By Taponeel Mukherjee
Events in India’s credit market over the last one year have once again shown that debt used well is a value creator, but excessive debt can lead to severe problems. The crucial point to keep in mind is that well-structured lending institutions in the credit space are much needed to aid a rapidly growing economy, and, therefore, strategies that will help create such companies are worth analysing.
In general, the significant learnings from any credit or liquidity crisis are mainly around the three issues of poor lending standards, a mismatch in the asset-liability structure of the lenders and credit ratings not reflecting the embedded credit risk in the financial securities in question. While the last two factors primarily drove the recent Non-Banking Financial Company (NBFC) crisis in India, a thorough understanding of all three elements is key to structuring profitable and, more importantly, robust lending companies.
For NBFC operators and investors in India to indeed generate the next phase of growth, asset securitisation will have to play an ever-increasing role. The utilisation of lower cost balance sheets along with greater securitisation will boost credit expansion and access. However, an improving asset-liability profile must balance the increased securitisation and usage of larger low-cost balance sheets by the NBFCs.
Lenders, and specifically NBFCs, take advantage of an upward sloping yield curve (though not always the case) to borrow in short-dated tenors at relatively low-interest rates and lend for longer tenors, thereby capturing the interest rate differential for profits. The flipside is that when credit markets are illiquid, a lot of lenders are unable to refinance their borrowings.
Going forward, NBFCs must bridge the asset-liability maturity gaps. Bridging this asset-liability maturity gap means the NBFCs need to borrow for a longer average duration than they do at present to create a more stable liquidity profile and a more robust balance sheet capable of dealing with tighter credit conditions. Of course, borrowing for longer terms will reduce the interest rate differential earned, thereby reducing profits. However, the reduction in profitability will be more than made up by additional strategies that a more robust balance sheet allows.
Asset securitisation will have to play an ever-increasing role along with the use of higher-rated and, therefore, lower cost balance sheets to generate the next phase of growth for NBFCs in India. The ability to utilise a lower cost balance sheet to deliver more credit will mean that for a given investment return from a financial security, a lower cost of funding will translate into higher profits for the lenders.
The more significant role by asset securitisation is especially true for non-Priority Sector Lending (PSL) securitisation. According to CRISIL, the share of non-PSL assets in retail securitisation stood at 42 per cent in fiscal 2018. Going forward, the percentage of non-PSL assets will have to get a further boost.
Another vital question is how can we utilise highly-rated and robust balance sheets to bring down the cost of funding? The lower cost of funding can be passed on through the NBFC towards generating a more valuable business and providing greater access to credit.
Lower cost of financing through high-quality balance sheets is crucial for NBFCs as they use more securitisation to generate business since the low funding cost does not force them to lend to riskier borrowers to make up for higher wholesale funding costs. The issue around riskier lending practices to compensate for higher wholesale borrowing costs is a pitfall that NBFCs must look to avoid.
“Partnership structures” between NBFCs and large institutional capital providers through a variety of avenues is a must. The first of which is where the NBFC will be in the traditional role of a lender, whereby a component of the portfolio sits with the NBFC, while the NBFC securitises the rest of the portfolio and passes on the risk to the institutional capital provider.
An alternative model could be wherein the institutional investor, in addition to investing in the securitised portfolio, also takes a partial equity stake in the NBFC. The securitisation portfolio gives the investor access to the bond-like investment returns that institutions such as insurance companies, pensions and endowments require, and the equity ownership helps align incentives between the NBFC and the capital providing institution.
There are heated debates around the merits of securitisation. The critical component to keep in mind is an investment strategy that looks to reduce the refinancing risk for NBFCs to boost securitisation and lower the cost of funding is one that seeks to maximise the long-term value that credit access provides to investors, consumers and businesses.
(The views expressed are personal. Taponeel Mukherjee heads Development Tracks, an infrastructure advisory firm. He is reachable at [email protected] or @Taponeel on Twitter)