Hungry for market share, lenders have failed to cover their risks adequately while promoters have bent the rules
One needs to respect the professional judgment of mutual fund managers when it comes to any stand-still agreements they may enter into with borrowers. After all, if the NAV of a scheme falls because the fund manager didn’t sell the shares in time, and the price tanks, the reputation of the fund will be at stake. However, that RBI is frowning on such an arrangement is not surprising. The regulator’s concerns revolve around the chances of such unhealthy practices triggering a liquidity crisis in the financial markets. One default is enough to shatter investor confidence and trigger redemptions from MFs. That would compel MFs to sell equities or bonds at sub-optimal prices or to recall loans to borrowers. And we have not even begun to dwell on the exposures to real estate. RBI is worried because, according to Prime Database, banks account for a not-so-low 15% of pledged shares transactions while NBFCs account for an uncomfortably high 40%.
Even otherwise, by not selling the pledged shares in the market, the price of the stock is being artificially held up as is the NAV of the scheme. It is surprising that Franklin Templeton agreed to do this in the case of some ADAG Group shares because it is misleading to investors; any kind of evergreening is. Already, most bonds are not valued correctly because the bond markets are so illiquid; while the outstanding value of corporate bonds was Rs 29.5 lakh crore, trading volumes in December were close to Rs 41,500 crore. The unrealistic valuation means there is no commensurate increase or decrease in yields on certain classes of paper.
While pledging shares is, in itself, not harmful, the disclosures have been very inadequate with promoters camouflaging the true quantum of shares pledged. So, while the official data may show that the share of pledged promoter holdings—within the BSE 500—was just 6.7% in the December quarter and similar to that in the September quarter, the truth may be quite different. The Securities and Exchange Board of India (SEBI), which regulates mutual funds, needs to figure out how to ensure promoters disclose the true value of the shares pledged. Also, SEBI must insist on a big-enough cushion in terms of the loan-to-value ratio of at least 1:5 or better.
While bankers and fund managers must take their own investment decisions, it is also true credit rating agencies are simply not able to give lenders a good enough assessment of the state of a company’s finances. More critically, they’ve been very late to spot any turn taken for the worse, as was the case with IL&FS which should have been redflagged a year back, if not earlier, and, by then, the damage has been done. It is possible the lenders, too, don’t always want a realistic rating; in the case of banks, for instance, they would need to raise the risk weights and set aside additional capital which would push up their costs. So there is, at times, a cozy relationship between lenders or investors and rating agencies. And this perception that ratings can be tweaked could cause a loss of trust which will hurt all lenders and mutual funds until ratings agencies show us they can be a lot more capable.
In many ways, this is the price that an economy pays for growth. Banks, NBFCs, mutual funds, and insurers are all hungry for market share and, in the process, tend to bend the rules. The markets must evolve and disintermediation in the financial markets is needed but the NBFC sector has grown way too fast for its own good and this disproportionate gain in asset share—especially in real estate—threatens to upset the ecosystem. As Jefferies has pointed out, while core developer loans—relatively more risky—have grown at 18% between 2014-15 and 2017-18, the portfolio for non-banks grew at a high 46% while for banks it increased just 4%. As a share of total credit of NBFCs and HFCs, the mix of total developer loans increased from 6.2% in 2014-15 to 10.7% in 2017-18. Builders today are sitting on large inventories and little cash.
The fact is, India’s bond markets aren’t deep enough to absorb a big liquidity shock. And with the stock markets having performed so poorly for more than a year now—80% of all stocks with a market cap of Rs 1,000 crore or more in January 2018 are now in the red—even HNIs who may otherwise have invested in stocks or bonds will think twice. Should there be a crisis in the market due to this, the sad fact is that the regulating system—RBI and SEBI—has been caught napping once again. SEBI hasn’t monitored whether adequate disclosures were made about loans-against-dues—and their impact—and while RBI has flagged risks in the past, it raised risk weights on loans to NBFCs to 150% only on Friday.
For now it would be prudent to let the market correct and let some NBFCs or Mfs fail; only then will there be some correction. This will lead to many M&A opportunities—we have already started seeing these—and the stronger players will be able to pick up assets at attractive prices. A purging of the system can’t hurt; in fact, it will make it stronger.