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Financial institutions are the backbone of any economy. Their robustness, agility and depth are critical feeders for economic growth. Empirically, financial services typically grow between 1.3-1.5x of GDP growth across economies. However, the Indian financial ecosystem has had a challenge of trust and perception which has got exacerbated over the past few years. As the sector was emerging from the challenges of a huge NPA backlog, growth slowed down, as a result of lower growth in GDP. A series of defaults at IL&FS, DHFL and, Yes Bank, and the Supreme Court verdict on telecom AGR revenues had a debilitating impact on banks. Repercussions were evident in the bond market, where yields of most banks/NBFCs in India hit historical highs. Just as the Yes Bank issue was getting resolved, the sector got whiplashed by the Coronavirus pandemic.
The impact of the Coronavirus pandemic on the global economy is likely to be significant and widespread, given that nearly half the global population is under lockdown. Various research houses have predicted global growth between zero to 0.5%. India too will be significantly impacted. GDP growth in India may witness contraction in Q1FY21 and on an annual basis is likely to be about 3-3.5% for this fiscal. Governments and regulators across the globe have responded with fiscal and monetary responses to the current crisis. In India, the first of many likely fiscal responses (aggregating USD 22.5 billion) was focussed on supporting those in need of humanitarian assistance. Monetary response from the RBI was focussed on providing liquidity to the system and providing a moratorium on loan servicing. The RBI action has ensured that there is comfortable system liquidity (~USD 35 billion as on March 31) and borrowing costs continue to be low. Government action of cutting deposit rates on saving schemes like PPF and Post Office deposits is targeted to ensuring better transmission of lower rates. Nonetheless, India is likely to have a slippage in its fiscal deficit from its budgeted target of about 1.5-1.75% due to higher spending and lower GDP growth.
The Indian financial ecosystem will bear a significant brunt of this economic dislocation. The immediate challenge for most banks and NBFCs is Asset Liability Management. With no collections from borrowers due to the RBI moratorium, the solvency of most lending institutions is likely to get tested. Liability management at a time when the collection from assets is negligible is going to be a significant challenge. While banks can access Long Term Repo (‘LTRO’) funds (the RBI has earmarked INR 1 trillion for this purpose), the challenge is more pronounced for NBFCs. It is estimated that ~55% of the liability base of NBFCs comprises market borrowings on which there is no moratorium. Servicing these is going to be a huge challenge given the low probability of raising fresh borrowings. Mutual funds, one of the largest financiers to NBFCs, are unlikely to take fresh positions given the general risk aversion and likely redemptions requests from their mutual funds itself. This poses serious liquidity management challenges and chances are that a few lending institutions will have to dip into their capital to finance this phase. This of course precludes institutions with strong parentage which are well capitalised. Disbursal growth is also unlikely in this environment in the absence of any significant private investment, save for a short-term spike in working capital loans once things start to normalise and as the supply chain restocks and replenishes inventory.
Post the moratorium, the quality of the asset book is likely to get tested to the hilt across the financial ecosystem. Most borrowers across the spectrum, be it mortgage loans, vehicle loans, personal/consumer loans or SME loans, will have a challenge on repayments. The likely job losses coupled with income and wealth impairment will been widespread across industries and will disproportionately impact self-employed professionals, SMEs and the urban poor. NPAs of most lending institutions are likely to increase by 200-400 bps across the board and Return on Equity for most such companies is likely to drift significantly lower (~400-500 bps). The challenge will be greater for some private sector banks and NBFCs which were grappling with a trust deficit even before the pandemic. The current scenario is likely to exacerbate their woes. Recently, a flight of deposits from some private sector banks was a manifestation of this trend – prompting the RBI to issue an advisory against it.
Most constituents of the Indian financial system will need to be recapitalised. Capital, both public and private, will chase high quality franchises in this environment. Historically, Indian financial services have attracted capital on the back of high growth and superior return metrics. Muted disbursals and asset quality impairments will cause a significant reset in valuations – both in the public and private markets. With the IPO markets being extremely unpredictable in the foreseeable future and access to credit lines becoming a challenge, we are likely to witness structural consolidation within the industry. Participants with stronger balance sheets are likely to view this as an opportunity to acquire new customers, and /or expand verticals or territories to shore up their market positioning.
Going forward, it is likely that the RBI may come up with a dispensation providing flexibility in NPA recognition and provide further flexibility in loan repayments at least for individuals and SMEs. With low crude prices and a benign interest rate environment, financing costs may not increase although the availability of capital is expected to become scarcer and more demanding. The market is likely to get fragmented and with a large divergence in funding costs depending on balance sheet strengths and business mix.
For any financial institution, the customer’s perception is its reality. Trust is earned over decades and perception can be the biggest enemy of trust especially in uncertain volatile times. The ability to navigate these turbulent times and retain customers will differentiate the winners in the marketplace. The financial ecosystem, specially lending businesses, will have to undergo more pain before things start improving and hopefully lead to the emergence of stronger, well capitalised financial institutions.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy of the company.
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