Question

choose a type of non-bank financial institution and make a case for whether or not you think the level of financial leverage employed puts the overall financial system at risk.

for Money and Banking class

Answer 1

The important role played by the non -banking finance companies (NBFCs) in financial system has complemented the banking system andbought about enhanced coherence and diversity in financial intermediation. NBFCS have progressed considerably in terms of operations, heterogeneity, asset quality, regulatory architecture and profitability. NBFCs disbursing credit to the overall commercial sector has increased and gained importance in the preceding few years as banks have faced challenges in lending amid the non -performing assets (NPAs) overhang.

However, of late the NBFC sector has encountered challenging liquidity conditions.

The sector is facing a credit crunch and liquidity concerns which has had a contagion effect on other sectors dependent on NBFCs for funding their growth. In addition, the Global Financial Stability Report released by the International Monetary Fund (IMF) has apprised systematic risks associated with shadow banking practises which might spill over to the banking system. Given this backdrop, the foregoing study analyses the performance of the companies in the NBFC sector across three broad categories:

-Source of Financing

-Loans granted under financing activity

- Profitability indicators

As the global financial crisis intensifies, non-banking financial companies (NBFCs) are facing basic questions about the viability of their business model.

Several firms are finding it difficult to operate in an environment where money is scarce, defaults are becoming common, and asset-liability mismatches have become more the norm than the exception.

At the heart of the problems being faced by NBFCs is the growing reluctance of banks to lend to such companies because the risks involved in doing so have increased since the middle of September, when investment bank Lehman Brothers Holdings Inc.’s bankruptcy highlighted growing credit risks in the global financial system.

NBFCs also borrow money from mutual funds (MFs) and through deposits, but even that has become difficult: in the backdrop of the ongoing credit crisis, investors are turning to bank deposits and MFs are seeing investors bailing out.

NBFCs account for Rs4 trillion of assets in the Indian landscape and, therefore, are not an insignificant entity (in the financial system),” said Vikram Limaye , executive director at Infrastructure Development Finance Co. Ltd (IDFC). He added that the problem has more to do with the lack of credit than anything else.

“...the institutionally funded models have suffered in the recent liquidity crisis. It has got to do more with the liquidity and not with solvency. There are enough assets. They are viable and making money, they are profitable entities,” he said.

According to a senior executive in the business, it also has to do with the model used by most NBFCs.

The cost of capital for NBFCs is usually 2-3 percentage points higher than that for banks, but these firms can leverage up to eight times on their equity. NBFCs typically leverage five-six times, sourcing funds from banks, MFs, wholesale markets and retail deposits to generate 13-14% return on equity (RoE).

RoE for NBFCs, a measure of their profitability as compared to their equity, is a function of the number of times they can leverage.

When the number of times an NBFC is leveraged falls to 4, its RoE falls to 10% or below, this executive, the head of a large Indian financial services group, added. When leveraging falls further, the business cannot sustain itself, the senior industry executive said, asking not to be named because it could lead people to conclude that his firm was in trouble.

The Reserve Bank of India (RBI) has taken several steps, including reducing risk weightage and provisioning norms for loans given to NBFCs, to help them survive the current liquidity crisis, said T.T. Srinivasaraghavan, managing director of Sundaram Finance Ltd, a Chennai-based NBFC.

“No doubt the country and the NBFCs are going through a credit crisis..., (but) if we are to assume that this is the end of equity markets, mutual funds, public deposits and every other debt market, then the answer will be frightening,” said Srinivasaraghavan who is also the chairman of Finance Industry Development Council, a self-regulatory organization for the sector.

Product innovation

Credit rating firm Crisil Ltd, which has been downgrading NBFCs recently, expects the business model to change over the long term.

“More than 50% of NBFCs’ borrowings have maturities of less than one year, while most of the assets have tenures of about three years,” Crisil said in a 10 November report that predicted a decline in business volumes for such firms. “Most of these NBFCs, especially asset finance companies, have significantly slowed down disbursements because of a lack of funds: the average monthly disbursements during September and October are estimated to be half of disbursements during August,” Crisil added in the report, which analysed the disbursement pattern of the 33 NBFCs it rates and that represent 30% of the sector.

“NBFCs’ share in overall retail finance space has reduced over the past few years as banks, with their superior size (and) resource diversity, have achieved dominance: banks today make more than two-thirds of retail finance disbursements, up from about 20% in 2002,” the rating agency said, adding that it does not expect this trend to reverse.

Roopa Kudva, managing director and chief executive officer of Crisil, said that despite increased defaults in NBFC portfolios, cash flows from existing assets would allow these firms to meet on time their debt obligations.

“The decline in business volume will mean a further marginalization of the sector—a trend that has been accelerating over the past few years, as banks have taken over the traditional NBFC stronghold of retail lending.”

Cholamandalam DBS Finance Ltd (CDFL), a joint venture between the Chennai-based Murugappa Group and Singapore’s DBS Bank Ltd, is among the affected NBFCs. The company went through a liquidity crunch in September, but negotiated this with the help of some funding support from the promoters.

In late October, its chief executive Atul Pande resigned, the company said without specifying a reason. The Economic Times reported on 27 October that he was under mounting pressure from the board after the company had its first loss in 30 years.

As long as the NBFCs are financially healthy, they can continue to co-exist as they bridge a gap that the banks could not. Of course, the NBFCs (and others too) will have to carefully negotiate the next 12-18 months in a planned conservative manner. Once the confidence is restored in equity markets, things should bounce back.

Not all NBFCs have been hit. But even it could face problems on the leverage front, as highlighted by the local arm of Goldman Sachs Group Inc. in an August report.

“The balance sheet leverage position of the company is unlikely to exceed the levels achieved in March 2008 at ~5X (five times). From our interactions with Crisil...as well as the company management, we believe IDFC would need to maintain a high capital adequacy ratio if it were to keep its current rating. We believe this may lead to reduced market expectations for earnings growth and RoE over the medium term,” Goldman Sachs analysts wrote in the report.