First green shoots of growth visible in NBFC sector

India’s shadow banking sector, which finances a majority of auto, consumer durables and housing sales, is expected to come out of its slump and get back on the growth track next year. This will help fuel consumption, improve demand and generate growth.

There could be light at the end of the tunnel. The first green shoots of growth are becoming visible in India’s critical non-banking financial company (NBFC) sector.

A recent report by Crisil, the Indian arm of global ratings agency S&P’s says: “Navigating a raft of headwinds for over two fiscals – culminating in de-growth in the current fiscal – assets under management (AUM) of non-banking financial companies is set to grow again – although at a relatively subdued 5-6 per cent next fiscal. The turnaround will be led by larger entities with stronger parentage.”

In India, NBFCs play a very important role providing credit to micro, small and medium enterprises (MSMEs) and individuals. But the Covid-19 pandemic has exacerbated the liquidity problems they were facing since the crash of IL&FS, India’s largest NBFC. Result: The domino effect has taken its toll on all the individuals, businesses and sectors that depended on this shadow banking sector for capital – both term loans as well as for working capital.

Consider this: NBFCs financed 40 per cent of total consumer lending when the IL&FS scandal broke in the October-December 2018 quarter. According to Reserve Bank of India figures, its share in credit to industry was at 39.1 per cent in 2018-19; this dropped sharply to 26 per cent the following year.

Even today, a year and a bit later, the NBFC sector accounts for about a quarter of the total credit flow to consumers and industry. The problem: NBFCs have not been lending as freely as before.

Liquidity crunch hit NBFCs, economy

The reason for this was the lack of liquidity. Following the failure of IL&FS, mutual funds were a major source of funds for NBFCs, found themselves holding worthless paper and, hence, reduced their exposure to the sector. This cut off a major source of money for these shadow banks.

With funding drying up, NBFCs could no longer finance the purchase of cars, gadgets, consumer durables and to sectors such as construction, mining, infrastructure and MSMEs. Banks, another source of funds for the sector – NBFCs borrow from regular banks and on-lend to end customers – also became wary and risk averse and this further affected the liquidity position of the sector, thus, severely impairing its ability to keeps the wheels of the economy moving.

Consider this: According to reports, more than 90 per cent of vehicles were financed by the NBFCs or by agents before the IL&FS crisis hit the economy in 2018.

Most customers took loans from NBFCs either because banks don’t always have the last mile connectivity to customers needing credit or because banks have procedures and protocols that are too stringent and take far too long. For example, NBFCs, typically, take between one and three days to process a vehicle loan; for banks, the time is 20 days on average.

Then, real estate developers and several infrastructure companies depended on funding from NBFCs to keep the wheels of their businesses running. This was especially true for their working capital requirements.

With NBFCs themselves being cash strapped, the sectors they financed suffered. Result: car and two-wheeler sales felt the pinch particularly hard and many real estate projects came to a standstill.

Since these two industries have massive upstream and downstream linkages with hundreds of other industries, the entire economy suffered.

Government, RBI provide timely support

To provide liquidity support to the sector – and to get credit flowing seamlessly through the economy once again – Indian Finance Minister Nirmala Sitharaman announced a $10-billion liquidity support package for NBFCs in May 2020.

Under this scheme, NBFCs that are not highly rated will get special liquidity support of $4 billion. “A lot of these stressed NBFCs support the MSMEs with working capital and this support will help the liquidity supply chain intact thereby help MSMEs to deal with situation… The securities will be fully guaranteed by the Government of India; this will provide liquidity support… and create confidence in the market,” she said while announcing the scheme.

The government also announced a $6 billion Partial Credit Guarantee Scheme for NBFCs, wherein the government will guarantee the first 20 per cent of any loss arising from a default by NBFCs on their repayment obligations. Even unrated papers floated by NBFCs are covered under this scheme.

Further, RBI has made an additional $7 billion available to banks to on-lend to NBFCs under the second tranche of Targeted Long-Term Repo Operation (TLTRO 2.0) window.

Growth to be slower

“Despite an estimated GDP growth of 10 per cent next fiscal, overall NBFC sector growth is likely to be slower because access to funding remains a challenge due to concerns about the impact of the pandemic on asset quality. Additionally, competition is expected to be more intense from banks – which are flush with low-cost deposits and better placed with improved capital buffer than in the previous years,” Gurpreet Chhatwal, President, Crisil Ratings, said in the report referred to above.

Banks to gain market share

For this reason, banks are expected to gain market share at the cost of NBFCs, especially in the home loans and vehicle financing segments, which are currently the mainstays for the shadow banking sector.

Even a relatively modest 5-6 per cent growth for the NBFC sector will be a positive for the overall economic recovery in the country as the sector slowly recovers from the setbacks it suffered following the crash of IL&FS and DHFL and the troubles at Reliance Capital.

Asset quality improves

So, even as growth remains a challenge, experts say the improvement in asset quality augurs well for the sector. According to a Crisil report, “extensive recovery efforts by NBFCs, coupled with the recent uptick in economic activity, has lifted the median collection efficiency ratio for November 2020 payouts (October 2020 collections) to their highest levels in fiscal 2021, and near pre-Covid-19 pandemic levels for most asset classes”.

“The monthly collection efficiencies of most CRISIL-rated securitised pools are almost at pre-pandemic levels. That’s because economic activity has been gathering steam in recent months, and agricultural activity, which was less impacted, has steadily picked up, too. As cash flows improved, borrowers have started repaying their loan instalments,” said Krishnan Sitaraman, Senior Director, Crisil.

The agency estimates the stressed assets as on September 2020 for the overall NBFC sector is 6.5-7.5 per cent of industry assets under management. It did not give any comparable figures to benchmark this against.

Challenges to continue for smaller NBFCs

“From a funding perspective, for larger NBFCs, the challenge is primarily their ability to fund balance sheets beyond a certain size purely through wholesale liabilities. Here, conversion to a bank does provide benefits, but over the long run. For the small to mid-size NBFCs and large standalone ones, funding access challenges continue so the imperative is to raise confidence capital, ensuring stringent underwriting quality to avoid asset-quality surprises, and build partnerships with banks to develop a funding-light business model,” said Krishnan Sitaraman, Senior Director, Crisil.

With the economy expected to recover sharply next year, consumer lending will also rise over the next few quarters. NBFCs will almost definitely account for a large chunk of this lending. As India’s economy grows further, and credit requirements rise in tandem, and NBFCs, along with banks, can act the key credit facilitators, which could give a strong push to the overall growth of the Indian economy.