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Act now or repent later: the NBFC crisis

If the NBFC crisis starts heading towards financial contagion, it's better for the government to act sooner rather than later

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Or it could even be Repent Now and Act Later. In fact, that's more likely. If financial crises of the past are any guide, then authorities generally act as well as repent. The only problem is that they do the two at the wrong time and in the wrong order. There can be few investors who are not aware that for the past many months a kind of a low-intensity crisis has been building up amongst NBFC (non-banking finance companies). It all started with IL&FS last year, when the precariousness of that company's financial situation was discovered to be much worse than known. Now, another suspect NBFC, DHFL, has been found to be unable to fulfil its debt obligations.

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Could this become a much bigger crisis? Among people in the financial business, the dreaded word 'contagion' is now being mentioned quite regularly. So what is contagion and why is it so dreaded? The dictionary defines it as 'the communication of disease from one person or organism to another by close contact.' In this context, that would appear to mean that the ILFS' problem was one of the causes of DHFL's problem. That sounds like a suspect idea but it's not. The question to ask is that if, hypothetically, the ILFS crisis had not happened and if ILFS was a healthy company today, would the DHFL crisis still have happened? The answer is probably no. If banks and debt investors had not been frightened by ILFS, it's quite likely that DHFL would have been able to raise the funds to weather the storm.

So that looks like contagion, but mild contagion because DHFL was already suffering from the disease. Real contagion would mean that perfectly healthy NBFCs would start having problems raising money and would get into trouble. From that, non-financial companies may also start having trouble raising finance and there may be a general business crisis. In fact, that's exactly what happened in the US, triggering the 2007-2009 financial meltdown. The chances of anything like that happening in India at this point are remote, but not non-zero.

As always, the time to stop such problems is better earlier than later. There are some news reports that the government is not inclined to interfere and would prefer the problem to sort itself out. Presumably, this means that weak NBFCs should fail and their investors take losses. This amounts to a certain confidence that no contagion can take hold. One hopes that such confidence is not misplaced.

As it happens, investors in debt mutual funds have been having a preview of such a crisis for a few months now and that's something I've been watching closely. There are two opposing ways of looking at their problems and its instructive to seperate them out clearly.

The top-down approach: All investors must be aware of the statutory warning that is delivered with mutual funds, which says, in part, that their investments are subject to market risk. Debt mutual funds are not banks so there is no promise and no contract that the NAV will never decline. Investors who expect that are mistaking what usually happens (no losses in debt funds) with what will always happen. No matter what the investment process that is followed, and what the track record, investments can always go wrong.

The bottom-up approach: Debt funds, have always been sold as being virtually zero risk. In fact, when bank customers go to a bank to make a fixed deposit, they're often diverted to certain types of debt funds. The fact that an overwhelming proportion of debt fund investments never have any problems is no comfort for those investors who do have problems.

Some of you will gravitate towards the first argument and some the second. In my view, to earn higher returns, a little bit extra risk is needed and one cannot really complain if that risk comes home. However, a risk to the larger system is a different matter. If risk threatens to become a chain reaction and itself becomes a cause for greater risk, then someone needs to pause and think hard.

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