The current article provides responses related to the query: Why do finance companies use short term funds like commercial papers (CPs) and current/savings account (CASA) for giving long term loans and create an asset liability mismatch?
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Why do finance companies use short term funds for giving long term loans and create an asset liability mismatch and in turn increase insolvency risk?
I am grateful to you for patiently clearing the doubts of the amateur investors and astute investors alike.
Sir, following the reports of irregularities that came to the surface in case of IL&FS, asset liability mismatch is cited as the biggest issue. The nonbanking finance companies (NBFCs) are indulging in acquiring loan assets by floating commercial papers (CPs) and rolling over the CPs on the due date. Seen in this context, please clarify how banks whose current and savings account (CASA) deposits are 35% to 40% of total deposit liabilities, are funding loan assets whose maturity is above 7 years to 25 years. Moreover, how the banks having higher CASA ratio are rated as the best performing banks?
Why does this dichotomy between NBFCs and banks exist as far as maturity profiles of liabilities when compared to the loan book (asset liability mismatch)?
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An investor would appreciate that to lend for the long term, a financial institution should ideally have long term sources of funds. In situations where a financial institution (FI: Bank or NBFC) has to give out long term loans by using money raised from short term sources like commercial paper (CP) or current and savings account (CASA), then it exposes itself to risk.
The risk is that the counterparties, which have given it short term funds may demand it back whereas the FI would not have money to pay them back because all its money would be stuck in long term loans given by it. This is the scenario which has played out for many NBFCs including IL&FS and is called an asset liability mismatch.
To avoid the situation of asset liability mismatch, ideally, an investor would assume that FIs should fund all the long term loans by long term sources of money. Now let’s attempt to find out what can be these long term sources of funds.
1) The longest source of money is equity.
Therefore, indirectly, investors may believe that all the long term loans of financial institutions should be funded by equity. In this manner the FIs can avoid asset liability mismatch altogether. However, using 100% equity for giving out long term loans limits the growth prospects of the FI. Raising equity whenever a FI has to give out long term loan is not easy and is a costlier and time-consuming affair.
Therefore, if the FI only relies on equity, then it will lose out on the business when compared to its competitors. This is because the competitors would give out loans faster and cheaper using money raised from debt rather than equity.
2) Other solution to avoid asset liability mismatch can be that the FIs give long term loans by using funds raised from long term debt.
Investors would appreciate that most of the time, the long term sources of funds are costlier than the short term sources of funds. This is simply because the probability of anything going wrong with the FI is more in the longer term. As a result, the providers of money to the FI ask for more return when they give long term money than when they give short term money to FI. Therefore, one would appreciate that for a FI, giving loans to its customer by using long term debt/long term sources would be costlier than giving loans using short term sources of funds.
To cumulate the learning from our above discussion, it comes out that the stability/risklessness in giving out long term loans and the cost of giving these long term loans varies on a spectrum but moves in opposite direction. Meaning:
- To have the highest level of stability, financial institutions (FIs) should fund all the long term loans by equity/long term sources. However, this makes lending a very costly affair as long term sources of money are costlier than short term sources. This, in turn, decreases the profits of the FI.
- On the other hand, if the FI uses cheaper short term funds to give out long term loans, then it increases returns/profits because the short term sources of money are cheaper than long term sources of money. However, when the FI uses short term sources of money to give long term loans to its client, it exposes itself to the risk where providers of short term money may ask their money back and it will not be able to repay them. This is called asset liability mismatch or solvency/liquidity risk.
Therefore, the final decision to use what kind of funds (equity/long term funds/short term funds) to give out long term loans is a tricky decision.
FIs use a mix of long term and short term funds depending upon their ability to convince the short term funds (CPs and CASA) providers to give them cheaper money and keep rolling these short term funds over and over again. This rolling-over facility provides an opportunity to the FI to give long term loans at lower cost and in turn, increase its profits. However, if a FI is not able to give the confidence to short term fund providers about its ability to repay them whenever they call their money back, then these short term fund providers may not give the FI any money. As a result, the FI will have to rely on costlier long term funds and give loans at lower profits.
As the aim of all the financial institutions (FIs) is to generate maximum profit, therefore, they tend to use cheaper short term funds as much as possible whether by way of commercial papers (CPs) or CASA. However, they also need to show the short term fund providers that the FI is financially sound and can pay them back whenever they want their money back. The ability of best performing banks to repay the short term fund providers (CASA) at any time, is reflected in their ability to keep such short term fund providers stick with them/roll over their money.
Investors would appreciate that this best performing image for high CASA banks is not permanent and if there is any doubt on the ability of the bank to repay CASA at short notice, then banks also face the same fate like IL&FS. It is called “Run on the Bank”. In the past, many banks have faced it.
Therefore, we believe that instead of looking it as a Banks vs. NBFCs perception, investors should look at it from the perspective of the confidence that any financial institution (FI) provides to the short term fund providers (CPs/CASA). If any FI provides high confidence to CP/CASA providers, then it will want to and it will be able to fund its long term loans from short term funds and in turn, it will generate high profits for itself/its shareholders. However, whenever, this confidence goes away, then the FI irrespective of being a Bank or NBFC will face a run on it and will face bankruptcy.
Therefore, in summary, the market perception of the stability of a FI (Bank or NBFC) lets it use short term funds (CPs/CASA) to fund long term loans. FIs want to use short term sources of funds like commercial papers (CPs) and current and savings accounts (CASA) to give long term loans as short term sources of money are cheaper. This increases profits for the FI. However, whenever any FI overuses short term funds, then it faces stability (liquidity) risk and results in its bankruptcy.
Therefore, it is not a debate of Bank vs. NBFC. It’s only a matter of market perception. Banks with higher perceived stability are able to get higher CASA and use it for giving long term loans and in turn generate higher profits. The day, this perceived stability goes away, they face the same fate as any NBFC, which is “Run on the Bank”.
Hope it answers your query.
All the best for your investing journey!
Dr. Vijay Malik
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