Implications of re-pricing of credit risk in India (February 16, 2019)

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India has implemented two significant regulations in the recent past.   GST and the Bankruptcy Code.  We argue that a third one is on the way which will lead to Re-pricing of Credit risk or put simply, more differentiated pricing of loans between good and bad borrowers.

India has the highest number of AAA rated companies compared with other countries.  Clearly, our Rating Agencies are not differentiating between princes and frogs.  And as Banks charge credit risk spreads based on Credit Ratings, Credit risk is being significantly mispriced in India.  For example, within NBFCs, pedigreed companies like Bajaj Finance, currently troubled players like ILFS and players under a cloud of suspicion e.g. Dewan Housing were all rated AAA before July 2018. 
The data above suggests some-thing is amiss in our Ratings process and needs to be fixed.    There is a conflict of interest in the Ratings business – they are paid by the same companies they rate.  To understand this, watch this 2 minute clip of the scene from the movie “The Big Short” where the rater explains that if they did not give the company a favourable rating … the company would just take its business elsewhere.

Given the reliance of the Banking system on their judgement, we should shortly expect more regulatory supervision on Rating Agencies which should result in relatively more honest ratings going forward.   Hence, we should expect the ratings of many companies to drop by a few notches example AAA –> A

If credit risk is mispriced, deserving and undeserving companies often have the same credit rating – and hence the same cost of credit.  This results in distortions of profit margins in many sectors due to excessive fragmentation.   A combination of GST, the Bankruptcy Code and now re pricing of credit risks will create many winners and losers.

Some Investment implications

a)Most NBFCs rating should reduce resulting in a significant increase in their cost of funds.   We expect a shakeout in the NBFC sector with many NBFCs exiting the industry as a structurally lower ROE profile makes the business un attractive.

b)Private Banks (and genuinely AAA NBFCs) will see further market share gains from NBFCs – both from NBFCs vacating markets where they cannot compete on Cost of Funds and as formalization results in SMEs having better documentation which makes them bankable.

c)The conglomerate discount should come back in vogue.   Subsidiary’s cost of Credit will increase as Rating Agencies will be mandated to take into account aggregate debt of the parent rather than just an “assurance of support” from the parent.  And as more guarantees are provided to subsidiaries, the parent rating should get adversely impacted resulting in higher cost of credit for them.   Expect more focus in large conglomerates around a core.

d)There is clear hesitation visible in many Private Banks towards participating meaningfully in Project Finance.  Hence, risk spreads for Project Finance will trend higher on both lower demand for Project Finance as well better pricing expectations from Banks.  This coupled with the threat of loss of the Asset due to a wrong Investment decisions, means one should see more disciplined Capital deployment in Capital intensive sectors.   We see Steel and Power as prime beneficiaries from rising Capacity Utilizations and increasing Operating Margins.

e)Many sectors will witness Consolidation.  For example, Real Estate development should witness further sector consolidation both due to RERA and now higher cost of credit in a working capital intensive business which weaker players will not be able to absorb.

f)One should expect certain AMCs to gather even higher incremental market share.   Quality of debt paper held by Mutual Funds will come under increased scrutiny and NAVs of many funds holding paper of dubious quality could see markdowns triggering a flight to quality.

g)Mid-Cap companies who enjoy a good Credit rating will become significantly more advantaged vs their peers on both quantum and cost of credit.

It’s a great time to be an Equity investor in India.  Every wave of regulation strengthens well run companies as it chips away at the unfair advantage enjoyed by many other participants.

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