DHFL and Reliance Capital Used the ‘Box System’ to Avoid Disclosure, says...
Over the past one year, the corporate world has been rocked by bankruptcies and huge liquidity crisis. This includes one of the country’s largest airline suspending operations, Rs10 lakh crore of bad loans, the disintegration of the Infrastructure Leasing & Financial Services (IL&FS) group and the Anil Ambani group and rapid demise of Dewan Housing and Finance Corp Ltd (DHFL). This had badly shaken the confidence in non-banking finance companies (NBFCs). How bad is the situation? A just released report by Risk Event-Driven and Distressed Intelligence (REDD) throws some light on the shenanigans of few very large NBFCs have been up to.
NBFCs & housing finance companies (HFCs) together constitute 19.20% of total credit extended by the Indian financial system. Typically, the NBFC sector services borrowers deemed too risky for commercial banks. However, there is an inherent flaw in the system; the NBFC sector gets majority of its funding from commercial banks and mutual funds. So something that was not doable directly by the banks, the same is being done through NBFCs as a vehicle.
(Source: REDD Report)
To add to inherent instability, what is of greater concern is the malpractices as highlighted in the case DHFL, wherein the company was accused of being a vehicle to divert funds. The company used a new structure called as ‘box companies’, says REDD, to evade reporting of funds given to related entities. Using, the box system these companies have found an alternative way to rollover or ever-greening of loans. This is how the Box system works-
1. Say X owns an NBFC XYZ and wants to source funds from it. But the NBFC cannot give funds to X without disclosing the same as a related party transaction.
2. So X promotes three other companies- A, B and C, each with a capital of Rs1 crore. Company A, B and C have Rs1 crore in capital and Rs1 crore in cash each and are owned by X; thus are the related party for the NBFC XYZ.
3. Now, Company A buys 50% of company B and 50% of company C from X. The same is repeated by company B and company C. The end result of this is that, all the 3 companies A, B and C are now owned by each other and X has no ownership of any of these companies and has received back his initial Rs3 crore invested.
4. The company A, B and C now have Rs1 crore of capital and Rs1 crore in investments each.
5. Now company A, B and C approach the NBFC XYZ for a loan. XYZ does not have to report these loans as related party transactions, as none of these companies is owned by X. But, in reality the real beneficiary of these companies is still X.
6. This way X has extracted money from the NBFC XYZ without having the NBFC to report the same.
7. Next time, when these loans falls due, another box of companies will be created to fund the companies A, B and C loan repayment; thus effectively rolling over the loans.
Take the case of DHFL, on which a report by Cobrapost highlighted how the company using the box system avoided reporting to the exchanges on the sale of a 9.97% stake in the company. The companies forming the box in this case were Hemisphere, Galaxy and Silicon. The three box companies owned 31.1 million shares in DHFL as of March 2018.
All through the year, they sold the stock, disposing four million shares by the end of June and by September; their holdings had come down by another 7.65 million shares and did not appear in the register by March 2019.
REDD points out that Reliance Capital and its two affiliates, Reliance Home Finance and Reliance Commercial Finance, have engaged in similar kind of funding through box companies. The report indicates that the amount of loan outstanding to these box companies totals around Rs137 billion. REDD also provides details of three box structures of the Reliance ADAG.
The report further points out that, apart from using the box structure for pulling out funds for themselves by the promoters, some NBFCs may be using the same structure to ever-green the loans of each other.
Liquidity problems at Dewan Housing Finance Corporation Ltd (DHFL) and its reported failure this week to pay coupons highlight the funding challenges faced by India's non-banking finance sector, Fitch Ratings says.
"Issues in the non-banking financial companies (NBFCs) were already known to the market but DHFL became a focus point after the failure of Infrastructure Leasing & Financial Services Ltd (IL&FS) in September 2018," the ratings agency says, adding, "This also contributed to a sector-wide liquidity squeeze as investors became more risk averse. Indian NBFCs' liquidity is sensitive to market sentiment as their business models rely on short-term wholesale funding, which can dry up fast if market sentiment turns negative. Funding models of housing finance companies and NBFC loan companies, which have become increasingly reliant on short-term funding to fund longer-term assets, have been particularly affected by the liquidity squeeze."
According to the ratings agency, the liquidity pressures in NBFCs are in stark contrast to the banking sector, which has not faced significant liquidity pressure or deposit withdrawals, despite asset-quality and capital adequacy weaknesses.
The sector pressures have led India's top NBFCs to explore other sources of funding and to start positioning themselves to tap the US dollar bond market. "We expect Indian NBFIs to become more regular issuers in the offshore bond market as they seek to diversify their funding sources. If prudently managed, this should be credit positive as funding profiles are strengthened," Fitch says.
The funding squeeze has contributed to higher funding costs and a slowdown in loan growth for India's NBFC sector. NBFCs are an important channel for extending credit to the wider economy, given their extensive distribution networks, which are often more far-reaching across rural India than those of banks. The sector's role as a credit-provider became outsized as the Indian banking system was forced to deal with its weak asset quality.
Banks, particularly public sector banks (PSBs), were undercapitalised and had limited capacity to lend more. NBFCs now account for nearly 20% of credit to the economy compared with about 15% five years ago.
Indian NBFCs fast loan growth in an environment of relatively benign interest rates was increasingly funded by short-term funding, in particular, commercial paper issued to the mutual fund sector. The banking system also is an important source of funding for NBFCs, driven in part by the regulatory push for banks to provide 'priority lending', with NBFCs being an important conduit for this.
Fitch says, "Both of these funding sources for NBFCs have become more risk-averse, which means that the sector is likely to face higher funding costs and a period of deleveraging, although the better-positioned NBFCs should still be able to achieve loan growth. The sector's reliance on short-term funding has reduced since late 2018 and some stronger NBFCs have shifted towards longer-term funding, such as term loans or negotiable certificates of deposit."
"We expect credit growth in India to remain slow, despite this week's interest-rate cut, as most banks are capital-constrained and NBFIs face tighter funding conditions," the ratings agency concluded.