Here's how the IL&FS crisis spread to NBFC stocks in Indian markets

Advait Rao Palepu explains how the crisis at IL&FS spread to NBFC stocks.  

What caused the recent sell-off in equity markets, particularly in non-banking financial company (NBFC) stocks? 

Over the past two to three years, NBFCs have over-borrowed funds from the commercial paper (CP) market, which, regulators and analysts believe, has led to asset-liability management (ALM) mismatches. That is, they are borrowing funds in the short-term debt market while servicing loans, like mortgages or term loans, that are long-term in nature. According to analyst reports, as of March 2018 around 74 per cent of funds raised by NBFCs came from non-banking sources while they raised around 25 to 30 per cent of their incremental funding from CPs during the last financial year. The fact that CPs are short-term instruments means that the issuing NBFCs would have to honour the redemption on the date of maturity. 

The sell-off in NBFC stocks, over the past two weeks, is caused by market concerns that these companies do not have the requisite cash balance and liquidity strength to honour their redemptions. India Ratings says the top 12 NBFCs have around Rs 300 billion worth of CPs due for repayments in the three months ending December 2018.

How is IL&FS involved in all this? 

Last month, subsidiaries of Infrastructure Leasing and Financial Services (IL&FS), a systemically important NBFC that works both in the financial world and in the infrastructure world, began defaulting on loan repayments, as well as payments on inter-corporate deposits (ICDs) and CPs worth a total of Rs 41 billion. Subsequently, rating agencies downgraded the credit quality of IL&FS subsidiaries to “non-investment grade (junk)”, after having a high rating of “AA” just a few days prior to that. DSP mutual funds’ debt fund took a cue from the negative situation and decided to sell bonds of DHFL, albeit at a heavy discount. This immediately led to rumours in the stock markets that CP yields had shot up because of a liquidity shortage in the short-term debt market, and therefore CPs issued by NBFCs would have to be sold at large discounts. Although CP borrowing by NBFCs has become rampant in the past two to three years, industry executives said that the market was panicking and rumours were the cause of the NBFC sell-off on September 28. 

With over 348 subsidiaries, IL&FS is said to have funnelled money, raised either from the debt market or banks, to these subsidiaries as a form of equity investment and therefore created an unsustainable business structure. The company has a high leverage ratio — of 13 times — as total borrowings as of September 2018 stood at Rs 910 billion on an equity base of just Rs 69.5 billion. Last week IL&FS defaulted on another Rs 1.72 billion worth of ICDs. It is in dire need of Rs 35 billion in liquidity support as in the next 30 days the company needs to repay Rs 40 billion of bonds.

With liquidity constraints in the economy, are all NBFCs in a vulnerable position? 

For the last one year or so, the RBI has repeatedly stated that it aims to ensure that liquidity in the financial system is at a neutral level; however in the last one month it has dipped to negative levels. Viral Acharya, deputy governor of the RBI, said that the high reliance on the CP market has led to a maturity rat race and that NBFCs should look at raising funds from longer term sources like bank loans. 

Analysts say that on an average bank loans are costlier for NBFCs as compared to the CP market; therefore if these financial companies shift their source of funding from the debt market and to banks, there will be pressure on their net interest margins. Rating agency ICRA said that the higher borrowing costs will compress the overall profitability of NBFCs during FY2019. Some of this incremental borrowing costs may be passed on to customers. While it is likely that NBFCs will face reduced profits and margin pressure, it is only a few NBFCs that are over-leveraged and have large outstanding CP balances. The top housing finance companies, that have faced the brunt of the sell-off pressure, have stated that they have healthy liquidity positions with adequate cash balances to repay all short-term liabilities, even without accounting for any fresh borrowings they may seek. 

What will be the effect on the wider financial system and the economy? 

Many institutions including banks, NBFCs, mutual funds and asset management companies (AMCs), LIC as well as foreign investors have invested a substantial amount of their funds either in equity shares of IL&FS’ subsidiaries or in the debt papers issued by the company and/or its subsidiaries. According to the Department of Economic Affairs (DEA), a default or insolvency of IL&FS would have a cascading effect on the economy. While the total investment in debt mutual funds accumulated to Rs 16 trillion over the last year, AMCs have an exposure of Rs 28 billion to IL&FS bonds. The DEA says that the recent pressure in some NBFC stocks may force AMCs to sell government securities, which will cause the 10-year bond yield to rise to 8.30-8.50 per cent or the RBI would have to resort to OMO (open market operations). 

Further, since 40 per cent of IL&FS’ shares are held by LIC, SBI and the Central Bank of India and the total exposure of the banking sector to the group stands at Rs 530 billion, defaults on principal and interest payments will impact the asset quality of the top public and private banks. Given the systemic exposure to the IL&FS group, the government in its petition to the NCLT, said that, “there is a substantial public interest in ensuring financial solvency and good governance and management of this group”.