The road ahead for banking and NBFC sector

The road ahead for banking and NBFC sector

Article taken from Business Lines dated 4th Nov 2019

By Mahesh Patil

The government and the RBI should work together to get the lending cycle back on track

Credit is like the lifeblood of the economy. A streamlined credit cycle, with a smoothly functioning banking and NBFC sector, is imperative for a high-growth economy such as India. It has been a year since the default by a large financial institution took place, leading to tightening of credit in the country. This has been followed by issues cropping up in a few other names in the banking and NBFC sector. In response, even as the system liquidity is in surplus, banks have tightened their credit evaluation standards. Consequently, credit growth has witnessed a sharp deceleration to about 9 per cent y-o-y in September 2019.

There is risk aversion in the system — banks just don’t want to lend and are content parking money with the RBI’s reverse repo window. A large number of NBFCs, real estate developers, and MSMEs are not able to access financing, and the few that are able to, face higher spreads.

Winning Trust

Given the trust deficit prevalent currently, it is imperative for the RBI to provide some comfort on the quality of the underlying NBFC book. Since a resolution of the troubled names is crucial to get the trust back into the system, the RBI can also take inspiration from the troubled asset relief program (TARP) of the US government to purchase illiquid and difficult to value assets as well as equity from troubled financial institutions.

In addition, although the RBI has reduced its policy rate by 135 bps so far in 2019, rate transmission has stalled and the gap between the repo rate and the lending rate is inexplicably wide. However, the RBI has now directed banks to link their lending rates to the repo rate. There could be a further decline in the lending rate over the next six months as the recent repo rate cuts flow through.

The key issue is that the money multiplier has been falling since September 2018, and the M3 growth is now below 10 per cent y-o-y.  A reduction in the velocity of money and lack of money rotation in the economy have led to a slowdown in the economic growth. In response, the government has announced a series of measures aimed at releasing liquidity into the system, such as clearing its outstanding dues and paying out GST refunds. It is also working on getting the credit cycle back on track with the continuing recap of the PSU banks and encouraging them to lend to NBFCs and MSMEs.

Overall, a coordinated effort from the government and the RBI should help get the banking and NBFC sector back on track.

Consolidation in NBFCs

In the NBFC sector, consolidation is underway. There is a lot of stress in NBFCs which are focused on mortgage finance and developer finance. Asset quality issues are cropping up and liability side challenges remain for many of these NBFCs, impacting their competitiveness and viability.

At the same time, NBFCs that have more retail-centric lending, catering to segments which are under-penetrated and not catered to by banks, should continue to do well. They can manage their spreads much better, despite costs going up in the recent times.

Also, those which have a strong liability franchise owing to strong parentage will do well in this environment. That differentiation has already started to play out. There is a second tier of NBFCs that are healthy in asset quality but not as strong on the liability side. They should start performing once the liquidity situation improves.

Going forward, private banks with a good retail mix should continue to do well as they gain market share. Banks are betting on a monsoon-aided revival in rural economic growth, as well as festive season demand, for healthy credit growth. With the recent cut in corporate tax rates, especially for new investment in manufacturing, companies are evaluating new capex projects which should also drive credit growth for some banks. Credit demand is coming in from roads, oil and gas and other sectors.

The tax cuts have given some downside protection to the market. Without them, the market could have fallen further. So, while the bottom of the market has been taken care of, the upside will depend on several factors — how the NBFC situation is resolved, how demand fares during the festive season, and so on.

However, some of the NBFCs and banks, which have seen sharp correction, offer opportunities for investors as they have come down to a level where their valuations look attractive, given their growth, margins and ROEs. They could offer good upside to long-term investors once the dust settles down.

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