There has been no prior experience as to the financial impact of a pandemic like COVID 19 on world financial markets. The nearest experience of such widespread disruption was the Second World War which was over many years and where large parts of humanity were left physically untouched by the event. Of course, there have been many smaller economic disruptions due to unforeseen events which provide some markers as to what to expect.
There were issues even before COVID-19:
Indian Banks and Non-Banking Finance Companies (NBFCs) have been grappling with a deluge of Non-Performing Assets (NPA’s) for the past three years. This resulted from a diverse set of reasons, the most prominent being poor credit decision making by public sector banks and NBFCs which were also prone to systematic fraud. Some private financial institutions like Yes Bank, DHFL and IL&FS are facing bankruptcy as their credit-bets started unravelling. Efforts by the regulator to manage this have been partially successful, however, the scale and scope of NPA’s have made all these efforts look insufficient. India’s financial managers were still struggling with these issues when the pandemic struck.
COVID-19 has added more dangerous elements to an already strained fabric of lending:
Before the pandemic struck, there was a distinct move towards retail assets by all the financial institutions as these had demonstrated better credit performance compared to SME and Corporate Assets. COVID has disturbed this oasis of stability as unemployment has spiked to unthinkable level in days and a large part of the workforce is unsure as to when they will return to work.
Key players in the Indian financial services landscape are Private and Public Sector Banks; Non-Banking Financial Companies (NBFC); Housing Finance Companies (HFC) and Micro Finance Institutions (MFI). Each of these institutions has defined its customer and product focus building significant expertise in their lending niche. We take a forward look at what these institutions will need to deal with in the immediate future and what will be the implications of the pandemic on credit behaviour:
- MFIs to Face Losses in Urban Portfolios:
Credit performance of MFIs has been exceptional due to two key lending practices; loans are linked to the individual’s earnings and are repaid on a daily or weekly basis. In addition, a larger group within which the individual resides guarantees the payment of the individual.
During and post-COVID, the urban worker is going to be hit the worst. These are individuals running micro-businesses without any safety net. With the lockdown, it is likely that they will denude their working capital as well as the small assets that they have acquired for their business making it difficult for them to restart their business.
MFIs will have to make the difficult decision of supporting these individuals with additional loans to restart their business and regain the capability to repay their loans.
MFIs rural customers are in better shape as their economy has recommenced and the crop has been harvested infusing cash. I anticipate that MFIs will not have significant losses from this customer segment.
Standalone MFIs as well as banks and NBFCs who have acquired smaller MFIs to diversify their lending are going to take some losses in their urban portfolios. One key problem here is going to be that a lot of the urban poor have moved back to their villages. Some mitigation can be possible if customers with good credit records are provided additional credit or top-up to restart their micro-businesses once normalcy returns. This segment will see significant credit losses.
- Losses Anticipated for NBFCs (and Banks) Who Focused on Higher Risk Portfolios
Unsecured lending is done both by NBFCs and Banks. Banks have focused on individuals with credit history while NBFCs have done subprime lending which reflects their cost of funds. This segment has been performing well for the past few years as it is priced to risk.
Salaried employees working for the government and large corporates will not have any salary erosion and their credit behaviour should mirror their past track. Those working for smaller SMEs which is the majority in the private sector will be impacted by the pandemic which will result in job loss or at best lower and delayed salary payment. Their ability to repay the loans will be impaired and will result in higher losses in this portfolio.
We anticipate significant losses for NBFCs who are focused on the higher risk portfolios. The banks with unsecured loan exposure will get away with higher losses but it is likely that many of their customers will be able to meet their loan commitments albeit with some delay.
Higher loan losses will be inevitable. Mitigation here is the price to risk.
- The Impact on Secured Lending
Retail secured lending comprises two-wheelers, automobiles, commercial vehicles and housing loans.
These portfolios will perform better than the unsecured portfolios but will still see losses along with the job losses in the economy. Rural demand will continue to be robust and loan performance will also be good. Given the focus on individual transportation, there will be a strong second-hand marketplace which will enable the lenders to get a fair value for the assets they repossess. We anticipate a period of heightened losses in urban areas as customers earning capacity decreases. The eventual losses will be mitigated over a 12-18 month period as the repossessed assets are sold and recoveries have been made.
The loans are both from salaried individuals as well as self-employed. The least impacted segment will be the salaried segment, that is the high-end white-collar worker, government employees and those employed with reputable private companies. Those individuals who are rendered unemployed will likely turn in their cars and go back to two-wheelers. Losses will be moderated by sale of repossessed assets.
The segment that will be most impacted will be those who are self-employed. Their performance will largely depend on the recovery and return to normalcy. If disruption to their earnings is more than 4 -6 months then the impact will be considerable. If recovery is sharp then many of them will bounce back and be able to pay their outstanding loans. This is a hardy segment with some financial assets and should do better than anticipated. Once again some short term additional write-offs followed by a couple of years of increase in recoveries.
Management of foreclosures, restructuring of loans and efficient sale of repossessed assets by the financial institution will determine the final losses in this category of loans.
These portfolios consisting of CVs which are earning assets and pay for themselves have already been hit by the current lockdown and restriction in movement.
The health of these portfolios is going to be dependent completely on the rapidity of recovery and goods movement back to normal. We anticipate that this will take another 3-4 months which means that most borrowers will not be able to pay their dues for about six months. The logical way to deal with this is to restructure the loans. Larger transporters will be able to secure this with their lender.
The most hit by this slowdown will be the single truck owner who is likely to be forced to sell his vehicle. CV portfolios will see significant losses in the next 12 month period.
A new policy to scrap older CVs (Clunker Policy) could come to the rescue if announced and executed quickly.
As the bulk of these loans are for housing which provides accommodation for the borrower the anticipated loan losses here will be the least of any segment. Despite the proclivity to pay there will be some customers who will be unable to pay the monthly dues due to livelihood loss caused by COVID. The pain in this segment will be drawn over a period of time as there will be some payment waivers and the lenders will be inclined to show leniency in payment delays. Once the COVID pandemic is over and people are able to recover their livelihood then the longer-term impact will not be too significant.
In a scenario of the continuing impact of COVID on the economy, there will be considerable foreclosures resulting in a decline in the property market and eventual losses for the financial institutions.
Overall, this segment will perform the best and losses recognised may be high to begin with but the recoveries will follow as the assets will be sold over a period of time
- SMEs the Worst Hit and the Consequent Impact on Financial Institutions
The smaller and mid-sized SME companies are impacted the most by the disruption in the supply chain. They will need to pay their employees, purchase raw material, resume production and wait for their receivables to be paid before normalcy is restored. Their credit requirements are largely met by Loans against Property.
It is my estimation that this set of borrowers will be the worst hit and a large number will not be able to get back into a stable business cycle given the huge increase in the degree of difficulty caused by COVID. As these loans are largely secured by property and the process for foreclosure is fairly routine under the safesi act, Indian lenders will see a huge amount of property being foreclosed. The key problem here will be the sale of this property due to insufficient demand. This will tend to drag the process longer than necessary with the attendant risk to the lenders
Losses to Financial Institutions will not be immediate but it will take two or three years for the entire cycle to be completed. The loss to the economy, on the other hand, will be significant as many of these SMEs have developed a niche skill in production.
In conclusion, Retail and SME lenders can anticipate 2-3X write off compared to the prior year in most categories. If they segment their portfolio holdings on a risk basis they can separate the customers based on the continuity of income. By doing this the lenders will be able to focus on the riskier portfolio segments. Remedial action will need to be pro-actively taken and many loans will need to be rapidly restructured. For those not responding, collection activity will need to be efficiently carried out, the asset valued and sold at the earliest. The quantum of losses incurred by the financial institution will largely depend on their underwriting standards and the quality of execution in their ability to restructure, collect, foreclose and sell the assets. The game for these institutions has suddenly changed but will present new challenges and opportunities.