India's nonbanking financial companies, once a major strain on the nation's financial system, may have put the worst behind them as enhanced liquidity, regulatory measures and resilient asset quality puts many of them in a stronger position than they were at the start of the year, analysts say.

Several months into the coronavirus pandemic that upended India's economy, the country's nonbanking financial company, or NBFC, sector is faring surprisingly well, a turnaround that seemed unlikely at the start of 2020. The shadow banks have managed to raise more capital and banks have increasingly started lending to the sector in recent months after scaling back amid defaults and scandals that plagued some of these nonbank lenders since 2018.

Fundraising by NBFCs in the short-term money market surged nearly 15 times between April and August. They raised 636.77 billion rupees in August selling commercial papers, compared with just 42.75 billion rupees in April, according to data from the Department of Economic Affairs under the Ministry of Finance.

Bank credit to NBFCs was up 17.1% year over year to 7.968 trillion rupees in August, outpacing the 6.0% increase in overall lending in the month, according to data from the Reserve Bank of India, or RBI. However, outstanding loans to the NBFC sector are still down 1.3% so far in the financial year that started April 1, latest numbers from the central bank show.

"The outcome [for NBFCs] seems to have been much better than what we were fearing," said Nidhesh Jain, an analyst at Investec India. Bond issuance by NBFCs has recovered and coupon rates have crashed by as much as 200 basis points in the last six months for top-rated NBFCs. Even small and medium-sized lenders have seen improvement, though the top NBFCs have benefited "disproportionately higher," Jain said.

The asset quality fears at the start of the year did not play out as initially estimated, with many sectors of the economy recovering from the blow of the pandemic and the strict lockdown imposed to check the spread of the virus, Jain said, adding: "The worst is definitely behind for most NBFCs."

Key role

NBFCs play an important role in the Indian financial system. They complement banks in extending credit to the economy and are often the primary lenders to small and medium-sized businesses. They also fund infrastructure projects. The total assets of NBFCs and housing finance companies stood at 44.4 trillion rupees, which is about quarter of that held by commercial banks, according to a July 24 RBI report.

Liquidity had become a challenge for NBFCs after the government took over debt-laden Infrastructure Leasing & Financial Services Ltd. in 2019 to prevent further defaults and avoid systemic risk in the financial system. The crunch continued into the first few months of this year as the sector was hit by COVID-19. A moratorium placed on YES Bank Ltd. added to the drag.

"Both these events had frozen money markets. Since then, bond issuances have eased up significantly and across rating categories. Banks are also supporting NBFCs with more liquidity and interest rates have come off as well," Nirmal Jain, chairman and CEO of IIFL Finance Ltd., told S&P Global Market Intelligence.

Policy measures such as a 3 trillion rupees credit guarantee plan where the government will guarantee loans to medium, small and micro enterprises by banks and NBFCs has helped increase lending.

The central bank's governor, Shaktikanta Das, said in an August policy speech that "market financing conditions for NBFCs, which had become challenging, have largely stabilized in the wake of targeted policy measures."

The Indian economy, which contracted 23.9% year over year in the June quarter, is expected to recover and grow 8.8% next year, according to the International Monetary Fund. Business activity trackers such as Nomura's business resumption index and Jefferies recovery tracker have improved as India relaxed one of the strictest lockdowns to control the spread of the virus. The onset of the country's main Diwali festive season is expected to spur demand.

Business momentum is picking up and collection efficiencies are also improving, Jain said. "September has proved to be an important month where collection efficiencies have crossed 90% for several lenders and for others, the efficiencies have improved sharply since August," he said.

Overall, NBFCs are now better placed to weather the COVID-19 pandemic than was thought in April or May, he said. "At that time, several experts pointed out that some NBFCs would go under or default on debt due to liquidity issues. However, nothing of the sort has happened. NBFCs managed to consolidate their business, conserve cash, build liquidity buffers and focus on collections."

Jain believes that in the next six months, "disbursements will improve, collections will normalize and profitability of NBFCs will not be hit as badly as what was widely anticipated three to four months back." While there could be some lingering impact in the MSME and the vehicle finance segment, provisions made by NBFCs this year would help, he said.

Unequal gains

However, Hemant Kanoria, chairman of Srei Infrastructure Finance Ltd., cautioned that the uptick in fundraising by NBFCs has been limited to a few players, often those backed by the government or large industry houses.

"NBFCs operating in sectors like infrastructure financing, asset financing, offering loans to MSMEs have largely been left out as banks continue to avoid lending to these institutions. A thorough analysis will probably reveal that the fundraising exercise did not happen across the sector and most NBFCs continue to experience difficulties in raising resources," he said.

Following the IL&FS episode, "many NBFCs have been facing a liquidity crunch as their resource-raising capacity got affected," Kanoria said in an email to Market Intelligence. NBFCs should be allowed to widen their funding sources and the asset side needs to be monitored closely to check bad loans, he said.

The RBI, which is seeking to increase its oversight over NBFCs, accepts that some issues still remain. "Vulnerability of NBFCs remains a concern. NBFCs are not at par with banks in terms of regulations. We don't want a repeat of the crisis in another NBFC," Das said at a meeting of a local industry association, according to a Sept. 16 Mint report.

Much may depend on the trajectory of India's economic recovery. "The only variable now is how the economic growth plays out. On all other metrics, NBFCs are in a sweet spot," Investec's Jain said.

As of Oct. 19, US$1 was equivalent to 73.35 Indian rupees.