Bailout dilemma

Dewan Housing Finance Ltd’s (DHFL’s) decision to freeze premature withdrawal of deposits is the latest in a series of bad news coming from non-banking finance companies (NBFCs). The problems began in September last year when infrastructure finance company IL&FS defaulted on payments to banks and term deposits and failed to meet the commercial paper redemption obligations. It caused panic in the markets as it impacted banks, mutual funds and investors. A spate of rating downgrades over the past month has also stoked fears of a liquidity crisis, with a cascading effect on the broader markets, leading to the demand that the Reserve Bank of India (RBI) should extend a special credit line to NBFCs to help them tide over the crisis. Those who back this demand say without a dedicated credit line, the NBFC segment is going to sink, and they will certainly not be alone in that. The RBI’s own Financial Stability Report in December showed how the interconnectedness was increasing in the financial system. Mutual funds were the largest net lenders to the financial system, and NBFCs and housing finance companies (HFCs) were the largest net borrowers, the report said.

The asset liability mismatch is indeed stark and scary. Among the various players within the financial sector, NBFCs and HFCs together had a gross payable of Rs 13 trillion, whereas the receivables were only Rs 97,000 crore. The money due was mainly to banks and mutual funds. Supporters of a special credit line also say it is wrong to paint all NBFCs with the same brush. If they were really such a concern, why did the regulator allow more than 10,000 of them to come up in the system? Since the IL&FS defaults in September, the sector is now dependent upon its own cash flow, and that means the balance sheets would scale down. And it is but a matter of time before the real economy starts showing signs of a slowdown simply for the want of credit.

While the arguments have some merit, the RBI’s reported decision against a special borrowing window should be welcomed. Such bailouts can fuel the problem of moral hazard because other financial institutions may expect a similar lifeline in the future. After all, quite a few of them are highly leveraged mainly due to their reckless lending in the past — they lent to weaker companies, including the real estate sector, and the quality of the security is suspect. The tactics some of the NBFCs use to get marginal funding advantage by relying on short-term borrowing have led to the crisis. In that context, the RBI has done well to ask the management of large NBFCs to submit concrete plans, with specific timelines, for capital infusion and asset monetisation. The central bank is already keeping a tab on the liquidity position of these firms on a monthly basis and recently asked NBFCs with assets over Rs 5,000 crore to appoint a chief risk officer. There are several other questions on how a special window would work. For example, there is no clarity about the collateral against which the RBI would lend to the NBFCs. The RBI should thus try to focus on taking steps to address the structural problems that contributed to the crisis, instead of hurrying through a bailout package. The demand that NBFCs are regulated like banks, given their asset size and growth, is also a broadly valid argument.