We will provide supplements on regular basis on some of the burning topics of last one year. The opinion mentioned are prone to interpretational biases. Readers are advised to use discretion.
What went wrong with the NBFC sector ?
It all started with Infrastructure Leasing and Financial Services (IL&FS) defaulting on its debt in June 2018 and a subsequent breakdown of this large NBFC in September 2018. The huge debt obligation of ₹91,000 crore as of September 2018, and ensuing defaults, gave the world a sense of the fatal flaws intrinsic to NBFCs—such as
- skewed asset-liability management practices with short-term borrowing funding long-term assets,
- imprudent lending practices,
- and lack of due diligence coupled with ambitious growth targets
(These three can majorly be grouped in two categories – ALM problems and issues related to corporate governance)
In detail – Root of the crisis
- The mismatch – The IL&FS crisis brought to the fore the inherent problem of asset-liability mismatch in the shadow banking system. It showed up how NBFCs have been raising short-term loans—typically ranging between three and six months, through commercial papers—and lending long-term to infrastructure loans, home loans, among others.
- An RBI research report showed that 99.7% of shadow banking in India makes long-term loans against short-term funding, primarily carried out by NBFCs and housing finance companies.
- The ongoing meltdown did not go entirely unnoticed by the central bank and was somewhat predicted in a report by one of its committees. In 2012, the Usha Thorat committee had highlighted the risks that NBFCs carry by being dependent on money market instruments with little flexibility in shedding off their long-term assets under situations of stress. It suggested uniformity in prudential regulations between the two financial entities—banks and non-banks. (This means that still NBFCs and Banks have to follow different set of rules whereas in many developed countries there is no difference between a bank and a shadow bank).
- Banks Stopped lending and rating downgrades – Following the IL&FS debacle, funding streams for non-banks have dried up. Banks and MFs—their major sources—have been unwilling to lend a helping hand. Further, rating agencies have downgraded the debt papers of some of these firms, making it even more difficult for them to raise funds from banks or MFs since financial institutions base their lending decision on ratings to a large extent.
Impact- While mutual funds are not allowed to lend to firms rated below B, the threshold for insurance firms and pension funds is at AA. This created a situation of liquidity squeeze for NBFCs.
In short ; What were/are the major ongoing issues with NBFC sector? Your short answer can be – the sector is facing issues of ALM mismatches and weak corporate governance. This was further exacerbated by bank’s reluctance to give credit to NBFCs.
Efforts done by RBI to Support NBFCs since IL&FS crisis.
RBI allowed banks to provide partial credit enhancement of NBFC bonds
The move was aimed at enhancing the credit rating of the bonds and enabling these NBFCs to access funds from the bond market on better terms. PCE, which was introduced in 2015, is expected to help NBFCs and HFCs raise money from insurance and provident or pension funds who invest only in highly-rated instruments. Basically, NBFC issue binds to raise funds however after this crisis they were not able to do so. In this situation, RBI allowed banks to provide partial credit enhancement ( a kind of guarantee) so that NBFCs can raise money through bonds in this difficult time.
RBI eases risk weights for some NBFC loans
RBI has decided that exposures to all NBFCs, excluding core investment companies will be risk weighted as per the ratings assigned by the rating agencies registered with Sebi and accredited by the Reserve Bank of India, in a manner similar to that of corporates. This will help to align the treatment of NBFCs with normal corporates.
Previously, exposures on rated as well as unrated non-deposit taking systemically important NBFCs (NBFC-ND-SI), other than asset finance companies (AFCs), NBFCs–infrastructure finance companies (NBFCs-IFC), and NBFCs–infrastructure development funds (NBFCs-IDF), are uniformly risk weighted at 100%.
Previously, banks had to keep 100% margin (equal to loan amount irrespective of the rating of the NBFC) while they used to lend to NBFCs but with this change banks have to keep less capital for high rated NBFCs. This will allow top rated NBFCs in accessing Bank funding with ease.
RBI wants NBFCs with assets over ₹5,000 cr to appoint chief risk officers
Due to the increasing role of NBFCs in direct credit intermediation, there is a need for NBFCs to augment risk management practices. This was done to enhance the corporate/Risk governance in NBFC.
RBI revised liquidity risk management guidelines for NBFCs
RBI had revised the extant guidelines on liquidity risk management for non-banking finance companies (NBFCs) in order to strengthen and raise the standard of asset liability management (ALM) framework applicable to them.
All non-deposit taking NBFCs with asset size of Rs 100 crore and above, systemically important core investment companies and all deposit taking NBFCs irrespective of their asset size will segregate the 1-30 day time bucket in the statement of structural liquidity into granular buckets of 1-7 days, 8-14 days, and 15-30 days.
The NBFCs were also advised to adopt liquidity risk monitoring tools/metrics in order to capture strains in liquidity position. Basically, NBFCs have to monitor liquidity ( inflow of funds vs outflow of funds) in small buckets for better management.
NBFCs to receive more liquidity support as RBI raises exposure limit
RBI has allowed banks’ lending to non-banking financial companies (NBFCs) for on-lending to agriculture, micro and small enterprises, and housing to be classified as priority sector lending, up to specified limits. Banks’ lending to NBFCs for on-lending to agriculture up to Rs 10 lakh a borrower will be treated as priority sector lending.So, too, for loans up to Rs 20 lakh for micro and small enterprises and housing.
Basically this means that Bank can also lend to NBFCs to cover their priority sector targets this means extra funds to NBFC.
The RBI raised any bank’s exposure limit to a single NBFC from the existing 15 per cent to 20 per cent of tier-1 capital. The idea is to ease liquidity pressure in NBFCs. Gain this means extra funds to NBFCs.This has been done to increase the credit flow to certain sectors which contribute significantly to economic growth in terms of export and employment, and recognising the role played by NBFCs in providing credit to these, but you can always see that the timing of this move was to provide support to NBFCs.
In the measures mentioned above RBI has tried to provide Easier funds to NBFCs through Mutual Funds and Banks which shall help NBFCs in better management of its ALM.RBI has also made certain adjustments to Corporate governance and risk management through new Chief Risk Officer and ALM guidelines. If you see above ( highlighted in Yellow), these two were the main issues of NBFCs.
- What is your understanding of NBFC crisis?
It is a crisis of ALM mismatches and poor corporate governance.
- What are the steps that RBI has taken to help NBFCs?
- What is the meaning of ALM mismatch?
You had money but not at that time when you were to pay.
- Should RBI provide liquidity support to NBFCs who are facing any liquidity trouble?
NO, RBI cannot provide liquidity support to NBFCs as RBI can only provide liquidity support as a lender of last resort to Banks not to NBFCs. Plus, providing support to one nbfc can create a situation of moral hazard or in other way it will incentivise the risky behaviour by protecting them.
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