This is an interesting story that dates back to the 1980s, so millennials would probably relate more to it. LML Vespa had just hit production for the first time in India. A two-wheeler, straight from a foreign land, trying to cater to the hungry demand for Indian middle-class scooters. At its peak, the waiting period for the scooter was almost 10 years. Yup, not a typo, a decade. The customers would pay a decent upfront amount (Around ₹500 in the 1970s) to book their scooters and wait for years to get their hands on the vehicle. Upon the date of delivery, the customer would have to pay the remainder amount and take the Vespa home. Now you must be thinking, where am I going with this story? Hold this thought as we get into the details.

During those years, Bajaj rebranded its scooter and launched the new Chetak. The waiting time for Chetak was much less and it was more feature-rich than the LML Vespa. So the customers naturally fled to Bajaj. Now this is where the trouble started brewing for LML. Not because of reducing demand but because of refunds. The booking amount that LML took from customers was recorded under current liability, as the company had received the cash but hadn't delivered the product yet.

And LML used the cash from these advances to fund their long-term capex projects for setting up production. And tada!! You have an asset-liability mismatch. This means, that when the customers who wanted to flee to Bajaj asked for refunds, the company did not have enough liquid cash to pay them back!

And remember, this is the time when the borrowing cost for corporates was sky-high. With the reducing demand and huge ALM mess, LML had to stop the production of Vespa and sell the assets to pay creditors and customers. In the end, LML paid back the entire booking amount to all its customers with all the accrued interest but not without facing serious challenges. This story shows how ALM can turn into a BIG issue if not paid close attention to it.

What is an Asset Liability Mismatch a.k.a ALM?

Asset-liability mismatch is a huge concern for banks and it makes them quite fragile. Banks, as we all know, take surplus cash from people as deposits and lend it forward to borrowers. During this process, depositors' wealth grows by a certain percentage, borrowers get access to capital by paying interest and banks take home the spread between returns paid and interest earned, also known as net-interest margin.

The problem here is, that banks use their balance sheet to provide these services, where long-term loans are funded by short-term deposits. Thus if a lot of borrowers ask to withdraw the money, the bank won't have enough liquid cash to pay them back.

The recent case of Silicon Valley Bank is the best example of this. The bank collapsed due to three main reasons.

• It was investing the short-term deposits in long-term US Bonds. But the bank conveniently forgot to hedge the interest rate risk, even though 55% of its deposits were in US treasury instruments. So during the COVID interest rate hikes, the market price of these treasury bills fell to a record low, and the market value of these securities was not enough to pay back depositors even if completely liquidated.

• Secondly, the short-term deposits were used to give long-term loans, so when the depositors made a run on the bank, well we all know what happened next.

• And lastly, the bank had low FDs when compared to CASA (Current Account Savings Account). Usually, FDs give a good cushion of cash to banks and give them some certainty of cash flows.

If the bank had actively managed the duration of its liabilities against the duration of its assets, it might not have collapsed today. Watch this short video by WSJ to understand more.

How Does RBI oversee the ALM Issue?

Now obviously ALM is a huge concern area, so what can we do about it? RBI came in with several liquidity norms to at least provide a cushion in case there is a mass withdrawal of funds. Basically, for every ₹100 deposit (5% goes to CRR), the bank will have to keep roughly ₹20 aside in cash and money market securities to have liquidity. This is called the Statutory Liquidity Ratio. Similarly, out of the remaining ₹75, banks will have to maintain a loan-to-asset ratio, which means they can only loan out a percentage of the total deposit, rest can be invested in long-term treasury bills, FDs etc.

These figures, which are calculated as a percentage of deposits, are average for the entire year. So on various occasions throughout the year, the SLR, CRR and Loan-to-asset ratio may be lower than the set norms, but the average for the entire year should meet the requirements.

Managing assets and liabilities for a bank is much more complicated than simply maintaining certain ratios. This is because of the periodic or even daily fluctuation in the assets and liabilities. Take the time of month-end for example. The salaries for all the corporate employees in India get credited on the 1st of every month. This means banks have to maintain liquidity in their current accounts portfolio for these transactions to happen. Same is the case during the end of fiscal year, when companies are filing advance tax returns, there is a huge cash outflow. Banks obviously cannot keep excess idle cash as they will lose out on returns, so they try to maintain an optimal balance.

P2P Lending Basics with ALM Context

Now that you are aware of the importance of ALM, let's come to P2P lending. And how tweaking a small feature of this model, completely changed the way NBFC P2P was expected to function, but also opened the floodgates for massive ALM mismatch. We won't go much into the details of P2P Platform, you can read our blog here to understand how they function. So let's get into the ALM bit.

RBI granted P2P platforms NBFC-P2P licenses to facilitate financial activity. Facilitate here is the keyword, as they were supposed to be an intermediary or a pass-through platform to facilitate the transaction between lenders and borrowers. There is nothing on the balance sheet of P2P platforms, and hence no real risk for them.

The P2P lending products were supposed to help investors lend directly to borrowers, whereas a P2P platform's job was to perform due diligence, help in loan recovery and be a platform to aggregate borrowers and lenders. Simple.

So the investors (lenders) would only get their money back when the borrower pays the monthly installments, and if the borrower defaults, it's the lenders who lose the money. By far, you must have understood that there is no real guarantee for returns. This also means that theoretically, the tenure of the investment will be the same as the duration of the loan disbursed.

P2P products are designed in a way, to create a pool of borrowers to diversify risk for the investor. The product was in no way meant to be a liquid instrument, at least until some other buyer agrees to buy the product directly from you in a secondary market which some P2P platforms facilitate on their website.

But some big VC-funded P2P platforms in order to chase growth tweaked some of their offerings and transformed themselves like deposit-taking NBFCs (even if they don't admit it) but unknowingly also brought ALM risks on themselves and exposed investors to it as well.

Why ALM can create havoc in P2P Lending Business

Several P2P platforms are now selling short-term fixed-maturity liquid products, while the loans disbursed against them are generally longer duration. Let me explain to you with a few numbers, the majority of loans disbursed by P2P platforms have a tenure of 12-36 months, while the majority of investments received are in short-term 2-3 months liquid category products.

I guess you have already spotted the problem here. There are two issues with such an arrangement.

• Firstly, there is a mismatch between the tenure of Investment and the duration of loans and they have to use their balance sheet to structure this which is strictly prohibited as per RBI rules. The platforms claim to be not using their balance sheets but they are also very opaque about how they are offering this product then.

• A fixed-maturity short-term P2P product artificially creates a sort of guaranteed return for investors. Because to fix the mismatch, P2P platforms may be using their own capital, to create liquidity and buy back these products at a given rate. This is a major concern as P2P platforms are not allowed to take deposits or use their balance sheets to create liquidity. This essentially transforms them into deposit-taking NBFCs.

Another potential goof-up by P2P platforms is pre-mature withdrawal schemes. Platforms have started offering instant liquidity for P2P lending products without any lock-in. This means that an investor can withdraw their money anytime without any repercussions.

It would have been fine if the product was liquidated, only if there was a ready buyer on the other side of the transaction, but this cannot be the case given the volume we are talking about.

This feature of the P2P Lending platforms can lead to a huge Asset-liability Mismatch in the future. They may be able to handle this at a small scale using their own capital and revenues, but what if all the investors holding the investment product, want liquidity at the same time? The platform will not be able to fulfill such requests. These P2P platforms have to keep a capital requirement of just ₹2 crore with the RBI and if there's a run on them, their situation will be much worse than the SVB Bank collapse.

What Does RBI have to say about this?

So what has RBI been doing when P2P-NBFCs took their own sweet road to misinterpreting the regulations? Well, all of these developments have been noted by RBI, and recently the regulator called several heads of such platforms to discuss the topic of pre-mature withdrawal, fixed maturity plans and another issue of P2P platforms' strange relationship with fintech start-ups.

It seems that RBI has something in store for P2P-NBFCs which will be released next year, and I am afraid that many of the platforms won't be a huge fan of the regulatory changes. But such changes are necessary, as P2P is slowly becoming a mainstream alternative investment, thanks to the fintechs. To give you an idea, roughly ₹10,000 crore loans have been disbursed by these platforms.

We can only wait and guess as to what changes RBI will bring to the P2P-NBFC regulations. But, these changes will definitely reduce the systemic risk which is currently plaguing this sector.

The strange relationship between P2P platforms and Fintechs

Lastly, to conclude, let's visit the symbiotic relationships that NBFC-P2Ps share with fintechs. As we discussed earlier, the NBFC-P2P license allows these platforms to create products and aggregate borrowers and lenders. But, the borrowers and lenders don't magically stumble upon these platforms, they need to be acquired.

Enter - Fintechs. Startups such as BharatPe, Cred, etc have raised millions in VC funding, which they have lavishly splurged in marketing and advertising. Thus they have an established base of Vendors and corporate employees who are looking for avenues to invest their money, while also borrowing for personal use.

P2P-NBFCs use their license to cater to such fintech and create a closed borrower-lender ecosystem exclusively for that fintech. Platforms such as 12% Club, Cred Mint, etc are products of such an arrangement.

But why does RBI have a problem with this model? After all, it's a win-win-win-win situation for fintechs, P2Ps, borrowers and lenders. It's because, in such a model, the P2P-NBFC is virtually renting out its license to some other company that is not exactly playing by the rules. Let's see what RBI has to say in this matter, and whether there will be any restrictions set by the regulator to control this mutual arrangement.

Conclusion

We hope this article gives you a fair amount of idea of what Asset Liability Mismatch is and how it can ruin some P2P platforms in India right now and in turn you can lose your hard-earned money.

Some of the platforms that offer fixed maturity, fixed return products are:

• Lendenclub

• 12% Club

• Cred Mint

• BharatPe

• Liquiloans

• LendBox

We recently caught up with the founder of Monexo (Mr. Mukesh Bubna) whose platform claims to not offer any such fixed tenure, or fixed maturity products for a podcast and also covered challenges of ALM and his views, feel free to watch it here:

If you are not already aware, we also run a Whatsapp community with 250+ active people in it discussing all sorts of alternative investments, if you would like to be a part of it, feel free to apply at the link below and we will review and add within 1-2 days!

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