What’s next for NBFCs after the music has stopped?

The current crisis in the Indian NBFC (non-banking financial companies) sector has cast a serious question mark on whether the present model whereby non-banking institutions borrow money short-term to lend for long-term projects or assets has run its course.

In the aftermath of debt defaults by Infrastructure Leasing and Financial Services (IL&FS), liquidity in the entire NBFC space has suddenly dried up. While the relatively lesser-rated institutions find themselves struggling to raise funds, the more well-known ones are also bearing significantly higher cost of liabilities.

This is in stark contrast to the situation somewhere around 2017 when the NBFC sector was booming. With the system being flush with liquidity post demonetisation, NBFCs had no challenges whatsoever in raising funds at competitive rates via commercial papers sold to mutual funds. These funds were then used to finance everything from homes to working capital loans and even consumer durables. These NBFCs were filling in the gap left behind by traditional banks that went slow on lending as they focussed on cleaning up their existing books that were riddled with non-performing assets.

But the maths isn’t adding up any longer and in the absence of a liquidity window, which the NBFC sector has been demanding from the central bank for some time now, fresh disbursals are slowing down, even as the focus shifts to recovering existing receivables.

The present situation has proved enough ground for some unusual alliances to be considered. One such is Indiabulls Housing Finance Ltd’s (IHFL) proposed amalgamation with Chennai-based Lakshmi Vilas Bank (LVB). The intention to combine the two entities was first announced in April and the proposal is still awaiting the Reserve Bank of India’s (RBI) nod.

From LVB’s perspective the rationale behind the deal is clear. It is bleeding and desperately needs a partner with a bigger balance sheet and capital (IHFL has around ₹21,000 crore of cash on its books). But why on earth would IHFL, India’s second largest non-bank housing finance company after HDFC, consider joining hands with LVB, which is besieged with bad loans and was on the verge of being recommended for Prompt Corrective Action (PCA), that would have forced the bank to put a pause on fresh lending?

The answer is simple: A low-cost and sustainable source of funds by way of public deposits (₹30,000 crore to be precise), which IHFL – like many other NBFCs – isn’t allowed to otherwise raise. When a non-bank lender like IHFL – with a balance sheet size of ₹1.28 lakh crore, loan assets of ₹1.24 lakh crore and net worth of ₹17,792 crore – contemplates a step such as this and doesn’t even mind taking on the NPAs on LVB’s books to access funds, the writing on the wall is clear. The current NBFC model has indeed run its course and there is no more cheap debt to be raised, which can help roll over existing borrowings. The music, in that sense, has stopped for now.

That’s not the only compromise that Indiabulls is ready to make. It is well-known that the RBI isn’t favourably disposed when it comes to issuing banking licences to entities with a high degree of exposure to real estate. That could have been one of the reasons why Indiabulls’ application for a universal banking licence wasn’t accepted a few years back.

To assuage the central bank’s concerns, Indiabulls – led by Sameer Gehlaut, an aggressive, first-generation entrepreneur– is even willing to divest its real estate development arm altogether. It has already reached an agreement to sell its real estate assets comprising commercial and residential projects in markets like Mumbai, Chennai and the National Capital Region to Bengaluru-based property developer Embassy Group and private equity firm Blackstone. Furthermore, IHFL, which has made a killing in the past by lending to real estate developers by way of project finance, will also cease lending to such projects, if it can convert to a bank, and focus on ensuring repayments to water down the existing book.

If the IHFL-LVB deal goes through then Gehlaut will become the principal promoter of the bank with a stake of around 19.7% in the combined entity. RBI’s regulations prescribe that promoters of a bank need to eventually, over time, bring their stake down to below 15%. Gehlaut is even willing to bring down his stake to below 15% in the merged entity immediately.

Also, given the central bank’s hesitation of late towards promoters continuing as executive heads of banks, Gehlaut is ready to give up his executive position and remain a non-executive director (perhaps part-time chairman) on the board. Gehlaut, currently, is the executive chairman at IHFL. Apart from the compensation he draws as executive chairman, he earns around ₹400 crore annually by way of dividend due to his 21.5% stake in the company. Becoming the non-executive promoter of a bank that will be directly supervised by RBI might substantially curtail his power, as well as the dividend and compensation that Gehlaut gets, since the RBI has stringent policies in these matters.

Indiabulls Lakshmi Vilas Bank, as the combined entity is proposed to be called will be the eighth largest bank in the country by account of a consolidated balance sheet size of around ₹1.5 lakh crore. Ajit Mittal, executive director, IHFL, says that the proposed bank will focus on lending to small and medium enterprises (SMEs) that have found it difficult to access growth capital from traditional banks in the past owing to inadequate means of assessing their creditworthiness. Mittal says Indiabulls has been lending to SMEs against property successfully and will utilise that expertise to grow the SME book at the bank. IHFL also prides itself on its expertise in debt recovery and plans to use its capabilities to help the bank recover money from existing defaulters.

But the merger isn’t a done deal yet and everybody is keenly watching the RBI’s stance in this regard, as that is likely to set a precedent for the future. Since the RBI framed clear rules in this regard in 2016, two such deals involving a bank and an NBFC have received the regulator’s blessings. IndusInd Bank acquired Bharat Financial Inclusion earlier this year; and Bandhan Bank acquisition of Gruh Finance is work-in-progress.

However, the central bank – led by governor Shaktikanta Das – may find itself in a tricky spot vis-à-vis this merger, the proposal for which is at its doorstep. On one hand, allowing the merger to go through may help resurrect LVB. On the other hand, this would mean allowing IHFL to become a bank which could go against its own principles of not allowing entities with exposure to real estate enter mainstream banking. IHFL, in particular is an entity that had earlier unsuccessfully applied for a licence. So that would play on the regulator’s mind as well. Moreover, IHFL has been in the eye of a controversy recently due to allegations of corporate misgovernance against Gehlaut. Even as IHFL’s stock price plummeted, the allegations were later withdrawn by the complainant.

There is an emerging line of thought which says that central banks should get systematically important NBFCs to convert to banks in larger public interest. This will bring them under the RBI’s direct supervision and help keep a check on them. Who knows? It might also prevent an ‘IL&FS-esque’ financial misadventure and crisis in the future.