What are NBFCs? What is a debt instrument?
What are NBFCs?
- Non-banking financial companies (NBFCs) are financial institutions that offer various banking services, but do not have a banking license.
- Generally, these institutions are not allowed to take deposits from the public, which keeps them outside the scope of traditional banking regulations.
- NBFCs can offer banking services such as loans and credit facilities, retirement planning, money markets, underwriting and merger activities.
What is a debt instrument?
- Finance companies normally source funds by issuing a debt instrument, which is a paper or electronic obligation that enables the issuing party to raise funds by promising to repay a lender in accordance with the terms of a contract, and loans from banks.
- Indian NBFCs issue debt instruments like bonds, non-convertible debentures (NCDs), certificates of deposits, commercial papers (CPs), mortgages, leases, or other agreements between a lender and a borrower.
- Debt papers are issued at a specific interest rate linked to the market rate.
- CPs and NCDs are two widely used debt instruments used by Corporates to raise money.
- The IL& FS group defaulted on CP, which is an unsecured money market instrument issued in the form of a promissory note with a maximum validity of one year.
How did the IL& FS default play out?
- The infrastructure lender has a total consolidated debt of close to Rs 1 lakh crore, and it started to miss deadlines on its debt obligations beginning August 27, 2018.
- It has already defaulted on around Rs 450 crore worth of inter-corporate deposits to Small Industries Development Bank of India (SIDBI), and more defaults are likely in the coming weeks.
- Following the defaults, rating agencies ICRA, India Ratings and CARE abruptly downgraded IL&FS and its subsidiary from high investment grade (AA plus and A1 plus) to junk status, indicating actual or imminent default.
- Insurance companies, state-owned banks and their provident funds and pension funds, and mutual funds (MFs) have exposure to the debt papers of IL&FS; state-owned banks have also extended term loans to IL&FS.
- As the group’s financial health weakened, several listed entities of the company saw a sharp decline in their share prices.
How has this situation hurt NBFCs?
- Many corporates, mutual funds, and insurance companies have invested in CPs and NCDs of the IL&FS group, and there is fear that in the wake of the default, their funds could be locked in IL&FS debt instruments, leading to a liquidity crunch.
- The situation has created a liquidity shortage of close to Rs 1 lakh crore in the system, and fears have intensified that the funding cost for NBFCs will zoom, and result in a sharp deterioration of their margins.
- Default by a big corporation like IL&FS is likely to keep away potential investors in debt instruments of HFCs and NBFCs.
- Sharp losses in NBFC stocks have triggered a vicious cycle — losses in leveraged positions are leading to selling in other stocks to cover those losses, which is in turn fuelling further losses in the market.
- According to a Kotak Securities report, the probability of a full-fledged liquidity crisis is currently low — however, the pressure in the NBFC debt space may continue for some time, with a consequent hardening of short-term interest rates.
- As short-term rates harden, the funding cost of most NBFCs (and companies) will rise in the near term.
- Borrowing costs in general have been adverse over the past few quarters as the debt markets have priced in concerns on systemic liquidity, fiscal slippages, and policy rate hikes by the RBI.
What is the exposure of banks to NBFCs?
- Banks are a big source of funds for HFCs and NBFCs. The exposure of banks to NBFCs had shot up by 27%, or over Rs 1 lakh crore, to Rs 496,400 crore in the span of six weeks in March 2018.
- However, banks have cut their exposure since April this year, leading to a 4.6% decline in their exposure to NBFCs, according to RBI data.
- The sudden spike in banks’ exposure to NBFCs prompted the RBI to direct them to bring it down.
- There is no concern on liquidity of NBFCs in view of their liquid cash position and availability of committed lines.
- The RBI has initiated supervisory action against NBFCs that are non-compliant, inactive, and do not meet the minimum Net Owned Fund (NOF) criteria.
What is the exposure of MFs to NBFCs?
- In line with rising inflows into MFs and growth of NBFCs, the MF exposure to debt papers of NBFCs has gone up significantly over the last five years, raising their vulnerability in the event of NBFC books coming under pressure.
- NBFCs and HFCs have raised their borrowing from MFs significantly over the last few years.
- While MFs had an exposure of Rs 98,738 crore to CPs and CDs of NBFCs in August 2014, the exposure jumped to Rs 2.65 lakh crore in August 2018.
- A rush to liquidate such holdings may put more pressure on NBFCs.
Could this situation spill over into the broader market?
- The panic in the fixed income market due to the IL&FS default has led to a liquidity freeze, and it is putting pressure on the equity markets too, especially on HFC and NBFC stocks.
- With the panic in the market around liquidity, corporates are redeeming their investments in debt schemes of mutual funds, which is leading to a further liquidity issue in the market.
- If the liquidity situation does not stabilise soon, it may lead to a bigger issue in the near term, and may hurt both the debt and the equity markets.
- Investors were earlier not too worried about concerns around currency and rising crude oil prices; however, with the liquidity issue in the fixed income market following the IL&FS default, they have started looking at those headwinds, too.