Are NBFCs on thin ice?

'Promoter funding', has contributed to the growth of NBFCs but there is no substantial productive asset behind such funding. Will the RBI act?


As children, it was a great fun to build castles with wet sand. The castle will stand fine and firm till it was small. But then there was always a temptation to make one bigger than the next kid – so, the height of the castle would grow bigger and bigger. Needless to say, it will eventually collapse under its own weight. The non-banking finance companies (NBFC) remind me of such castles in the sand.
The NBFC sector has had its own cycles of booms and busts. One shakeout that happened, following a mushroom growth in both number of players and volumes, was in 1997.
Prior to this, NBFCs were allowed to source public deposits to the extent of 1000% of their net worth, which many of them actually did, and many collapsed under burden of severe asset liability mismatches. Thereafter, there have been periods of optimism and pessimism, and sometimes, a mix of the two.
Over the last 10 years or so, the NBFC sector has grown impressively. This is best demonstrated by the consistent increase in the share of NBFC assets versus those of the banking sector. The growth has been steady, from 10.7% of bank assets in the year 2009, to 14.3% of bank assets in 2014. Please check for more details
The growth has been impressive but the financial sector is facing a huge burden of non-performing assets. The heady days of infrastructure development in the country were associated with too little capital luring too much debt. Most infrastructure operators formed thinly capitalised SPVs and piled debt to invest in infrastructure assets.
“Investments” included political and other non-returning expenditure. Many of them securitised their cash flows, and are effectively operating at negative capital.
Promoter funding in various ways – subordinated debt, SPV financing, loans against properties – have been quite popular with many an NBFCs. In fact, the sharp growth in numbers of several NBFCs has been associated with growth in these funding where there is no substantial productive asset behind the funding.
There are RBI guidelines against financing of promoter capital by banks. There was a similar guideline of the RBI issued in January 2014 in respect of NBFCs as well. The RBI made a strong, though a bit garbled, reference to “quality of promoter equity” and disguising of the debt/equity ratio if the equity is financed by external funding. 
In many ways, the scenario today, where NBFCs are sitting with huge portfolios which are effectively equity financing, is similar to what it was in the subprime crisis in the Western world in 2007-8. There were massive levels of leverage – too little equity was bearing the burden of too much debt. 
It is very important for regulators to ensure that real debt/equity ratios get reported. Build-up of leverage in the system is one of the most important handles for regulators to take timely action. Financing against equity comes from core investment companies. Sometimes, funding may also come in form of preference shares, which are effectively counted as equity but have features of external finance.
Despite substantial action taken by the new government after it came to power, there is still a long lag in the scenario on ground improving at all. NPAs continue to bulge. The capital levels of most NBFCs are easily five times of the reported net NPAs. However, there are two devils that lie in the detail. First, the reported NPAs may be disguising the substantial extent of restructured or refinanced loans. Second, the difficulty lies in tremendous squeeze on profitability that NPAs pose. Assets stop earning income; interest continues on the entire liabilities, and operating costs are in fact higher as there is more of expenditure to incur on collections. 
The coming few quarters may bring a new phase in the life of NBFCs. Whether it is one more turn of the cycle or not remains to be seen.
(Vinod Kothari is a chartered accountant, trainer and author. He is an expert in such specialised areas of finance as securitisation, asset-based finance, credit derivatives, accounting for derivatives and financial instruments and microfinance. He has written a book titled “Securitisation, Asset Reconstruction and Enforcement of Security Interests”, published by Butterworths Lexis-Nexis Wadhwa)
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