India: Non-banks not out of the woods
- But balance sheet constraints and higher funding costs is likely to …
- … prompt NBFCs to slow lending activity
- This is likely to moderate overall credit availability, adding to growth headwinds
- Regulatory changes for NBFCs are forthcoming
Following up with our previous note, in midst of a funding squeeze facing non-bank financial companies (NBFCs), banks’ loans growth improved further in October. The latter rose 14.4% YoY by mid-October from 12.5% in September. While loan growth has been on an upmove since early-2017, the latest boost was likely due to, firstly, substitution demand as firms shift away from non-banks. Secondly, non-banks have also sought more bank credit lines as cost of markets-based borrowings tick up. This trend is apparent in late-August, where bank loans to NBFCs jumped 44% YoY and is likely to have persisted into September and October.
We continue to look for banks to increase their share as a primary source of funding to the commercial sector, as balance sheet constraints and higher funding costs prompt NBFCs to slow lending activity. NBFCs made up 12-15% of the total credit generated in FY17, and likely built on it 2017-18. As funding costs rise, their liabilities are likely to get re-priced more often than assets (particularly shorter-tenor borrowings), posing refinancing challenges. Larger NBFCs can still manage their costs by tapping public issues, however, the smaller outfits will find it a challenge to seek alternate sources of funding. Impact on margins is also likely, which in turn will push players to restrain balance sheet expansion plans.
It will be, however, a challenge for banks to meet all the displaced funding demand; on two counts. Firstly, at least half of the public-sector banks that face high NPAs have been ring-fenced under the PCA (Prompt Corrective Action) framework, with restrictions on fresh loans and dividend distribution. This has crimped credit availability, with higher due diligence amongst non-PCA banks. The future of the PCA framework has been one of the key areas of disagreements between the Reserve Bank of India and the government, with the latter calling for relaxations of few of the restrictions placed on the PCA banks. There is a likelihood that few of the operating rules might be relaxed in the coming weeks.
Secondly, NBFCs (particularly specialised entities in microfinance, housing, vehicle, rural etc.) have thrived in pockets where traditional banks face limited geographical reach, lower appetite and ability of mainstream banks to reach such borrowers. Take for instance MSMEs (micro and small medium enterprises). According to SIDBI’s MSME Pulse, the share of NBFCs in MSME financing has risen to 11.3% as of mid-2018 vs 8.4% two years prior. By comparison, public sector banks make up 51% in June 2018 vs 60% two years ago . Even if troubled NBFCs were to rollback their presence, it will be an uphill task for banks to fill this gap. On a related note, the government announced measures for the MSMEs on November 2, making access to credit easier and lowering associated costs, including interest subsidies.
Lower credit availability to hurt growth
The likelihood of stricter lending controls on NBFCs and tougher operating environment is likely to impinge on their ability to expand their books, prompting them to scale back their aggressive growth targets. Slower growth could reduce asset quality concerns, if incremental funding is deployed in quality loans rather than high risk loans. On this count, overall credit availability is likely to moderate, in turn hurting GDP growth. An RBI working paper  estimates that an 1% increase in real bank credit increases non-agricultural output by around 30 bps with a lag of one year. This adds to other growth headwinds (higher rates, lower fiscal headroom, sub-par private sector spending etc.), raising downside risks to our FY19 and FY20 forecasts, presently at 7.4% and 7.8% respectively.
Erroneous to place heterogenous NBFCs in the same basket
Understandably in the initial phase of panic in September, all NBFCs were viewed in the same light and hence endured a broader sell-off. Since then, nerves have settled as markets differentiate between solvency and liquidity risks within the sector. In a tough operating environment where rates are rising, and liquidity becomes scarce, quality NBFCs are the natural winner. Higher-quality entities i.e. with a strong promoter or shareholder backing, lower reliance on wholesale funding, favourable sectoral and geographical spread, will be able to withstand volatile market conditions, for instance by fixing any asset-liability mismatches through sale of non-core assets or issuing a rights issue. Few NBFCs also benefit from strong shareholder support, which is a key credit strength, especially as operating conditions get more challenging. A shift from capital/ money market borrowings to bank borrowings, particularly those with unutilised/ undrawn credit lines is likely. Smaller entities, however, which were heavily reliant on leverage and benefiting from regulatory arbitrage will have to revisit their strategies.
Finally, the government and the RBI are likely to reach a common ground on support mechanism for NBFCs, which has been a contentious point of late. The government has called for dedicated liquidity windows, while the RBI has, keen to contain moral hazard risks, opted for indirect liquidity support through banks (including purchase of good quality loans) and money markets. One of the litmus tests will be the upcoming commercial paper maturities, in the region of INR1-1.5trn, in Q418, like the scale in Q3 according to press reports. Other high-frequency data has suggested that NBFCs have returned to banks and INR debt markets to raise funds, lowering the reliance on short-term borrowings. Nonetheless, the writing is on the wall that more regulatory changes are forthcoming for NBFCs, particularly on the funding make-up for non-bank entities to limit pipeline systemic risks.
 MSME Pulse; SIDBI-TransUnion CIBIL; June 2018
 RBI Working Paper; June 2018
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