There’s a bit of problem with the new Companies Act, it seems. (Thanks to @_kirand for the heads up)

In the new Companies Act, which gets active from April 1, 2014, we have a new set of rules governing debentures. Debt issued by companies of any kind qualifies as a debenture. Two new rules come in for issuers of debentures: (Source: Notified Rules)

a) A debenture redemption reserve (DRR) must be created, which contains 50% of all of the amount issued through debentures, and

b) For all debentures maturing in that financial year, companies will need to put 15% of the maturity amount into liquid avenues (bank deposits, government bonds etc.) This has to be done by April 30 of that financial year.

Why?

The answer is simple; a company typically borrows money to invest in certain things. It will pay back the principal and interest through the profits generated out of that investment. The principal that must be paid back is a liability; and the idea of creating that reserve out of retained profits is to earmark that amount as a liability that will eventually need to be paid out anyhow.

This used to be only 25% in earlier rules but in the new companies act has been bumped up to 50%.

This by itself will only reduce the profits of all companies that issue debentures.

Note: this amount is only earmarked from profits. It is not actual money that is set aside for this reserve; that comes in the next provision.

The second provision – of putting 15% of the maturing money into a liquid avenue is more to protect investors. This is similar to the 23% Statutory Liquidity Ratio which banks have to invest, of all deposits,into government securities or cash. Effectively, this is a 15% SLR for companies, but only on those deposits that mature in the immediate financial year.

The placing of this 15% creates a cash problem for companies, who can’t use that money any more and must plan liquidity better.

Non Banking Financial Companies Get Hit Badly

The problem isn’t so bad for industry. Debenture or bond issuers may be able to absorb the DRR on their balance sheet for now, though companies that don’t have enough retained profit will be hit hard (since the reserve eats into retained profits).

But think of a Non Banking Financial Company, like HDFC or L&T Finance. They borrow from the market (debentures) and use that money to lend onward for home or corporate loans. Typical subscribers to the debentures are mutual funds and institutions. NBFCs earn the “spread”, which is the difference between the borrowing rate (at which their debentures will be bought) and their onward lending rate (what customers pay for loans)

In such a case, I may have only Rs. 15 in capital, and can borrow Rs. 100 at 10% and lend it out at 15%, earning 5% (or Rs. 5, as the spread). After my expenses and taxes I earn Rs. 3 which is my “retained profit”, and that’s a fairly decent 20% return on capital (of Rs. 15). 

If I had to create a reserve for the Rs. 100 I borrow, into a 50% Debenture Redemption Reserve, I have to put Rs. 50 into that reserve. That is like 10 years of profit gone!

Contracting Margins, Increased Borrowing

Worse, assume that out of the Rs. 100, a sum of Rs. 30 is maturing this year. I have to put 15% of that into a redemption reserve. I have to put Rs. 4.5 into the reserve, and that money can’t be used for any other purpose.

That means I only have Rs. 95.5 available to lend further. That contracts the amount I can earn (it’s not 15% of Rs. 100, but 15% of 95.5). I will of course earn some interest on the Rs. 4.5, but it’s lesser than 15%, probably lower at 9%.

This contracts my margins.

And then, I might still need the Rs. 100 to lend out, so I just go ahead and borrow more, by about this 15% number. So I will borrow Rs. 105 to help me keep my redemption reserve funded (I have to pay it Rs. 4.5). I now have to pay interest on the larger borrowing (offset marginally by the interest I earn). The difference may be as low as 0.5% but that can be a significant number.

The Numbers are Big

Tamal at LiveMint has a wonderful piece, with some figures of how huge this issue is.

Even if one considers conservatively that in 2015 bonds worth Rs.2.5 trillion will be issued with an average maturity of five years, the bond issuers will have to create a DRR of about Rs.25,000 crore each year. The arithmetic is quite simple. A total of Rs.2.5 trillion with an average term of five years would mean Rs.50,000 crore per year. At 50% requirement, Rs.25,000 crore would need to be set aside out of the profits of companies before payment of dividend. This will impact not only the private sector but even public sector companies such as Power Finance Corp. Ltd and Rural Electrification Corp. Ltd.

The top six NBFCs and housing finance companies collectively had outstanding bonds of about Rs.3.7 trillion on 31 March 2013. I don’t have the March 2014 data. Assuming an average maturity of five years, they will need to provide a DRR of Rs.37,000 crore every year. The combined net profit of these NBFCs for 2012-13 was Rs.16,394 crore .

While this will wipe out their profits, setting aside 15% of the funds to be redeemed in the next one year will push up the cost of funding and, in turn, the loan rates of NBFCs.

(Emphasis mine)

Example: HDFC Sees Profits Wiped Off

For example, HDFC has about 82,000 cr. of debentures outstanding (Source: Shelf Prospectus), with over 22,000 cr. coming up for maturity in 2014-15. If they issue fresh debentures to replace that, then they have to have a reserve of Rs. 11,000 cr. (at 50%).

HDFC made a pre-tax profit if Rs. 6,800 cr. in 2012-13. Assume 30% growth for two years, and you might not see more than 11,000 cr. in profits in 2014-15. If you need 11,000 cr. in reserve, it will wipe off all the profits HDFC makes.

Further, the 15% requirement means they will need to put Rs. 3,300 cr. in government securities by April 30. This will reduce available cash and increase their funding costs appropriately.

Reactions: Legal Challenges, Pleas

It seems NBFCs have written and requested clarifications and exemptions for themselves. (Banks are already exempt)

Such an exemption has to come soon. If it doesn’t arrive by April 30, NBFCs have to invest in the G-Sec market to meet the reserve cash requirements.

But right now, in election season, no one will want to take a large decision against a rule that has been communicated nearly three years in advance. It’s unlikely the rule is completely removed, and the SLR requirement is something that’s been on the cards for a while.

It is likely that the DRR for privately placed debentures is removed (as was the case earlier).

But the situation needs to ease up by this quarter – if not, we’ll see the next set of financial results for NBFCs in the toilet.

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