In India, there is a unique category of institutions called Non Banking Finance Companies (NBFCs). They borrow large sums of money from Banks and then lend it to the customers of banks. And the reason banks are okay with this is that the cost of underwriting, lending, collecting is very high when dealing with smaller ticket size borrowers.

For example, if you walked into a branch of HDFC Bank and asked for a loan of Rs 50,000 you are unlikely to get it because the cost associated with lending and recovering that money is too high for a bank. On the other hand, Bajaj Finance (an NBFC) can borrow hundreds of Crores from HDFC Bank and would be happy to give you a Rs 50,000 loan. That’s because Bajaj has built efficiencies around borrowing large sums and breaking it up and disbursing small sums.

So NBFCs and banks have their own strengths and operate in different niches.

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The second idea that I wanted to talk about is fragility. You (an individual or institution) are fragile when external shocks can break you. NBFCs are fragile because they are dependent on banks and external funding. Banks by design are less fragile although sometimes they go and do stupid things and make themselves more fragile.

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NBFCs are even more fragile than banks.

And within the NBFC-verse, there are some that are more fragile than others. The NBFC I want to talk about today was actually doing dumb things and getting rich. Kind of like playing the Russian Roulette and getting rich. It’s loan book was growing at something like 100% year on year for 6 years and the stock price zoomed 9X between 2012 and 2018.

What dumb things was it doing? Many. Like giving large ticket size loans and therefore there was concentration of borrowers ( a source of fragility).

Another was their outflows (or liabilities) were less than their inflows (assets). And they made up for the difference by borrowing more short term money. It’s like borrowing money from a friend (called short term credit market) to pay credit card dues. And then of course repaying the friend back. And then repeating it again next month. Both you and the friend are happy with this arrangement. This worked beautifully until the day the friend refused a loan. Being dependent on a friend to bail you out every time is another source of fragility. (When the times were good, you refused to acknowledge this fragility and do something about it. It’s called denial.)

If you keep doing stupid things again and again and getting away with it, then there will come a time when your luck will run out. Or as Warren Buffett put it funnily:

It’s only when the tide goes out that you learn who’s been swimming naked.

-Warren Buffett, Letter to Shareholders 1993

And duly, in August-September of 2018, that friend could no longer bail you out. One AAA-rated NBFC called IL&FS defaulted on it’s loan. And suddenly Banks became very shy of lending money to any NBFCs. And it was like self-fulfilling prophesy. Banks didn’t lend to NBFCs because NOW they were fragile making the NBFCs even more fragile.

And our company too came crashing down. Between Sep 2018 and Sep 2019, the company lost 50% of it’s market cap and when Covid happened they lost another 50%.

Now, not many companies can suffer body blows like these (freeze in the short term credit market because of IL&FS and then lockdowns because of Covid). But this company did. They sold assets, they raised equity and debt money; they corrected all the cash flow mismatches and pivoted their business model. The promoter had a very good reputation built over many decades and hence they were able to do things which other companies may not have been able to.

But still- why do dumb things and then correct them instead of just avoiding them in the first place?

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Some of my friends are exceptional investors. But they are blind to risks. They have 100% of their money invested in stocks. Like one friend who sold BSE in Feb of 2022 to pay tax dues. It turned out to be one expensive tax to pay because the stock of BSE has zoomed 6X since then! In the same vein he says that buying a car was erroneous because he had to part with 5% of his net worth. What he doesn’t see is that spare cash and an idling car are like insurance for the rainy day. It may seem like a waste when you zoom in any one day…but when you zoom out over a long time frame, where unexpected events happen, you will see that those things bailed you out.

I heard that Pfizer had their entire supply chain based out of China because it costed $2 to manufacture one pill of Viagra and $2.50 to manufacture in India. And Pfizer sold it for $100 in the USA. Being dependent on one supplier or one country makes you fragile. But when you are making tons of money, nobody wants to think of fragility.

When Covid happened, they were unable to sell any because China was shut down. That savings of 50 cents per pill turned out super expensive. (Please treat this as an anecdote rather than a fact).

Below is an excerpt from Nassim Taleb’s Fooled by randomness. Notice how people when they are doing really well don’t want to be reminded of randomness or fragility or any such thing.

It’s hard to justify idling resources because it’s hard to predict what events can happen. But the wise like Warren Buffett have figured out the importance of redundant resources, of slack, of the importance of diversity in suppliers and customers.

We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity.

-Warren Buffett, Letter to Shareholders 2010

I wish you the wisdom.