The market is in a downward spiral and RBI has slashed repo and reverse repo rate which is down to 4% and 3.65% respectively. This is the lowest it has been since 2000. This does not concern corporate lenders much. However there was an announcement which granted relief to corporate borrowers. Chief Analytical Officer, Acuite Research and Rating had this to say –
This will provide some relief particularly to the MSME and the corporate borrowers who are likely to witness liquidity challenges for an extended period of time. In our opinion, going forward, there may be a need to provide special dispensation for a more comprehensive restructuring of loans at least in some of the relatively vulnerable sectors.
This has led many NBFCs which were previously in relatively safer waters because of their status as corporate lenders as prior to this there was the assurance that even if individuals would default due to unemployment or delay due to moratorium, corporate borrowers would not.
Owing to this we have observed growing concerns from this financial sector and ran a a research to understand how the coronavirus situation has impacted the NBFCs of India.
Reassessing the business model
It is a matter of public understanding that the market conditions are changing and is poised to change further. This is forcing companies across the board to shift their business/revenue models. In a similar capacity NBFCs will have to revisit their business models for their upcoming and existing financial instruments.
To make matters worse, banks are leaning towards credit freezes which will dry up some NBFC. Despite RBI announcing TLTRO (Targeted Long-Term Repo Operation) which was designed to enable money flow to NBFC. To that extent, banks have outright ignored the RBI auction to raise the funds under this scheme.
Banks are generally way of funding NBFCs since the ILFS crisis, mainly due to perceived risk. Hence, as long as perceived credit risk is higher than the TLTRO spread, banks will not invest.
-Abizer Diwanji, Head of Financial Services at EY
The most visible issue lenders are facing right now appears to be non-repayment of dues. This is driving up credit risk which requires course correction of NBFCs to have a model which accommodates such risks while maintaining the credit quality of its financial assets. That will ensure credit extensions even if there’s a complete breakdown of cashflow.
Given the market direction and the increase in unemployment across the nation coupled with increasing resentment towards financing, there will be significant reduction in volumes with retail customers as well as SMEs which forms the majority of NBFCs’ corporate clients due to their business going under.
Instability and failure to understand the expected credit loss
If we are to be in accord with re-assessing the business model and adjusting weights to make it work, we have to gauge the depth of damage. Widespread business disruption has already made the situation worse with particular regards to liquidity for some entities.
This can spiral into a domino effect and impact credit quality and hugely deteriorate the expected credit loss (ECL) estimations.
There are multiple factors which play a role in affecting the ECL.
- Industry wide ECL study needs to be done to understand the varying degree of coronavirus impact across sectors to better define the borrower’s profile.
- To understand macro-economic factors and how it affects the NBFCs and their borrowers.
- Fresh valuation of collateral being held to have a cushion to fall back on.
Apart from these important factors the entity will also have to see ahead of the crisis. To calibrate their ECL their business model must be relevant with the severely uncertain and volatile market situation. These are critically sensitive business decisions and even the slightest of error can cause damages to the macroeconomic extent.
Evolution of Fair Value Computation
All financial institutions give loans after taking them from a bank, in case of national banks they take loans from central banks and that gets passed onto us the borrower. Fair Value needs to be computed on the time of granting of such loan, on the entity’s holdings. This also includes the macro environment and investment specific value drivers.
Now I have talked about having a good credit quality before as well, however what is of particular concern in this case is the severe fluctuation of such values. Now because of such inaccuracies in knowledge of even the companies, it brings a problem while making critical assessments and judgements for measuring fair value. The onus of determining what conditions and corresponding assumptions were known to market participants is of immense importance.
Thus gauging the current market value of any asset or otherwise becomes practically impossible furthering causing accounting breakdowns.
A Grim Future
In the last few years, a lot of fintechs have sprung up across the nation. They all have incredible funding and industry leading backers such as Softbank and Y Combinator, yet all of them have been reporting losses over this course of time. Now granted, these are times of ebb and the same is being reflected in the market data as well. However, what cannot be ignored is the changing mindset of the individuals and businesses.
Businesses are willing to be less reliant on funding and more reliant on generating long term cash flow. That will greatly affect the NBFC industry.
No matter what, with tactful planning and careful execution there will be a way out and a market to capture. Changes are needed but that is only expected after severe market failures the likes of which we have never witnessed before.