Financial sector in the county is under pressure as key income driver for banks, non-bank finance companies (NBFC) and insurers face the heat.
The first line of pressure is on the banking sector. Pressure from the banks come from shrinking net interest margins, declining income from investments and the need to make provisions on non-performing loans. However, accretions to NPAs (non-performing assets) appear to have been contained.
NIMs ( the spread of the interest earned and the interest expended by the bank) are an average of 2.7% for the industry as a whole. Private sector, however, had higher margins of 5% and above, with some exceptions. But the bulk of banking sector comprises of the public sector.
Therefore, the averages tend to be low. Besides, banks recognise incomes only on a realised basis. For the financial year ended 2019, NPAs were Rs 3.55 lakh crore, according to the Reserve Bank of India’s DBIE database, which remains the authentic source on Indian banking. That would translate into about 3.7% of the total assets of the banking sector.
Although there has been writedowns, that include transfers to vulture funds or asset reconstruction companies, the shotgun merger of the banks and the quick gun recovery approaches have worked mitigating the capital requirement of the banking sector.
Yet there may be more trouble coming from the real estate and the shadow banking sectors. The real estate sector has used bank finance to the maximum extent possible. In fact, the real estate sector managed to bypass the sector exposure limits by utilising the unregulated non-bank finance sector where such limits are at best advisory in nature and never mandatory.
With real estate sector facing recessionary conditions evident from high inventories, builders are faced with liquidity pressures. The high costs have deterred potential home investors, and the reduced interest rates during the last few seasons have failed to enthuse demand. As far as lenders are concerned, apart from lending risks, there are fears on the mandated loan to value ratio deterioration.
Present convention is that the value of the collateral is required to be at least 150% more than the loan. However, with the inventory load, and expected price correction, the collateral value is expected to be far lower than the mandated number.
In the event of a Rs 50 lakh loan, if collateral value sinks below the loan value, bankers would need to recall part of the loan to conform to the ratio or seek additional collateralisation. Neither of these situations are likely to materialise. The safe option, therefore, was to restrict lending to the sector, which is precisely what appears to have occurred.
Since realty debt repayment is essentially raised from bank credit to retail credit to buyer, reluctance to purchase at prices even at low-interest rates, would sooner than later translate into credit delinquency of the real estate sector. But realty has also drawn funds to from shadow banking sector to bypass credit limitations from the banking sector.
The shadow finance sector however also relies to a large part on refinancing from the banking sector. Therefore, a default in the realty sector is likely to quickly infect the shadow banking sector and in turn the banking sector. Dewan Housing Finance was a case in point last year. It is a reflection of these expectations that have pushed banks, mutual funds and even NBFCs into the government securities, away from loans that are presently treated as high risk.
Preferred securities are one year and ten-year maturity government bonds, in view of the high liquidity. The effect of this preference is that one yield on treasury bills at 5.1% is at least 100 points less than one year deposit rates of 6.4%-6.25%.
For the insurance sector, the downtrend in the government securities yields have created both opportunities and problems. The insurance sector, especially the non- life sectors to offset the high claims ratios, rely heavily on investment incomes both trading and interest flows. However, reduced coupon flows on new securities in line with falling yields means insurer incomes are affected.
In the short term however, trading incomes have increased. For the life insurers sector, investments are biased in favour of long term bonds. That is because life insurers’ liabilities are long term, therefore assets are also long term.
However, yields at the long end have also dipped. Ten-year bond yields are level with one-year deposit rates. The opportunity is to shed the securities at a premium to face value, which is what happens with bond prices going up.
On the flip side, it means that on securities, the interest flows, as reflected by the coupons, shrink with an inherent risk of portfolio depreciation in the event of liquidity demand escalates. Such a scenario could impact solvency of insurers, though insurance is yet to be marked to market regime for asset valuation.
As for NBFCs, the regulatory focus is shifting to them. Presently, shadow banking is loosely regulated. Post ILFS, though, the regulators’ perceptions have undergone a sea change, refinance terms from banks have tightened.
Alternative methods of funding, through intercorporate borrowings or through bond issues, have also tightened. There are few takers for NBFC bonds even on a full recourse basis unless there are big names or public sector institutions like the Power Finance Corporation or the Indian Railway Finance Corporation.
In an environment of risk aversion, therefore, the Price Earning multiple may not necessarily be the right matrix to forecast investor returns. Seen from a different perspective, the PE multiple essentially conveys the period needed for amortising investor returns on the basis of earnings alone. A multiple of 25 is therefore too long. Wasn’t it John Maynard Keynes who said: “In the long run we are all dead.”