“Market moved to NBFC because banks anyway cannot refinance,” said Jayesh Mehta, Managing Director & Country Treasurer at Bank of America while discussing who will refinance pledged shares. Mehta made the statement while discussing the pledged shares. Somasekhar Vemuri, Senior Director at CRISIL Ratings and Ananth Narayan, Professor at SPJIMR were also part of the event. Here’s the full transcript of the interview:
Q: Before I come to the valuation of pledges not invoked, do you think there is a systemic problem here? Nilesh Shah of Kotak Mahindra AMC yesterday went on to say that even in these promoter instruments, at a higher haircut there are buyers. HNIs are buying their products, ARCs are buying their products and therefore there is no risk to the investor even in a credit risk fund. Are you sufficiently reassured?
Vemuri: Let me start by adding a caveat that CRISIL has not rated any of these debts which are backed by a pledge of shares. That said, our estimate of the debenture which is backed by pledge of shares is about Rs 40,000 crore. If you look at even the NBFC space which gives loan against shares, put all of that together, maybe it is about Rs 1 lakh crore which is outstanding in the market. So from a systemic perspective and the size of the market, it is just about Rs 1 lakh crore which is not very large and is not concentrated in one or two names. So that is a point I would like to highlight.
That said, when you are looking at the credit risk of these instruments, essentially these instruments are usually rolled over and refinanced; they are never actually repaid.
The ability to refinance clearly depends on what is the extent of cushion which is there in the market value of the instruments that are held at the holding company level vis-à-vis the debt which is there in the holding company level. There needs to be a sufficient amount of buffer that these covers will need to offer to withstand any volatilities in the equity share market.
Also, one point needs to be noted is, unlike retail loan against shares where there are very small holdings and the market will have the liquidity to absorb it even if the covenant breach has happened and not honoured, here you are really talking about very large stakes of companies which are pledged and potentially could result in change of control, etc. So when the market in the Indian context have enough liquidity and depth to absorb that, in case these triggers are breached and in case they need to be sold, I think that is a question which remains.
Q: Just one clarification, did you say promoter pledges are normally repaid or refinanced, what is the trend normally?
Vemuri: The trend is usually they are rolled over.
Q: This Rs 1 lakh crore, if it has to be refinanced, who will refinance? Banks clearly have been scared away, they have rules as well, now NBFCs and mutual funds have kind of burnt their fingers, so if it is not repaid who will refinance them? So there is a default down the year?
Mehta: I think very clearly this market moved to NBFC because banks anyway cannot refinance because banks have a regulatory sealing on loan against shares which falls as a part of that capital market exposure. So they have like 40 percent of your net worth, more than that you cannot go into capital market exposure which includes direct exposure in equity which cannot be more than 20 percent.
So in reality, both, real estate and loan against share market actually moved to NBFC because banks really cannot do that. So that is the basic genesis. So basically construction finance banks can do it, but they cannot do real estate land acquisition finance which NBFCs were doing and then of course loan against shares.
As Somasekhar Vemuri said, mostly pledge of shares by promoter generally gets rolled over. I think we were the pioneers to start both this construction finance and loan against shares way back in 2004-2005. I think the norm in the last few years, people have kind of diluted a lot. So when you do promoter financing, you actually try to restrict what is the percentage of pledge he is doing, not only with you, but with the market because you might do 20 percent, somebody else might do 20 percent, somebody else might do 20 percent, there is no liquidity left. So technically if you restrict that as a lender, and if you have a covenant where they need to take approvals from you, then even if the price falls generally you are prepared, even if price falls dramatically, you have enough pledge of shares coming in.
Q: So you mean standards had fallen in pledge governance you are saying?
Mehta: Yes. The standards have fallen. If you look at the boom in the last five years or so, particularly on the NBFC side, I think that is where the aggression started and then you had the credit funds. I heard your argument on credit fund, I am not defending Nilesh, but all I am trying to say, I think when people invest in credit fund, it is the same as equity. So, people that Rs 100 equity becomes Rs 10, nobody is bothered about, but if on debt fund and credit fund if your credit is impaired and it becomes Rs 60 then everybody makes a hue and cry. That is what the thing is. Real NAV if you pass on, then there is no problem.
Q: Do you think the problem is much bigger than what it seems and do you expect this to become a systemic risk?
Narayan: There is a problem, except it is probably being made out to be a lot more than it is. We are a growing economy, no economy is perfect, no market is perfect and we will stumble our way through and go ahead. But absolutely there are issues and I can list four of them.
First is there is a question mark rightly or wrongly about this entire trustworthiness of the credit rating agencies and what they come out with especially after the IL&FS event earlier.
Second bigger issue is on suitability and appropriateness. Look this particular instrument of lending against shares, look at the payoff to the investor, if things are going well, they get a debt return and if things suddenly turn sour, they start to face the same risk as an equity holder. So effectively it is an instrument which you can argue gives you a debt type of a return for an equity type of a risk on the downside. Now, do you really have investors being made aware of the nature of the risk that they are taking on right or wrong?
The third is an issue of governance. A lot of these bonds have been structured such that the fact that effectively the equity is pledged is not disclosed. They are just put up as a part of the covenant somewhere that there will be a top-up of the shares if necessary and effectively the fact that the promoter doesn’t have control on those shares is not disclosed to the overall larger community which is a problem as well.
Fourth on valuations and valuations not just for these particular bonds but for the entire set of corporate bonds. December end we had Rs 6 lakh crore worth of corporate bonds on the books of mutual funds. The monthly volumes in December, the whole of the month, was only 1.8 lakh crore. Most of these Rs 6 lakh crore, as Nilesh says, are good bonds, they are not bad bonds, but the secondary market liquidity simply isn’t enough to handle these kinds of volumes and we are producing NAVs every day. So, the problem is our market has probably grown too quickly too fast and the infrastructure to support this market doesn’t exist which means we have a problem at our hand.
Though these problems look egregious, I think they are manageable, we will get through with them. We will stumble our way through. I don’t think it is the end of the world, but yes there are some hard decisions to be taken here.
Q: The point on NAV, if you can come in there, we asked many of the credit rating agencies into this discussion, several of them didn’t come I think because they do the valuation and you have agreed because you are not in this pledge shares rating. But tell me, is the rating being done properly. When the collateral has diminished so much in value, are the rating agencies adequately reflecting it in downgrades? If they are not, even otherwise as Ananth pointed out when credit risk instruments themselves are full of bonds that are not traded is there a risk that the NAVs are being overstated?
Vemuri: Let me come to the first question since we have no rating in this space it will be difficult for me to comment on whether somebody else is doing an appropriate job or not. I can clarify what our approach is and how the current market operates. The current market is operating at cover levels of 1.3-1.7 times. Which means that for a debt of about Rs 100, you will have a pledge equivalent to Rs 130-170; different transactions have different covenants.
Whereas when we look at the rating of any of these structures, we would look at covers which are upwards of 6-8 times for us to be anywhere in the A category or so which typically is where the market has an acceptance.
So, I think there is a very big difference in terms of what our standards, in terms of the buffer that we would look for which will cover not only for the safety of rating but also cover for market volatility and give a cushion in terms of absorbent shocks. So clearly I think there is a need for having appropriate standards for rating such products. As I said these are usually rolled over or refinanced not repaid and hence the capability to refinance or rollover depends very clear on what is the kind of cushion that is available in terms of the overall market value of the holdings that the holding company has vis-à-vis the debt which is there sitting in variety of holding companies, and also the quality of the underlying operating companies.
Q: I will tell you actual evidence. Immediately after the IL&FS issue and this is I think documented in an IDFC paper, I am not very sure, in October-November AA paper yields had risen by 130 basis points, but A paper yields were shown as risen only by 30 basis points because they are not traded, they are this polling by rating agencies. So clearly that valuation by rating agencies needs to change, isn’t it? It doesn’t seem to be working.
Vemuri: That is something which I do not look at. There is a different team in ratings in CRISIL which would be in a better position to answer that question. So I would not be able to comment on that.
Q: You did bring up an issue of disclosures. Sebi, as we know, is the regulator for mutual funds and RBI is a regulator for NBFCs. So what needs to be done by both these regulators now? On NBFCs how should the RBI make sure or rather discourage these lenders especially NBFCs from entering into such agreements with companies and on Sebi, what are the disclosures that need to be done in order to secure investors?
Narayan: It is fine for this kind of lending to happen as long as there is appropriate disclosure and there is awareness of what people are getting into. If NBFC want to lend against shares and it is allowed to do so as long the promoter discloses and makes it abundantly clear to all the stakeholders that his shares are pledged – that should be fine. If it is done in a form which is effective a pledge but not shown as a pledge that’s a problem and that is where the governance issue comes in. I think the broader issue which Sebi and RBI have to address is this whole question of secondary market liquidity. Everybody want capital markets to grow. Sebi is saying every company over Rs 100 crore has to borrow 25 percent of its borrowing from the capital markets. RBI is saying large exposures perforce have to approach capital markets and borrow money from there. Everybody is pushing flows into capital markets. Therefore, to find fault with mutual funds for growing AUM to the size they have is wrong. The problem is that we do not have secondary market liquidity to sustain that kind of infrastructure and there are plenty of reports, since the time I had a lot more hair on my head we have been writing reports saying what needs to be done to improve capital market liquidity in this country, starting with RBI for instance; RBI Act being amended so that they can start to accept AAA paper at least as part of their liquidity adjustment facility.
Growing repo markets, having trading volumes grow with people like you and me starting to trade in bond markets just as we trade in equities.
There are the whole host of things that need to do; stamp duty for instance – that part is not being addressed and I think that has to be the starting point because the problem is all these issues about lending against shares etc. is the small portion of the overall, we have 28 lakh crore of corporate bonds outstanding. This is a very small portion out of that. The problem is the larger section which is good quality paper doesn’t have the infrastructure to stand on its own legs which is why when we have a panic situation or a near panic situation in September the whole system starts to shake which is wrong and that starting point of getting secondary liquidity is the area that we all have to concentrate on.
Q: I am worried about two issues. The first one that worried me is that in this credit risk fund 65 percent are in below AA paper. If there is an outflow you cannot sell that A and below paper because there is no market. You would have already exhausted the AAA that you have. So will there be a problem for those funds. The answer that mutual fund guys gave me is that even for that A they can sell it to HNIs. It’s not as if there is no market. Only the appropriate haircut will have to be shown because these guys will normally demand 13-14 percent even 18 percent in yield. Is there no systemic risk but only a fall in NAV that we should worry about in credit risk funds?
Mehta: Two things are required. One is as you said distributors explaining whether the credit risk – credit risk fund is between debt and equity and when you have defaults it actually becomes equity. So that is a need to make understand to the people not to hide away like we had, for a loan against shares, we had corporate default in one of the mutual funds 2-3 years back and everybody made hue and cry. Yes, if it is a credit fund default is going to happen otherwise that will pay government security yield. Second, in terms of liquid that is where we have to analyze looking at the volume like you have equity market NAV also happening at the previous day’s closing price but does it really mean that you can actually sell at that closing price outside Nifty-Fifty stocks, you cannot. So the repayment will come on that day’s closing. So NAV is a reflection. So when you redeem next day and a lot of the credit fund have time and when they actually sell then that is what you get is NAV. So that transmission should happen fast then there is no problem. Yes, there is a risk because you are getting higher return whether that higher return is priced well, but most importantly what has happened right now and that is why some of the investors are actually saying that I do not want NBFC paper to the mutual fund. If that goes on rising then the rollovers stop. It’s more like a mini-run and if that blows up then that becomes a problem. So it’s not blaming the industry; the run can happen on a bank, the run can happen on anything. We saw that in 2008.