The shutting down of six debt funds by Franklin Templeton is unfortunate at multiple levels. The collective assets under management or AUM of these six funds was over Rs 25,000 crore. The investors were largely retail and high net worth individuals and their money is now stuck — at least for 12 months if not longer.

Given the quality of assets and their current illiquidity, it is unlikely that people will recover the fund’s stated net asset value (NAV). After having successfully created a huge market for non-AAA corporate debt, Franklin Templeton has now marked the death knell for credit risk funds in India. We must brace ourselves for a slew of redemptions at credit funds, as investors are spooked and fear other fund houses may also close shop. Many of these funds are down 15-25 per cent in value terms currently.

The winding up of funds has taken away the biggest player in non-AAA bonds, and has effectively closed the bond markets to all but a handful of AAA-rated entities. Already spreads in the bond markets have widened dramatically and most bonds have turned illiquid. The ramifications of this are clear.

First, it marks the end of disintermediation. No longer will reasonable credits be able to bypass the banks and go straight to the capital markets to raise debt resources. The banks will become the only game in town for everyone except a handful of AAA-rated entities. This not only means pricing power for the banks, but also a return to the concentrated exposures and decision-making that marked the Indian financial system of yesteryears. The idea of building a vibrant corporate debt market was to decentralise and spread credit risk and decision-making, as well as improve risk-based pricing and enable innovation. Now, banks will become kingmakers, deciding in effect who will survive and who will fall by the wayside. Those who can access bank lines in size and at a reasonable cost will have an insurmountable edge over those who cannot.

Illustration: Ajay Mohanty

 
The non-banking financial company (NBFC) business model is now permanently impaired. If NBFCs cannot access the debt markets, and have to rely only on banks, they will struggle to scale and grow beyond a point. Their access to equity markets, with most trading below book, is also limited at the moment. Banks on their own cannot fund the growth aspirations of the NBFCs. They have limits on total NBFC exposure and most are already close to that level. With no access to debt markets, NBFCs will have no alternative but to shrink their books, and at best become origination engines for the banks. This shrinkage has already been underway since the Infrastructure Leasing & Financial Services Limited (IL&FS) crisis, but will accelerate now. The confusion around moratoriums has further muddied the waters for most. The NBFCs focus on borrowers who cannot get credit from banks (anyone who can raise money from banks will go there, given the funding cost differential). The scaling down of their business means the credit crunch will only intensify, especially among micro, small and medium enterprises (MSMEs) and higher risk borrowers, further weakening the economy.

The fundamental problem facing the financial system is risk-aversion. Banks are flush with liquidity. They have Rs 7 trillion currently parked with the Reserve Bank of India (RBI) in the reverse repo window at 3.75 per cent. It is not surprising that the targeted long term repo operations-2 auction failed. Why will banks borrow more money at 4.4 per cent, when they have trillions deployed at 3.75 per cent? The risk aversion is due to a fundamental breakdown of trust. After the IL&FS, YES Bank and DHFL fiasco, no one believes the ratings or audit firms anymore. Even among the AAA universe, there is a subset which can access money at reasonable rates and tenures, while most AAA cannot. The markets have created their own ranking of genuine AAA and the others!

There is risk aversion on both, the lending side and liabilities. After the YES Bank AT-1 bonds issue and deposit moratorium, there has been a flood of liquidity flow from mutual funds and smaller private banks to public sector units and the top three private banks. This money is effectively moving from players willing to underwrite risk (private banks and credit mutual funds) to public sector banks (PSBs), most of whom are just squatting on liquidity. The PSBs (excluding SBI) have structural reasons to be risk averse. Those willing to take credit risk have no liquidity, while banks that are overflowing with liquidity, do not want to take risk.

The only way to break this logjam is for the sovereign to take on the credit risk. The RBI — either directly or indirectly through Small Industries Development Bank of India, National Bank for Agriculture and Rural Development and National Housing Bank — has to put in place credit enhancement or credit guarantees on the loans the banks make to non-AAA borrowers, whether they be MSMEs or even NBFCs. Only then will the liquidity move to where it is most needed. This credit enhancement may be abused by some, but the mechanism can be fine tuned as we go along. At the moment, it is important to get credit flowing again, as opposed to finding the perfect construct. Again, banks do not need more liquidity from the RBI, they need the RBI or its agents to take the credit risk off their hands. They will only lend to or buy the paper of non-AAA entities if they are not forced to bear the credit risk.

Eventually, the situation may normalise and risk aversion reduce. However, we cannot wait for the current situation to play out. The damage to the economy will be too great because of this credit squeeze. The RBI and government have to short-circuit the fear and rebuild confidence in the system.

The mutual funds have to be provided the ability to sell bonds in an orderly fashion. The banks are the obvious buyers. They have the ability to buy these corporate bonds, yet they are baulking. It is clear that any scheme to save the mutual funds must acknowledge and address the unwillingness of the banks to buy the bonds on the books of the mutual funds. We cannot wish away the reality of extreme credit risk aversion in the system today. The corporate bond markets are defunct, smaller private banks are facing challenges on the liability side. The NBFC business model as we knew it will no longer work. Liquidity is building up in pockets which do not want to take any risk.

In the absence of sovereign support, the economy will suffer grievous damage. We have already gone through an 18-month credit crunch phase, and now it will only intensify if banks are not encouraged to lend to all reasonable credit-worthy borrowers. That will only happen if the credit risk is moved from the bank balance sheets to a sovereign entity. Simple liquidity support will not break the logjam. This reality is what the RBI and finance ministry must address. 

The writer is with Amansa Capital 



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