- Wealth PMS
Non- Banking Financial Companies have seen some changes in the Budget, and here’s piece that looks at potential impact.
NBFC have been reeling under liquidity pressure, meaning they can’t raise money and their assets are longer term. Like housing loan companies whose loans get repaid over a 10+ year period.
They could package these loans into a securitized product and sell them as a whole. To encourage this, the government has offered a first loss guarantee scheme. Below are scheme details.
NBFCs package a set of loans into a pool and then sell it off to banks. Typically the first 10% loss is borne by the issuer – say the housing finance company. But the trust has gone, so banks don’t think they will be able to take that first loss. With this budgetary change, the first loss will be guaranteed by the government up to 10%, if the pool itself is rated highly. What does that mean?
Rating agencies rate security pools. These are based on whether the pool securities are likely to see defaults – and some of that is based on how much the first (and/or second) loss facilities cover the pool already. A high rating means there’s enough confidence that the first/second loss covers will take any potential losses out there, and the current collection efficiencies and NPA is low. The government will thus guarantee 10% of the pools as the first loss facility.
First loss guarantee by government will be available for only the first 1 lakh Crore securitised pool. This itself means at maximum government will bear a risk of 10,000 Cr in case 10% of the securitised pool defaults. We believe it will be in first come first serve basis.
Guarantee for only high rated pool means, there is lower risk of default. We believe the rating needs to be above AA+. In such cases the default risk are lower and thus a lower risk for government in covering the losses. Why should you guarantee only higher rated pools? Because the high rating ensures that people don’t dump bad assets into security pools and let the government take the hit. (If bad assets or delayed repayments are high, the pool rating will be low)
First loss guarantee will be valid only for first six months of the issue. Post that the originator will bear the brunt in case of defaults. This will be clear when the final guidelines are published.
Note that this only applies if Public Sector Banks buy the security pools.
To understand how exactly securitisation works in Indian context, please read our article titled “Fundas : Securitization -The Growth Vehicle For NBFCs”
This is a good way to introduce liquidity into the system, but the clauses take away the juice. Only six months + only AA+ rated pools + only public sector banks means this is a bailout of some very specific NBFCs, not the sector as a whole, if it even happens. For a high quality pool of say AAA rating doesn’t require a 10% first loss in first six months. Most of the slippages start in later half of the maturity of the pool.
Government has been trying to provide level playing field for NBFC with respect to banks. In line with that NBFCs taxation on interest received from bad or doubtful debts has been changed. In earlier cases NBFC had to pay tax on interest pending from bad or doubtful debt. At a later point once they actually receive, NBFC will adjust tax accordingly. This simply led to prepayment of tax.
Now the rule has been changed and has been made similar to banks. Current changes state that tax must be paid for the year when interest is received for bad or doubtful debts.
It was much needed change in taxation for NBFC. You cant pay taxes for the interest which you have not received yet. With this change taxation for NBFC will be more in line with banks.
Earlier every company including NBFCs (but not banks) which used to do public placement of debt had to maintain a Debenture Redemption Reserve (DRR) apart from special reserve required by RBI. The DRR rule was mainly applicable for housing finance companies.
What is DRR?
As debentures are not backed by any collateral, a possible default by a firm will put investors money at risk. Thus government came up DRR. The reserve will be created by debenture issuing firm and will hold 25% of the face value of debentures. The 25% reserve will be proportionately rise every year till the time of maturity. In case the issuing firm does not maintain 25% DRR within one year of issuing the debenture, then they are liable to pay 2% interest of the issue to investors.
Issuing firms also need to set aside 15% of value of debenture maturing during the current financial year. This activity must be done at the start of the year. If Rs 100 Cr is maturing by Mar 31, 2020 then Rs 15 Cr should be set aside at the start of April 1st 2019. The 15 Cr comes mainly from FY19 profits (in most cases) or by issuing new debt at beginning of year.
The DRR can invest in corporate or government bonds or can put a deposit at scheduled bank. 15% of the investment should be in most liquid fund like government securities, which are low interest yielding. The investment can only be used to pay interest or principal payment of issued debentures.
Debenture Redemption Reserve was put in place in 2000 to protect investors from defaults. With DRR going away it will free capital for NBFCs who anyhow should be able to raise money through deposits or borrowing otherwise. DRR has been point for most of the institutions which raise capital via public issues. With DRR gone, NBFCs will increase their issues as repayments will not eat away into available cash.
There’s a Trade Receivable Exchange concept called TReDS, announced by the RBI. To make TReDS more inclusive and allow NBFCs to participate in the system, government is changing the criteria of registration for NBFCs. Before getting deeper we need to know about TReDS.
Trade Receivables Discounting System commonly known as TReDS is a platform for financing trade receivables. MSMEs which are major suppliers to big firms, would have raised bills that are pending with big firms for payments (trade receivables). Typically, even after the work is done, a large company will take 90 days to pay.
MSMEs working capital would be stuck in such bills and are unable to carry out their regular business due to lack of capital. In such cases, banks and financiers can step in and credit the MSMEs the discounted bills and later collect the same from the large corporates. Below is an example of how it works
Earlier for NBFCs to be part of TReDS, they had to register with NBFC- Factor. The clauses in NBFC-Factor made it difficult for all NBFCs to register. Some of The criteria under NBFC- Factor are as follows
The exact details of what criteria will be tweaked to accommodate more NBFCs in Factor system is still unknown. But it’s likely now that all NBFCs will be allowed to participate, which makes it easier for current NBFCs to go in and bid.
Note that after factoring the bills are paid by the larger corporates. So for a lender, it’s actually a credit to a large company, even if the person receiving the money is an MSME. So the rates can be more competitive.
TReDS is an excellent platform for SMEs as well as financial institution for meeting their capital requirements and outreach respectively. TReDS has not seen as much traction in Indian financial space as it should have. The problem has been, most of the financiers are banks on the platforms, which aren’t really showing the drive to lend. Banks seem to be better off by giving large ticket loans to corporate rather than micro managing these receivables. TReDS will be more suitable for NBFCs, which are into such kind of small ticket business. By allowing more NBFCs in, the competitive landscape will get better – and provide more business to both NBFCs and the SMEs that need to factor their receivables.
NBFCs till now have been working as pseudo banks with little regulations around it. Government to bring tighter framework around NBFCs has given more powers to RBI. Amendments to the existing section has been put in place to bind NBFCs within RBI authority. Below are some of the changes brought in budget 2019.
Additionally, housing finance companies will now come into the regulatory ambit of the RBI also (along with the NHB).
With more powers to RBI, NBFCs will have to adhere to regulation direct from the RBI, and with powers to remove directors or CEOs, the RBI has the ability to fix problems earlier.
Note that the RBI has already allowed banks to lend to NBFCs by borrowing from the RBI itself, and using excess GSec holdings as collateral. This excess GSec holding is also going to come from lower G-Sec holding requirements, after RBI reduced the amount of G-Secs totally needed for banks’ Liquidity Coverage and Statutory Liquidity Ratios, combined. Effectively, this allows banks to lend more to NBFCs through this window. However, this won’t change much – it’s not like banks have too little money (in fact, they seem to have excess money right now), and bank lending to NBFCs is already at a relatively high level.
The overall point of view here is that the shadow banks in India – the NBFCs – are facing challenges. The government wants to help, but not create a moral hazard by bailing them out entirely. The steps taken will help some NBFCs, but those NBFCs don’t need help. The bad ones are going down anyhow.
We believe more steps will come from the government if all hell breaks loose, but if the NBFC situation resolves through asset sales or resolutions, there may be no further steps required. Already, DHFL is working on a haircut and resolution plan. Other housing finance companies are looking to merge or raise capital. Yet others are doing excellently, like Bajaj Finance or the gold lending companies. Stronger oversight by RBI is expected, but with it will come more opportunities to grow, and the weaker competition is eliminated.