Introduction
A Non-Banking Financial Company [NBFC] is a company duly registered under the Companies Act, 2013, having financial activity as their principal business but does not possess a banking license. In essence they perform similar activities as that of a bank, like advancing loans; acquisition of shares, stocks; hire-purchase but perform only the lending functions of the banks and cannot accept deposits repayable on demand from public. In conclusion the NBFCs have to raise funds from other sectors to finance the projects. Unlike banks, NBFCs offer loans for specific activity in a specific industry, covering areas, fields and industries where banks have refused to venture. NBFCs are often called Shadow Banks due to their limited regulation in the financial sector.
Since their establishment in 1960s, the non- banking financial companies have become an integral part of the country’s financial system and the economy. The financial sector has seen an unprecedented growth of NBFCs since the Liberalisation, Privatisation and Globalisation of economy in 1991. This growth led to necessary changes in the regulatory policies of the Reserve Bank of India (RBI). Today, NBFCs are heavily regulated by the RBI but are not yet at par with the other Financial Institutions and Banks (Private or Public). As most of the NBFCs are non-deposit taking, the RBI only regulates these institutions to an extent.
Usually the NBFCs borrow funds from Banks or gather funds through Mutual Funds by offering to sell commercial papers. The collected funds are then lent to Micro, Small and Medium Enterprises [MSMEs], Retail customers, etc. Importance of MSMEs in the economy has increased nowadays due to emphasis put on the smaller industries and greater significance given to start-ups in the country due to centre policies like Make-in-India.
The NBFCs have become a fundamental part of India’s economy and any major changes in the financing industry create a ripple affecting the whole economy and its growth. Credit crunch faced by the NBFC reduces the credit flow in the economy causing the slowdown of economic growth. The cycle continues as the reduced credit in the economy forces many borrowers to default on loans and lenders to retract their support and funds.
The Ripple of Credit Crunch
The financial sector witnessed an onset of a crisis in September 2018 when one of the major players in the financial sector IL&FS (Infrastructure Leasing & Financial Services) Group, an NBFC, defaulted on several repayments. This out of character and unheard-of action shook the industry hard creating ripples of panic and apprehension.
IL&FS was set up in 1987, by a group of banks contributed to set up a financial institution that could also function as a technical consultant. Over the years the institution grew in size and its influence in the industry consisting of 300 group companies. Slow economic growth forced the company to rely on debt funding which led to accumulated debt of over 90,000 Crores making the company a liability in the industry.
The default of one group created a ripple effect of shock throughout the industry making it difficult for others companies to refinance the debt. The industry was put on red alert and every group, authority, company or institution was put under scrutiny. The rating agencies had given AAA rating to the bonds making the default even more unexpected and shocking. After the default of repayment by the IL&FS the rating agency, ICRA downgraded the ratings of several short term and long term borrowed funds of the company.
At that moment, around 45% of the NBFC were being financed through Mutual Funds but due to the market condition mutual funds lost the trust vested in the NBFC and stopped funding NBFCs, further worsening the situation.
After much scrutiny and investigation trying to figure out the underlying reason for this crisis, several flaws in the operational structure of NBFCs were pointed out. One of the major flaws in the financing structure of the NBFCs was the asset-liability mismatch. The company started lending long term loans while depending on short term funds, meaning the money they borrowed was up for repayment much before the repayment of rolled out loan is due. This led the companies to further take short term funds to repay the other short-term funds. Cheap funds were available during the demonetisation which motivated the NBFCs to keep on lending more money. The excess of credit flow available to the NBFCs led them to hasten their loans procedure compromising their various underwritten standards for lending loans. This cycle kept on growing unchecked and caused a major cash crunch leading the companies to default in their repayment of interest on bank loans and commercial paper redemption obligations
Another major reasons for the downfall of IL&FS was the hold-up of the funds directed towards several different projects which were delayed due to land acquisition. One sector where NBFCs have heavily invested is the housing sector, which was already struggling due to the new land acquisition regulation. These regulations have caused an overall stagnancy in the housing sector. The money lent to developers or homebuyers turned into bad investment as more and more projects are being held up, developers are being declared insolvent and an increasing number of homebuyers are still waiting on their properties. The cash crunch spread to the housing sector like a virus as their major lender, NBFCs, started falling short of funds. The decrease in the amount of construction loans available in the market combined with the stagnancy in, led to adverse liquidity problem in the housing sector and creating a cycle of cash crunch that proved hard to break.
The crisis is being compared to the 2008 market crash caused by the US mortgage backed loans and its major contributors- the Lehman Brothers. The NBFC crisis is dubbed by many as India’s Lehman Movement.
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Originally posted on https://www.kpalegal.com/ on 20 March 2020
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