Financial ecosystem – paying the price for willful blindness
(The following article appeared on CNBC TV18 online on 30th October 2018, URL below:
https://www.cnbctv18.com/
How green was my NBFI
https://www.cnbctv18.com/
Financial
ecosystem – paying the price for willful blindness
Relief, or else
For the past few days, some members of India’s financial
services ecosystem have been demanding relief from the powers-that-be, while
pointing a gun to their own head.
Ensure funding for the system, they say, or we could spiral
down and drag the broader economy along with us.
The immediate trigger is a trust deficit around the true
nature of non-banking financial institutions (NBFI) balance sheet
asset-liability mismatches, and more importantly, around the true quality of NBFI
assets. In the post-MPC press conference earlier this month, RBI itself indicated
that all is not well with all NBFI.
In this context, the focus is on INR 2.5 tr of NBFI debt
that will mature with mutual funds by March 2019. There is a fear that a chunk of
this debt may not roll over. While banks are looking to buy assets from NFBI, this
might not suffice to bridge the funding deficit.
The suggestions and entreaties to prevent a vicious spiral, range
from encouraging banks to fund NBFI, to the government readying a financial
institutions bailout fashioned after the extraordinary 2008 US troubled assets
relief program (TARP).
It’s ironical that just months ago, NBFIs were the darlings
of the capital markets.
How green was my NBFI
Per RBI’s last financial stability report (FSR), as of March
2018, all NBFI put together had 22.9% capital risk-weighted adequacy ratio (CRAR),
5.8% gross non-performing assets (GNPA), and 3.5% net non-performing asset (NNPA).
By comparison, banks as a class were much worse off, with only
13.8% CRAR, alongside high 11.6% GNPA, and 6.1% NNPA.
In fact, the RBI FSR devotes 20 pages to analyzing how banks
can impact financial stability, and barely one-and-a-half pages to NBFI.
Not only were NBFI ostensibly safer than banks, they were also
growing their assets twice as fast. No surprise, therefore, that NBFCs were the
stars of the capital markets till recently.
Why are we suddenly obsessing about NBFI balance sheet risks
and asset quality now? Why have some large NBFI stock prices fallen by 20-40%
in the last one month? Has the IL&FS default made such a big difference?
The explanations
As ever, there is no shortage of arguments to explain market
behavior post-facto. Here are a few sound bites and factoids that we now hear.
-
RBI’s asset quality review (AQR) process since
2015 focused solely on banks. As a result, reported GNPA of banks increased
from 4.6% in March 2015 to 11.6% in March 2018. For NBFI, which were not
subject to the same AQR process, GNPA rose from the same 4.6% in March 2015 to just
5.8% in March 2018. Is this really believable?
-
In fact, 15% of INR 22.1 tr of NBFI assets are
real estate or capital market exposures. These are riskier areas that banks are
restricted from lending to. Look at the mess in real estate, with all the
unsold inventory and builder distress. How have NBFIs managed to lend more, at
higher rates, and yet managed to keep NPA ratios much lower than banks?
-
RBI’s regulatory oversight over the 405 key
NBFCs – let alone the 11,402 registered NBFI as of March 2018 - is not of the
same intensity as that of banks. It gets even worse with housing finance
companies (HFCs) – the supervision process of National Housing Bank (NHB) is
even less comforting.
-
Of course, regulatory oversight is not the first
line of defense. There is frontline management, internal risk management, the
board, external auditors and credit rating agencies, who are each charged with
keeping things honest. And we believe each one of them is doing a great job – yeah,
right!
-
Mutual funds now hold about INR 12 tr of debt
securities, of which a significant majority is non-sovereign debt. Total traded
volumes in corporate bonds is about INR 1.5 tr a month. Given this illiquidity
of secondary markets, largescale mutual fund redemptions in any crisis of
confidence can severely push up credit spreads.
Of course, all this begs the question – if this (and more)
was or should have been well known, what were we doing all this while?
The trap – eyes
wide shut
There are many excuses to shut our eyes to such signals.
As a first excuse, we believe forbearance (a more
complicated word for closing one’s eyes) is a good way of letting the system
naturally adjust to issues. After all, we argue, Basel III norms do not really
apply in the Indian context – which is why we criticize RBI’s AQR drive,
culminating in the February 12th circular.
On the contrary, history shows that besides coming back to
bite us, forbearance has often delayed and postponed real reform – in our case,
areas such full recapitalization of banks and true reform of the banking system
(P J Nayak committee recommendations, anyone?).
As a second excuse, we argue that a growing ecosystem can
never be perfect, and this will be a journey with its inevitable ups and downs.
So why be the party-pooper, as long everyone is having a great time?
Ups and downs are of course inevitable – but the downs
should come from the unknown unknowns, rather than from issues that are staring
us in the eye.
As a third excuse, we also use a patriotic “greater good”
argument. If we classify the power sector as NPA, what will happen to all the
people employed there? If we value all corporate bonds in MF schemes adjusting
for the illiquidity of the secondary markets, how will the Indian debt
ecosystem ever grow? If rating agencies, auditors and boards start sticking to
the rulebook, how will industry and commerce ever take off in India?
These are important questions – and there are genuine, core,
difficult reforms that can answer these satisfactorily, and none of them call
for anyone to play the ostrich, or wink and nod.
In the financial services industry, trust is all-important.
Painful regulators, auditors, boards, credit rating and valuation agencies are
true allies in fostering that trust. By sticking to their respective individual
mandates, all stakeholders – frontline and support - fulfil both their patriotic
and professional duty.
The regulators and the government need to do their own bit
by undertaking true reform, addressing the core issues that check-and-balances
highlight.
The government has done well in implementing the Insolvency
and Bankruptcy Code, for instance. We now need to understand how recapitalization
and reform of financial services and secondary debt markets can be speeded up.
The price of
gun-on-head negotiations
We will get out of the current situation – notwithstanding the
now public spat between regulators and the government.
Things are not as bad as feared – NBFIs do have good assets,
and the financial ecosystem is not all bad. In any case, even if things start
to go out of hand, we will find a way. We have ample intrinsic buffers, and we always
get by.
But all of us guilty of willful blindness – whatever the
pretext - will have to held accountable. There has to be a price to pay for
pointing a gun to one’s head.
Going forward, we need a financial ecosystem that fosters
trust with conservative, eyes-open checks and balances – alongside the
willingness to undertake hard, true reform of institutions and markets.
Reforms are obviously difficult to undertake – but that cannot
justify us closing our eyes.
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