Shining the light on mis-selling in Indian banking
By Deepti George & Madhu Srinivas, Dvara Research
In the last few weeks, Indian non-banking financial companies (NBFCs), especially housing finance companies, have witnessed a fall in valuations and rising bond yields. Liquidity for NBFCs has also significantly contracted across the board. Yields on AAA rated commercial papers (CPs) of NBFCs have risen from less than 7.5% in the beginning of September to almost 8.3% now, an increase of 80 basis points. For the first time since 2014, corporate bond issuances have turned negative for the quarter ended June 2018. The liability profile of large, non-deposit taking NBFCs significantly comprises wholesale funding, with debentures accounting for nearly half of it (Reserve Bank of India Report on Trends and Progress of Banking in India, 2017). This is not a problem in itself, but for certain types of NBFCs, such as housing finance and infrastructure financing companies, asset-liability mismatches can be severe, especially given the near-absence of markets for long-tenure paper, and payments on short-term borrowings come up sooner than repayments from loans originated. This, coupled with the illiquidity in corporate bond markets, makes NBFCs particularly vulnerable to market reactions, unlike banks, which has access to both retail deposits and the liquidity facility of the Reserve Bank of India (RBI). Despite these challenges, the NBFC sector has been faring well on three counts.
One, the banking sector is struggling to grow their lending book under the weight of persistent non performing assets (NPAs), and NBFCs are beginning to meet the consequent unmet demand for credit across a variety of sectors and ensuring continuing credit flows to the real economy.
Two, NBFCs have been maintaining low net NPA ratios of 3.5% unlike their banking sector counterparts, where net NPAs continue to remain stubbornly high at 6.1% (RBI Financial Stability Report, June 2018).
Three, NBFCs have been found to be relatively more resilient to stress applied for credit risk as observed by the RBI in its financial stability reports of the past two years. NBFCs, even under severe stress conditions, continued to remain stable, buoyed by high economic capital levels hovering above 20% against a regulatory requirement of 15%. Banks, under stress scenarios, did not have such a cushion to fall back on.
Given the above context, there have been some calls, and rightly so, for providing the RBI’s lender of last resort (LOLR) facilities to NBFCs. However, we need to keep in mind that merely providing LOLR facilities to NBFCs, such as the liquidity adjustment facility and the marginal standing facility, would lead to behaviour consistent with moral hazard, because without demand liabilities, an LOLR disincentivises efficient liquidity management. This also creates inconsistency in regulatory treatment between banks and NBFCs, which unlike banks, do not have restrictions like statutory liquidity ratio. We, therefore, need a solution that is more holistic, long term and non-distortionary.
In this regard, it is worth bringing back to the table and considering wholesale bank licensing for India, an idea first floated by the the RBI Committee for Comprehensive Financial Services for Small Businesses and Low Income Households in 2014.
The committee envisaged these licensees to be like universal banks on their asset side with freedoms to originate a variety of assets, but with important differences for their liabilities side. Without permissions to access retail deposits, liabilities would comprise wholesale demand deposits (of minimum ₹5 crore, which is large enough to keep retail depositors at bay, but small enough to ensure a diversified depositor base) and other wholesale funding instruments. This obviates the need to apply micro prudential tools, which are needed when public retail deposits are accessed.
For instance, the high net owned funds (NOF) requirement of ₹500 crore can now be brought down to ₹50-100 crore. Under such a construct, the wholesale bank licensee would have access to RBI’s LOLR facility. The committee identified two categories within the wholesale banks, namely wholesale consumer banks and wholesale investment banks, which differed from each other in the nature of assets originated. While the former would originate retail loans, the latter would originate infrastructure and/or corporate loans. The limited construct of the wholesale investment bank was later taken up by the RBI and put forward in the form of the wholesale lending and term financing (WLTF) banks, in its discussion paper in April 2017.
However, the current construct envisaged by the RBI is extremely limiting with NOF requirements that are double that of universal banks, and restrictions that disallow origination beyond infrastructure and corporate sectors.
NBFCs have been able to complement the credit intermediation by banks by serving regions, sectors and customer segments that banks have either been unable or unwilling to serve profitably. Yet, as the recent episode revealed, these entities are particularly vulnerable to wholesale funding constraints in the form of high and volatile borrowing costs even when there is no concomitant deterioration in asset quality.
The regulator would do well to revive the wholesale bank idea and provide a pathway for some of the larger and better-run NBFCs to transform into wholesale banks with a cleaner design of wholesale demand liabilities supported with LOLR and business strategy driven choice of lending book. Such a transition would ensure that these important institutions now have a more permanent and stable way of dealing with their funding problems. With this, the RBI can get a better grip over potential contagion risks while supporting the banking system on its slow path to recovery.
This article first appeared in Livemint.
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One key issue listed in this article is the absence of long-term funds to match long term needs, specifically in infrastructure investments. The proliferation of more market-making entities through a wholesale banking license may be welcome, as such a license would enable them to react quickly to financing needs on their own – unique as “sales” representatives of a normal bank. But the mere presence of wholesale banks won’t suddenly increase supply of long term funds (the 20yr or 30 yr funds for infrastructure investments). While this aspect may not be the focus of this article, it may be worth looking into separately.
Thanks for your pertinent comment Mr. Prasanna. This is an important question and an important piece of the puzzle that makes up the Indian financial system. No straightforward answers on how to build depth for long term funding markets for a country like India that is currently still overly banking centric. We are in the process of studying alternative models in other jurisdictions that try to answer the question of who are the holders of such long term risks, and some interesting examples are emerging. We do hope to write up our findings soon.