ASIA

CONTENTS2

4Asian Investors Continue to Look

to GCC Despite Rising Geopolitical Risk

GCC Corporates Benefit from Asian Long Money

6Invest in Turkey: One Belt One

Road Already Helping Attract Capital from Asia

8Bank, NBFC Tie-Ups Create a

Path to Sustainability in India’s Financial Sector

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2 www.BondsLoans.com

GCC Corporates Benefit from Asian Long Money

The Chinese market, which has enjoyed unprecedented growth and gradual liberalisation over the past few decades, is becoming a destination of choice for many.

But investors searching for ‘safe EM’ credit are being forced to search further afield. After decades of booming growth, China’s economy is beginning to stutter. Between Q1 and Q2, growth slowed from 6.4% to 6.2%, respectively; January and February saw unemployment rise to 5.3%; retail sales dropped to a 13-year low of 7.2% in April, and the Caixin China General Manufacturing PMI slumped to 49.4 (anything below 50.0 tends to imply a contraction).

More concerning for investors is the rising default rates in the country. High-profile defaults across a variety of sectors – including the industrial conglomerate Jinggong Group and property developer Yinyi – have shaken investor confidence. The seizure of Baoshang Bank by the government in May, in response to alleged misappropriation of bank funds, has further marred the privileged position once enjoyed by Chinese bonds.

As appetite for Chinese corporate bonds dries up, GCC corporate bonds are beginning to fill the gap. Following the 2015 oil crash, the size of the GCC’s debt

markets exploded as the fiscal buffers provided by sovereigns evaporated and GREs were required to stand on their own two feet.

“Before 2015, many of these GCC corporates didn’t even have investor relations departments,” notes Oksana Reinhardt, Executive Director of EEMEA Trading Strategy at SMBC Nikko, “but since then the situation has changed – we now tend to see very detailed and sophisticated presentations from corporates at roadshows.”

The inclusion of GCC corporate debt into the JP Morgan EMBI, which is being phased in from 31 January to 31 September this year, promises to draw over USD30bn of funds into the region. Although these inflows are due to stabilise in September – making up around 12% of the index – both passive and active benchmark investment managers will have to pay closer attention to the region.

“Interest is GCC credit from Asia is definitely growing,” argues Reinhardt, “although Asian investors make up around 15% of all [GCC credit] trades, I spend over half of my time speaking to Asian investors.”

According to Hitesh Asarpota, Head of Debt Capital Markets at Emirates NBD

As rates continue to fall in many parts of Asia, investors have increasingly turned to emerging markets in their hunt for yield. But given their generally cautious and conservative approach

to investment, many have favoured so-called ‘safe emerging markets’. Now, as growth begins to soften in China, a growing number are turning their attention to the GCC’s corporate credit market to find secure, high-yielding opportunities.

Capital, investment flows from Asia to the GCC have picked up significantly.

“The general trend is an increase in demand and appetite from Asian investors. Ten years ago, Asian allocation made up less than 10% on bond transactions from the GCC, but this has changed in recent years. Now we see far greater participation from Asian investors.”

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counterparts. While investors in London tend to focus on technical factors – such as gearing ratios and CAPEX – Asian investors, often less familiar with GCC corporates, tended to ask broad-brush questions about the background of the business and its historic development.

Asian investors show particularly strong appetite for longer-tenor paper – a welcome panacea given the relative absence of an institutional investor base in the GCC. Over half of DP World’s recent 30-year bond, for example, was bought by Asian investors. Taiwanese investors often show some of the greatest interest in long-duration assets, due to the country’s sizeable insurance and pensions industries.

But not all GCC corporates have seen this recent surge in demand. For some leading corporates in the region, investment from the East is nothing new.

One Treasury official at a UAE-based property developer, notes that Asian accounts have made up a fairly steady proportion of the book across both conventional and sukuk issuances, varying between 10% and 20%.

Amr Aboushaban, Chief Investment Officer for Damac, echoed this sentiment.

“We are not looking more to Asian investors now than we did before – but that is because we have been involved with Asian investors for a while. Around one third of the book on our 2018, 2017 and 2014 sukuk was made up by accounts from the region.”

Aboushaban also noted that Asian money remains a linchpin of Damac’s funding strategy – particularly when it comes to sukuk.

“They are, in my view, one of the best investors you can have. They have a lot of capital to deploy and they often have a strong focus on high-yield strategy… We also see particularly high demand from Malaysia, for example, particularly for investment grade sukuk.”

As growth continues to soften in China and with ultra-low rates now the norm across much of the region, Asian investors look set to grow their exposure to the GCC’s corporates. Meanwhile, for corporates, this offers a vast pool of liquidity ready to be deployed.

The allocation of recent GCC issuances are testament to this. Emirates Development Bank’s USD750mn 5-year bond issued in February saw 42% of the paper snapped up by Asian investors. Almarai’s USD500mn 5-year sukuk and Emirates Strategic Investments Company enjoyed similar demand, with 23% and 33% going eastward respectively.

According to Asarpota, some GCC corporates may be inadvertently

making themselves more investible in the eyes of Asian investors.

“There is generally a growing awareness among GCC corporates who are cognisant of the increasing importance that investors are placing upon more frequent disclosure and on ESG considerations when making investment decisions. As such, GCC corporates are placing renewed focus on governance and revamping the disclosure in both their bond and sukuk documentation and their annual reporting, with several corporates now regularly issuing CSR reports.”

Making GCC Corporates InvestibleFor other corporates, Asian demand for their paper is growing steadily. One Investor Relations Manager at a major Dubai-based company, has seen growing demand from Asia.

“We began issuing again around 4 years ago. Since then, we’ve seen Asian accounts make up a growing proportion of our book on each issuance. Our most recent issue saw Asian accounts make up over 30% of the book – just a couple of years ago, they accounted for less than 10%.”

Others also concur. Until just a few years ago, DP World rarely visited Hong Kong and Singapore – now, they are crucial pitstops as the company looks to bolster its relationship with investors during its roadshows. Even corporates that haven’t seen a sharp uptick in demand from Asia still make regular trips to the region. One investor relations manager noted that their company only travelled to Asia when they were looking to issue, whilst they made far more non-deal roadshows to London and New York.

In part, the manager attributed this to a difference in investment strategies.

“Generally, investors in Singapore and Hong Kong tend to be more ‘top-down’ – they trust the fundamentals of the [GCC] region and trust in its stability. Western investors tend to hold more ‘bottom-up’ strategies; they are generally more sensitive to headline news.”

Another treasury official noted that the questions asked by investors in Singapore and Hong Kong often differed sharply from those asked by their western

4 www.BondsLoans.com

For Asian investors searching for returns across emerging markets, the GCC has long been considered a relatively low-risk, higher-yielding option. But with geopolitical tensions reaching a boiling point, and a number of GCC states fiscally exposed to oil price swings, former safe havens could become a riskier bet.

Asian Investors Continue to Look to GCC Despite Rising Geopolitical Risk

With ultra-low rates becoming the norm across many parts of Asia, institutional investors are looking further afield for high-yield opportunities, often turning to emerging markets.

Enter the GCC. Large bond and sukuk markets dominated by sovereign and quasi-sovereign names – which account for approximately 80% of issuance – have increasingly drawn the attention of both fund managers and institutional investors across Asia.

That institutional investment base is large and growing. According to a report from Willis Towers Watson, a consultancy, Japanese pension funds

held USD3.05tn worth of asset as of 2017, resulting in an assets-to-GDP ratio of 62.5%. South Korea also boasts a sizeable pensions industry, with USD725bn worth of assets, with a 47.4% assets-to-GDP ratio. Hong Kong’s pension system, meanwhile, manages USD164bn worth of assets, which equals a 41.9% assets-to-GDP ratio, and Malaysian funds hold USD227bn with a ratio of 73.4%.

But by comparison with many of their peers, Asian pension funds have typically been more conservative in their investment approach. As of 2017, for example, 56% of total Japanese pension fund assets were invested in

bonds, with 30% in equities and the rest in cash and alternative investments such as real estate. Australian pension funds, by comparison, have just 14% of their assets invested in bonds and 49% invested in equities.

“Historically, the GCC has been a natural place for Asian investors to engage with,” argues Todd Schubert, Managing Director and Head of Fixed Income Research at Bank of Singapore. “To a large extent, this is because of the ligatures with the sukuk market – there is a large Malaysian buyer base in Asia. Most roadshows from the GCC will come to Singapore and other parts of the region.”

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For risk-averse institutional investors in the East, the strong local bid within the GCC – where buy-to-hold strategies remain prevalent – is an additional benefit, insulating GCC credit from the volatility that often thwarts borrowers based in other EM jurisdictions. With around 60-70% of all credit in Asia originating from China, the GCC is a healthy avenue through which life insurers and pension funds can diversify.

According to one senior portfolio analyst, who handles institutional funds for a major Taiwanese life insurer, credit that is inherently tied to the sovereign is particularly appealing because of its implicit or explicit guarantee – hence the preference for the GCC, alongside select Latin American sovereigns and quasi-sovereigns.

Although GCC debt is well-received by Asian investors, there are not enough regular issuers in the GCC to fulfil demand from the east. In part, this is because of local banking sector is easily able to provide cheaper funding. But as sovereigns look to stretch the tenors they seek, they are increasingly being forced to look externally.

One fixed income analyst at Nippon Life, the largest life insurance company in Japan, explained that GCC sovereigns were appealing, and that over the medium- to long-term they plan to look in greater detail at GCC corporate debt. Currently, their mandate only allows a relatively slim proportion of their portfolio to be invested into the region – though the analyst noted that they are pushing internally to expand this limit

The long-term liabilities borne by Asian institutional investors are also beginning to dovetail with the longer-dated paper issued by GCC sovereigns as they continue to grapple with deficits and wide-reaching reform programmes that require robust external borrowing.

Growing HeterogeneityUntil around 2014, the GCC was often viewed as a relatively homogenous region. But the crash in oil prices exposed the degree to which economies across the region were dangerously yet unevenly unbalanced. Since then, as states

have embarked upon ambitious reform programmes (or didn’t, in some cases), the GCC is viewed with far more granularity than it previously had been.

But according to one senior portfolio manager, a number of Asian institutional funds often do not explore the idiosyncrasies of GCC debt; credit ratings remain a lynchpin of the investment process, dictating the portfolio selection process to a large extent.

As geopolitical risks in the Gulf continue to build, it is unclear whether these investors are cognisant of the potential economic damage on the horizon. One London-based fixed income analyst noted with alarm that geopolitical risk was yet to be priced into GCC credit and argued that it is politics, not fiscal issues, that poses the greatest issue to the GCC.

Geopolitics is the main driver that can potentially derail the region, Schubert argues.

“If geopolitical tensions continue, then we will see outflows, not just in terms of buying but also real investment; this is the wild card. The rhetoric over Iran in recent weeks is something altogether different.”

“From a ratings perspective, the GCC [credit] is cheap; from a geopolitical perspective, it is fairly valued,” noted another analyst.

One senior portfolio manager pointed to a spate of problems that could destabilise the region further. The murder of Jamal Khashoggi, rapidly escalating tensions with Iran, crises of succession in Saudi Arabia and Oman, alongside broader vulnerabilities to oil price fluctuations and a tepid real estate sector in the UAE all have the potential to tip the region into crisis.

Whether Asian investors, who often lean heavily on credit ratings in the investment process, will react early enough to this cocktail of potential threats remains to be seen. In the meantime, the GCC looks set to remain a sweet spot for the Asian investors looking eastwards.

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Invest in Turkey: One Belt One Road Already Helping Attract Capital from AsiaDespite being caught in the turbulence that rocked emerging markets in 2018, Turkey remains an

attractive destination for foreign investors, boasting strong fundamentals and a growing pipeline of projects in need of capital. Bonds & Loans spoke with Ahmet Burak Dağlıoğlu, Vice President

of Invest in Turkey, about the growing role of Asian investment in the country, funding diversification and Turkey’s project pipeline.

Q Bonds & Loans: Turkey is looking to embrace the opportunities offered by One Belt One Road. What Chinese projects are we likely to see come online in Turkey over the coming months?

A Ahmet Burak Dağlıoğlu: In fact, we have already seen investment projects being realized in key areas, such as transportation, logistics, energy, and financial services. As the Belt and Road Initiative moves forward, we may see more investments coming from Asia. Nevertheless, long-term investments often take time to be realised, therefore, we tend to focus on the mid- and long-term perspective.

Turkey continues to improve its local transport network with state-of-the art toll roads, bridges, railways, and multi-modal logistics centres across the country. Since 2013, the Turkish rail sector has been undergoing liberalisation as part of the

government’s ambitious plans to upgrade rail infrastructure. Launching cost-efficient logistics hubs to handle surging international trade volumes has also been a key priority. Both of these areas remain relatively untapped and offer first mover advantages for international investors, including Chinese investors.

Q Bonds & Loans: Are we likely to see Asian investors follow Chinese banks into Turkey? What can be done to help catalyse Asian investment into the country?

A Ahmet Burak Dağlıoğlu: Banks and non-financial corporations are complementary to each other in many ways. Our experience has shown us that banks play an essential role in attracting cross-border investments, especially from their home countries to the host countries where they operate. We attach the utmost importance to working with banks

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in many countries, in order to reach out to their extensive network of clientele. On the other hand, we have also seen that banks sometimes follow their clients to finance their projects abroad. In this regard, we expect Asian or Chinese banks to play an important role in bringing more investors from Asia to Turkey. Aside from commercial banks, the multilaterals, development banks, and export credit organisations from Asia are increasing their exposure to Turkey. In a recent report launched by the Asian Infrastructure Investment Bank (AIIB), Turkey was highlighted as a priority jurisdiction with a rapidly growing pipeline of projects.

Q Bonds & Loans: What can Turkish corporates do to make themselves more investible in the eyes of Chinese investors?

A Ahmet Burak Dağlıoğlu: I believe that Turkish corporates are already attractive — what is missing, however, is an awareness about the investment opportunities that Turkish companies offer. As the Investment Office, together with all relevant stakeholders, we are relentlessly working to raise awareness among Chinese investors about potential business and partnership opportunities with their Turkish counterparts. In addition to their strong footprint in the local market, Turkish corporates have an extensive track record in Europe as well as in the MENA region. Chinese investors with fresh capital, know-how, and competitive advantages can also leverage such synergies in third markets and create substantial value.

Q Bonds & Loans: Europe is currently a big investor in Turkey - how is that changing? Have they seen appetite shift in any direction over the past few years?

A Ahmet Burak Dağlıoğlu: Turkey is attracting investment from all around the world. As Europe is the largest source of foreign direct investment (FDI) in the world, it is, naturally, the largest investor in Turkey as well. Turkey has been in a Customs Union with the EU since 1996, which has built strong

economic ties, including capital investments across manufacturing value chains. However, we are also working to attract more investment from the rest of the world, in order to diversify our sources of funding and increase overall FDI inflows to Turkey. That is not to say that we are looking for alternative sources to Europe — this remains our main target to attract investment. As a result of our diversification and promotion efforts, the geographic composition of FDI inflows to Turkey has changed significantly. For example, from 2003-2010, the share of FDI from Europe was over 70%. However, from 2011 to date this has decreased to around 60%. Another reason behind this change could be attributed to emerging sources of FDI worldwide, especially from developing economies, led by China, which have recently emerged as new sources of FDI in the world.

Q Bonds & Loans: Which other regions are showing increasing interest in Turkey? What do you think is driving this interest?

A Ahmet Burak Dağlıoğlu: Asian economies are showing a strong interest in investing in Turkey. Similarly, we are seeing increasing interest from Gulf countries. There are several reasons for this. First, are the investment opportunities that Turkey is offering for these countries. Such opportunities include, but are not limited to, Turkey’s robust domestic market and strategic location. Asian companies are keen on investing in Turkey to access regional markets around Turkey, particularly markets in Europe, the Middle East and Africa. On the other hand, Gulf countries are intent on diversifying their investments abroad, while also ensuring their domestic market’s long-term needs in a variety of sectors. Another driving force is, of course, the increasing economic power of emerging economies that have also been increasingly investing abroad. For instance, two decades ago 16% of global FDI was coming from developing economies, but last year this figure grew to 45%.

8 www.BondsLoans.com

A default in September 2018 at infrastructure conglomerate and non-bank lender IL&FS cascaded across India’s financial sector in ways that are still being felt today, cutting off many non-bank financial companies – which account for more than a quarter of India’s domestic lending – from wholesale

funding markets, and putting the brakes on the segment’s hitherto remarkable growth. Linking up with their conventional banking peers could help NBFCs address their structural dependence on wholesale funding and improve the quality of banks’ assets.

Dubbed the ‘masters of retail lending’, it’s hard to overemphasise the importance of the NBFC sector in India. There are over 10,000 NBFCs registered with the Reserve Bank of India, many of which specialise in lending to micro-enterprises and SMEs, offering retail loans, construction finance, vehicle leasing, and a range of other funding services.

NBFCs’ impressive asset quality and capital adequacy ratios have made them the envy of their brick-and-mortar banking peers; the former’s stock of non-performing loans (NPLs) trend on average 3-4% below the latter, and are often far lower than NPL rates experienced by public sector lenders – where a build-up of NPLs over the past

Bank, NBFC Tie-Ups Create a Path to Sustainability in India’s Financial Sector

few years is still causing headaches. Most NBFCs, with the exception of a few larger incumbents, are smaller and leaner than their traditional banking counterparts, choosing to funnel resources away from renting large, expensive office spaces packed with personnel and high-tech kit, into their loan recovery teams, relying on a suite of lower-cost fintech to connect vast, regionally dispersed networks of branches.

Why IL&FS Thrust NBFCs Into the SpotlightWhile the full extent of the challenges facing Leasing & Financial Services (IL&FS) have yet to emerge, we know the first signs of trouble began to surface in the

public domain in August 2018, when the company defaulted on about INR4.5bn in short-term commercial paper to the Small Industries Development Bank of India (SIDBI), and defaulted on intercompany deposits, quickly catapulting the company’s AAA-rating to ‘D’ in one fell swoop.

IL&FS is amongst the largest infrastructure conglomerates in India. It is also one of the most structurally complex, with close to 350 subsidiaries and dozens more loosely-linked associated firms. Chief amongst its subsidiaries is IL&FS Financial Services, an NBFC with significant exposures to the infrastructure segment, including projects undertaken by IL&FS’s own subsidiaries.

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NBFCs expected to gain market share based on their especialized focus

Source: CRISIL Research

120%

78% 77% 76% 74% 74%

22% 23% 25% 26% 26%

74%

26%

72%

28%

100%

80%

60%

40%

20%

0%FY 14 FY 15FY 15 FY 16 FY 17 FY 18 FY 19 P FY 20 P

(%)

NBFC Banks

Although the scale of related-party and intercompany lending is hard to pin down, analysts suggest it was widespread – allowing it to rack up more than USD12.6bn in debt in less than a decade, while the complexity of the organisation allowed it to conceal the scale of its leverage. Its debt levels accelerated significantly over the past three years; the company’s leverage level rose by 59%, from 6.1 times in March 2016, to 9.7 times by March 2018 – at least according to publicly available data.

The crisis has highlighted a potential governance shortfall at the company, leading the company ’s board of directors to be replaced wholesale by the government. That board has now sought to charge 14 former directors of the NBFC group with money laundering, and breaching lending rules by extending loans to entities despite internal risk assessments showing those entities to be under financial stress.

But that a AAA-rated company could face such acute balance sheet distress has focused the industry’s attention, among other places, on the role of credit rating agencies: namely, their ability to penetrate such a vast and complex holding company, and to a great extent, how strong parentage influences ratings.

In India, strong parentage is often sufficient to secure a strong credit rating, even if many of a parent ’s subsidiaries have weaker fundamentals – a challenge compounded by the scale of intercompany lending at IL&FS, especially when combined with the nature of the infrastructure segment and complacency of large Indian banks and investors.

“Due to the nature of the infrastructure lending business, many of [IL&FS’s] projects exceeded the target completion time, therefore exceeding costs. There were huge gestation lags in their projects, which IL&FS had to constantly step in and fund. The entire financial sector, including credit rating agencies, were aware of this. However, no rating agency took any action because of the strong parentage IL&FS had. Both investors and rating agencies did not fully understand their increasing funding requirements because they sense that the promoters and shareholders of IL&FS group would take care of it and intervene as and when an issue arose,” explains Rahul Singh, a fixed income fund manager and deputy general manager at ILC Nomura Asset Management in Mumbai.

“The company maintained its AAA rating, so everyone kept on lending or

investing while ignoring its deteriorating fundamentals.”

Although IL&FS bears little resemblance to the thousands of NBFCs registered with the Reserve Bank of India, its story dovetails with – and to a large extent catalysed – seismic shifts in the broader funding environment in India, and access to capital for NBFCs specifically. An asset-liability mismatch – borrowing short-term to lend long-term – was at the heart of the IL&FS default, and has become an increasingly acute pain-point for a segment that largely depends on wholesale funding to grow, Singh adds.

NBFCs Were “Having a Ball” – Then, IL&FS DefaultedA confluence of factors led to a rapid increase in short-term borrowing amongst NBFCs in recent years, accelerating dramatically through most of 2018.

With the exception a small group of NBFCs, most are not deposit-taking institutions, and instead rely on wholesale funding markets to secure capital to lend. Interest rates shifted downward by 200bp between 2015 and early 2018, and after the demonetisation in late 2016, Indian banks were flush with liquidity and needed to lend.

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NBFC Funding Mix

Source: Ind Ra's analysis, company data

BankLoans

Debentures Publicdeposits

Comercialpapers

Securitisations Others

16.4

9.5

25.3

45.8

FY11

3

15.4

6.3

29.9

45.3

FY12

3.1

14.3 11.7 7.6

8.9 8.3 10.7

31.3 30.3 32.8

42.1 42.845.3

FY13 FY14 FY15

3.44.4 6.1

6.4

18.2

31.1

38.8

FY16

6.5

5.7

15.7

39.2

34

FY17

5.4

6

14

38.6

36.4

FY18

5

8.3

15.5

35.5

34.3

FY19

6.4

www.BondsLoans.com

NBFCs saw improved access to capital at reduced costs, not just because of a protracted decline in interest rates, but partly as a consequence of the rapid rise in non-performing loans amongst India’s lenders. Among other things, this prompted banks (particularly state-owned banks) to focus on lending to organisations that were very highly rated and saw strong asset growth, which saw traditional Indian lenders significantly increase their own exposures to the NBFC segment, mostly through revolving credit facilities or similarly flexible draw-down facilities in lieu of traditional bank loans.

But in scrutinising their own lending practices to help contain rising NPLs, and faced with slowing deposit growth, they also pulled back from lending to lower-rated organisations while trimming large corporate exposures in key sectors – pushing borrowers further into the hands of NBFCs and handing them greater market share, from 18% of overall credit activity in 2014 to nearly 25% by 2018.

To continue supporting their own remarkable asset growth (over 20% in many cases, excluding housing finance companies) and take advantage of the lowest interest rates seen since 2011, NBFCs also started turning to the short-term local bond markets for liquidity top-ups on a scale not previously seen. Between 2014 and 2018, the share of debentures and commercial paper in NBFC funding mix rose from 30.3% to 38.6%, and from 8.3% to 14%, respectively. But, in shifting their funding dependence from banks to mutual funds and local bond investors, NBFCs’ access to funding was increasingly linked with – or at the mercy of – short-term market sentiment.

“Until the default, NBFCs were having a ball – they had robust access to cost-competitive funding, even at times when the broader funding environment saw many other types of borrowers cut off,” explains Raman Aggarwal, Chairman of Finance Industry Development Council, a representative body cum self-regulatory organization of Indian NBFCs.

“Then the [IL&FS] default happened, and it caused a huge swing in sentiment, which played out in commercial paper and debenture rollover rates, and created serious liquidity concerns for many NBFCs.”

The rest, as they say, is history. CP rollover rates dropped dramatically between April and October 2018, falling to between 30-40%, a far cry from the near 100% rollover rates seen in previous years. Banks, fearful of getting caught out by ‘another IL&FS’ and risking the positive momentum they generated on reducing NPLs, also began withdrawing credit lines from NBFCs and refusing to rollover unused credit facilities, which are typically used by NBFCs as a capital buffer. All of this took place against a backdrop of rising interest rates and see-sawing stock performance, which also saw large bond borrowers in both onshore and offshore markets struggle to get deals across the line.

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In search of additional short-term credit to plug the gap, NBFCs began turning to the retail bond and securitisations market in bulk. During the 9-month period between April and December 2018, securitisation volumes hit INR1.4tn, compared with INR850bn sold during the entire fiscal year 2017; retail bond issuance during the same 9-month period reached INR300bn, up from INR50bn during the whole of fiscal 2017, according to data from CRISIL Ratings, a local subsidiary of S&P Global.

The RBI took some remedial action to ease funding constraints. It introduced an INR4bn securitisation window for NBFCs in November last year, and eased restrictions on NBFCs in securitising loans with tenors longer than f ive years – though it also introduced a 20% loan-to-value retention rate, and requires a minimum holding period of 6 months before a loan could be securitised, which could slow securitisation flow. The RBI also increased open market operations to inject additional liquidity into the system.

In February this year, the Central Bank also changed how it applies risk weightings for banks lending to NBFCs, reducing the risk weight for NBFCs with higher credit ratings in a bid to facilitate additional credit flow from traditional banks to NBFCs.

“This would mean the capital banks need to keep on hand when lending to NBFCs will drop, which could mean bankers will become more comfortable with lending to NBFCs, with cost savings passed down to the non-banks,” explains Krishnan Sitaraman, a senior ratings analyst at CRISIL.

But given concerns around the role credit ratings have played in the IL&FS saga, the move may not prompt banks to change their lending approach over the long-term. And although some funding to NBFCs has resumed, with the RBI unwilling to ease restrictions on deposit-taking for most NBFCs, many non-banks are caught in a structurally-induced feedback loop that sees growth intrinsically linked to their ability to raise capital in the wholesale markets.

Bank-NBFC Mergers: A Game Changer?“We’ve seen liquidity issues before. But post-IL&FS, pretty much every NBFC out there is looking at ways to build a more sustainable liability franchise,” explains Rajesh Sharma, Managing Director at Capri Global, an NBFC that provides home, business and construction finance from 82 branches across central and north-west India.

Sharma says one of the likeliest scenarios to play out is a rise in rise in bank-NBFC

tie-ups, which we are already starting to see emerge.

IDFC Bank and Capital First, a large NBFC with a predominately retail-focused loan book finalised their merger in December last year. The merger, originally announced in January 2018, enables IDFC to offer a wider range of retail and wholesale banking products while bolstering its customer base. But perhaps more importantly, the move allows the combined lender, IDFC First Bank, to diversify its loan book away from deep corporate exposures – the kind that led to a build-up of bad debt in the Indian financial sector – while enjoying the liability strength of a fully-fledged investment bank.

A similar tie-up in the housing sector – between Bandhan Bank and NBFC heavyweight Gruh Finance – is also in the works, while IndusInd Bank is looking to finalise a merger with microlender Bharat Financial Inclusion and eyeing two units of debt-strapped IL&FS.

“If the results of the mergers are successful, this could be a gamechanger for the rest of the industry,” Sharma says.

A.M. Karthik, Vice President, Sector Head-Financial Sector Ratings at ICRA agrees that bank-NBFC mergers would enable both institutions to leverage their respective synergies.

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Interest Rates Stable but Room to Cut

8.5

7.5

7

6.5

5.520182016

6

8

Source: Trading Economics

www.BondsLoans.com

“We are also likely to see consolidation in the NBFC segment itself, with for example smaller NBFCs linking up with deposit-taking NBFCs to de-risk the liability side of the equation.”

Jayen Shah, Co-Founder of Mavuca Capital Advisors Private Limited, a Mumbai-based investment advisory, says that further consolidation in the NBFC space is “definitely on the cards.” He cautions, however, that mergers between deposit-taking and non-deposit-taking NBFCs may not be as forthcoming.

“Deposit-taking institutions currently have more choice – they can choose between cherry-picking portfolio takeovers, which is faster, easier, and less costly than a full-blown takeover of a legal entity, or they can grow their asset base through deposits.”

“Until now, most banks have been content with simply buying filtered or curated loan portfolios from NBFCs. But some banks, especially those that haven’t grown organically through fintech-facilitated business models, should be on the hunt for small and mid-sized NBFCs.”

There are still practical hurdles to overcome.

The valuation gaps between potential M&A candidates could pose a challenge in many cases, and could dissuade equity investors from giving the go-ahead on proposed mergers.

Many potential candidates are also likely to remain in wait-and-see mode until the full scale of any regulatory intervention in the NBFC segment arrives, or new policy measures aimed at levelling the playing field between NBFCs and banks introduced. NBFCs are supposed to recognise income on NPLs on an accrual basis and pay tax on them, but international banking norms are such that income on NPLs are already ‘received’ and recognised as such. At the same time, there exists no provision for NBFCs to receive a tax deduction on interest earned from loans – a provision that exists for banks. Those clauses need to be corrected. But any intervention or policy

movement is only likely to take place after the upcoming election in April/May this year.

“Another facet of increasing tie ups between banks and NBFCs, has been unveiled by the regulator. RBI has introduced the concept of “Co-origination of Loans” by banks and NBFCs, where a bank and a NBFC enter into an agreement to lend jointly to a priority sector, in a mutually agreed ratio. The regulation prescribes a minimum stake of 20% for a NBFC in co-origination. While both bank and NBFC are free to price their share, the borrower is offered a blended rate. The entire flow of money happens through a joint bank account,” Aggarwal says.

NBFC-bank mergers may in a sense seem counterintuitive, at a time when traditional notions of economies of scale in banking are being challenged by smaller, more agile and technologically-enabled funding networks or partnerships – and not the least of which by NBFCs themselves.

Nevertheless, the benefits of these tie-ups – improved access to funding, increased investor attractiveness, greater client retention, asset diversification – seem clear, and suggest more mergers are forthcoming. That is good news for global EM investors looking to diversify into new regions and sectors amidst a decidedly mixed global macro outlook. From a macroprudential perspective, the move could help ease pressure on regulators as the NBFC segment continues to grow.

“Gaining access to a bank’s liability strength would de-risk their operations. If we look at the banking system, corporate loans are higher than any other lending category, and corporate loans by nature are chunky. If you look at the NPL problems in the Indian banking system, the biggest contributor is corporate loans. If through partnerships with NBFCs, banks can get access to a more granular, more diversified loan books, that would help de-risk the asset side of the balance sheets for banks. It’s a win-win situation,” CRISIL’s Sitaraman concludes.