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External Benchmark! How Will It Benefit You?


Posted on 06-Sep-2019 Comments  0

External Benchmark

Will the shift to external benchmarking benefit borrowers?

During the week, the RBI announced that all banks will shift to pricing their loans based on an external benchmark like the RBI repo rates or the RBI MSF rate so that any rate cuts can be seamlessly passed on. This shift will be effective from October 01st and will apply to all loans extended to retail customers as well as to small and medium enterprises (SMEs). Effectively, all home loans that are of a floating rate nature will now be linked to these external benchmarks and the rates will be adjusted accordingly. What does this mean and will it benefit the borrowers?

Average cost of funds formula

For a long time, the base PLR (BPLR) formula was used by the banks to price their loans. The BPLR considered the average cost of funds of the bank and hence the historical cost of funds of the bank also got factored into the cost of funds calculation. That would mean; even if the RBI cut rates but the average cost of funds did not fall, the impact on loan costs would be minimal. That explains why, despite the RBI cutting rates, the transmission of these rate cuts to the end borrower was not entirely seamless. Higher historical cost of funds stemmed from factors like higher interest cost on old borrowings, lower yields on SLR & zero yields on the CRR, unwieldy administrative structures etc. In the process, the end customer or borrower ended up paying a steep cost for such higher average cost of funds.

MCLR has not really worked

In the last few years, the banks had shifted to the MCLR based pricing. The difference in this method was that the marginal or incremental cost of funds was considered instead of the average cost of funds. The assumption was that this would automatically ensure the transmission of any rate cuts by the RBI to the final borrower. However, the MCLR is dependent too much on the cost of deposits, which is the largest component of MCLR. Unless the banks reduce their deposit rates, the MCLR would not come down and hence rate cuts would not be passed on. In a competitive market, most banks are wary of losing their CASA deposits and hence continued to hold deposit rates even when the repo rates are cut. This results in the MCLR becoming sticky and also being unable to pass on rate cuts seamlessly to the final borrowers.

External benchmarking

It is in this light that the government has decided to shift to external benchmark based pricing for retail and SME loans. This will ring-fence the loan rates from either the average cost of funds or the incremental cost of funds. However, banks are skeptical whether such benchmarking would really work in practice because it would make rates and yields too volatile. Cost of deposits will still be the key issue and that could be the limitation of this approach!

NBFC Repayments

How will the NBFC segment handle Rs.35,000 crore outflow?

Come September and the non-banking finance companies (NBFC) have fresh problems to worry about. Even last year the NBFC problems and the liquidity crunch had begun in September after the IL&FS defaults became public. So what exactly is the problem that NBFCs are going to face in the month of September and what are the options?

The Rs.35,000 crore challenge

Most NBFCs have historically had large loan repayments coming up in the month of September. That historically continued as it used to be rolled over each year and hence did not pose any fresh problems. However, there is close to Rs.35,000 crore worth of NBFC debt that is coming up for repayment in the month of September and this will have to be completed before the end of the month. The question is whether lenders will be willing to roll over the loans and at what cost. Normally, the tenure did not matter because these NBFCs could raise fresh loans from the market to repay the old loans and hence it was like a virtual rollover of loans. Things changed after the IL&FS crisis last year and the near fall of Dewan Housing in the current year. With combined debt of Rs.190,000 crore, these 2 companies pose a systemic problem and that has made lenders wary of NBFCs overall. Any roll over this time around will not happen easily or will happen at a largely unaffordable rate of interest. Both these options pose a major risk for NBFCs.

NBFCs – Repayment impact

Broadly, there are 4 categories of NBFCs that will have repayments coming up in September. Firstly, there are the likes of HDFC and LIC Housing with adequate access to institutional sources of funding and any rollover should not pose any major problems for these companies. Then there are the stronger private players like IIFL, Edelweiss that have maintained sufficient liquidity and kept  leverage in check. They should also sail through. Thirdly, there are the NBFCs without maturity mismatch who will still have fairly liquid assets and the problem will be much smaller for them. Finally, the most vulnerable segment will be the NBFCs that have a maturity mismatch. The ones that borrowed short and lent long may have the real problem. 

What is the way out?

The government has already announced an NBFC rescue package in its Union Budget and that must be extended to the fourth category of NBFCs. Of course, the FM is right in the sense that there must be a distinction between liquidity risk and solvency risk. At least, where the risk is purely of liquidity, the banks must step in with the required liquidity and the government must give comfort to the banks. When even a small bunch of NBFCs default on repayments, it can create a systemic crisis as their loan books get compromised. The cascade effect must be prevented!

Essel Debt

Zee Group begins debt repayment, but how will it complete?

The Essel Group owned by Subhash Chandra has repaid around Rs.4500 crore out of its debt owed to mutual funds for the group infrastructure and power forays. While a start has been made towards repaying the Rs.17,000 crore owed to mutual funds, it is still unclear how Essel Group will manage to close out the balance.

What exactly happened?

To understand the Essel case, one must step back to early 2019 when large mutual funds like HDFC, Birla and Kotak had asked investors to roll over their FMPs due to a liquidity crunch at one of the bond issuers. Subsequently, it did emerge that these FMPs were invested in bonds issued by group companies of the Essel group and were backed by the pledge of shares given by Subhash Chandra, the promoter of the group. In effect, this was promoter funding with inadequate collateral. That means; the MFs did not even have the luxury of selling the shares in the market to get their funds released. Shares were already down 30%, which means the FMPs would have ended up with a hole. That was when the mutual funds signed a standstill agreement with the Essel Group. Under the agreement, Essel group promoters would sell their holdings in Zee and its group companies to repay the debt before the end of September. Till that time, the mutual funds had committed to Chandra, the funds will not sell the pledged shares.

Understanding the numbers

Just over a month ago, the promoters had sold an 11% stake in the flagship Zee Entertainment for Rs.4200 crore. These funds have now been used to repay part of the debt owed to the mutual funds and mutual funds will be getting around Rs.4000 crore in the first round. The promoters were originally planning to sell around 20% stake but they could get the required price only for an 11% stake. The balance stake is also likely to be sold, but it is not clear whether the buyer will be the same INVESCO-Oppenheimer or another investor. The group also plans to sell its solar plants and other infrastructure projects that its units had invested in. 

Come September – what now?

Having just managed to repay 25% of the total amount borrowed from MFs, it is hard to fathom how the group will manage the rest of the amount by end of September, when the standstill deal comes to an end. If the balance amount is not managed then either Essel could negotiate for another extension or the MFs can sell shares in the market to make good the balance loss. Either ways, the final decision will have to be communicated quickly as otherwise there could be aggressive selling ahead of the MFs putting their shareholdings in the market. In that case, a sharp price correction may actually queer the pitch for the FMP holders of these AMCs!

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