitive sectors such
as SMEs, affordable housing (say, homes below Rs 50 lakh) and auto (say vehicles below Rs 10
lakh).

 Given that the annual audit cycle is done, the RBI should be able to hire on a temporary basis,
auditors from the large tax and audit firms who specialize in auditing banks and financial services
companies. Moreover, if the goal is to get the economy back on track, the RBI can focus the
voluntary AQR exercise on the top 20 HFCs and the top 50 NBFCs since the smaller lenders are
unlikely to be disbursing significant amounts of credit from the perspective of the economy.

Conclusions
That the non-banking financial companies (NBFC) sector has been facing troubled times for several
months is well-known. Now, a top-ranking government official has proclaimed that the sector is facing
an “imminent crisis.There is a credit squeeze, over-leveraging, excessive concentration, massive
mismatch between assets and liabilities, coupled with some misadventures by some very large entities,
which is a perfect recipe for disaster,” Corporate Affairs Secretary Injeti Srinivas told the Press Trust
of India in an interview.
Even if NBFCs are able to raise funds, it will mostly be used to repair balance sheets and refinance
liabilities. It will take at least 12 months for NBFCs to be back on the lending track
(Source:https://www.moneycontrol.com)

Flaws in the system:

 The NBFC business model itself is flawed, to begin with. It relied on raising short-term funds
which were then lent out as long-term loans. This leads to a situation called an asset-liability
mismatch. For example, an NBFC raises money by selling 6-month debt papers and on-lends this
as a car loan with a tenure of 5 years. This leads to a situation where the NBFC has to roll over
(or renew) the 6-month debt paper or raise fresh loans to repay the debt paper. In good times, this
happens as a matter of course. But when times are tough, this cycle is broken.
 The cycle was broken by a default of some firms of the IL&FS group. There were fears that this
would turn out to be a contagion. Simply put, banks, mutual funds and their investors were afraid
 that more such entities wouldn’t default. As this fear took hold, many institutions refused to give
money to NBFCs. The cost of funds rose by as much as 150 basis points for NBFCs.

Possible Solutions:

 In the last financial year, the Reserve Bank of India bought government debt paper worth Rs 3
lakh crore from the market. Basically, this meant that so much money was given to the banking
system to on-lend. This is the only way for RBI to help NBFCs since the central bank can’t lend
directly to the latter as they don’t hold government paper for use as collateral.But the cost of
borrowing for NBFCs is still high as banks are risk averse or have reached exposure limits
.
 This will prompt NBFCs to tap alternative sources such as external commercial borrowings,
public bond issuance, or sales of assets. But even then, analysts point out that most of their
borrowings will be used to repair balance sheets and refinance liabilities. Even if a full-blown
crisis won’t happen, it will take at least 12 months for NBFCs to be back on the lending track.

Limitations
 The scope of research was shorten by the para dime that the cases that come into public is very
less due to the fact that these cases occur in the public space only when the bigger crisis hits the
corporations.
 Lack of proper literature of the subject was one of the biggest problems.There aren’t many books
that have been written in the subject and if written they were way beyond our understanding level.
 Our basic understanding of the topic was also a big problem for the research and study.

Future Scope
 If in future proper data by the companies are issued in the public domain without any dressing or
third party interference these crisis can be detected easily
 There should be proper barometers for analyzing a NBFC’s performance so that such crisis could
be held early.
 Current study were purely based on case studies but one could surely analyse the whole sector and
analyze its performances.

References

[1]1 Bharat's manual of non-banking financial companies

[1]2 Non-banking Financial Companies (NBFCs) in India: Functioning and Reforms
[1]3 The Development and Regulation of Non-bank Financial Institutions
[1]4 timesofindia.indiatimes.com
[1]5 moneycontrol.com
[1]6 vikaspedia.in
[1]7 rbi.org.in
[1]8 finmin.nic.in
[1]9 ilfsindia.com
[1]10 dhfl.com
[1]11 mcagov.in
[1]12 scroll.in
[1]13 economictimes.com