The difficulties of signalling, old and new

INDIA - Report 25 Jun 2019 by Ila Patnaik

The NBFC (non-banking financial company) industry is in the midst of a stress test. Some firms such as HDFC are widely trusted by lenders, while others are not. The key puzzle for each healthy firm is about signalling to lenders that it is of high quality.

Lenders have relied on three key signals of borrower quality: credit ratings, financial statements signed off by auditors, and bond market spreads. All three signals have deteriorated in their informativeness.

The “assurance industry” (auditors and credit rating agencies) is facing intense scrutiny from government investigation agencies. The energy of many important firms is now absorbed in dealing with these investigations. The rank and file of these organizations is likely to become risk averse, which would generate pro-cyclical behavior.

We do not yet know the response of policy makers to the financial stress that began with the IL&FS default in August 2018. However, some newspaper stories (of limited reliability) show rather statist solutions.

The stress test, which began in August 2018, will result in the evolution of new signals, and healthy firms will be able to benefit from these.

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