NBFCs facing stringent regulatory headwinds

New Delhi | Published: May 30, 2019 2:59:14 AM

RBI may tighten NBFC regulations to the extent large NBFCs carry the seeds of financial instability

nbfc, rbi, mutual funds, non-bank financial companiesNBFCs face stringent regulatory headwinds, going forward.

By Barendra Kumar Bhoi

Since September 2018, the cost of raising resources by non-bank financial companies (NBFCs) has gone up significantly, mainly due to spillover effects of repayment default by the Infrastructure Leasing & Financial Services (IL&FS) and its subsidiaries. The yield spread of commercial papers (CPs) and debentures issued by NBFCs has widened considerably over the risk-free rates of corresponding maturities, except some softening of these rates during recent months. Following increase in the credit risk, banks are reluctant to renew their lending to NBFCs.

Let us understand the underlying reasons for NBFCs facing a sudden liquidity problem? The average credit growth of NBFCs was more than double compared to the non-food credit growth of scheduled commercial banks during the last five years. As banks were under the asset quality review (AQR), NBFCs got an opportunity to do brisk lending business, borrowing partly from banks and partly from the market, either directly or through issuance of CPs/debt instruments. Sitting on excess cash, particularly after demonetisation, mutual funds (MFs) were also lending liberally to NBFCs, mainly through market-based instruments. In the second half of 2018, MFs faced redemption pressures following portfolio outflows from India and, therefore, could not sustain their lending to NBFCs.

NBFCs demand a special liquidity window from the Reserve Bank of India (RBI) to manage their liquidity problem. Now, should RBI open a special liquidity window for NBFCs? After the global financial crisis in September 2008 and also during the taper tantrum in July 2013, RBI had introduced a temporary liquidity window for MFs to tide over acute redemption pressures. During mid-July to October 2013, commercial banks were allowed to borrow up to Rs 25,000 crore from RBI at a penal rate of 10.25%, which was well above the bank rate, for on-lending to MFs. There was no direct lending by RBI to MFs. In addition, MFs hardly availed this facility as the lending to them through banks was not cost-effective.

RBI feels that there is no shortage of liquidity at the system level and, therefore, opening a special window for NBFCs does not arise. As the repo rate has been cut twice and the liquidity condition has improved significantly in 2019, money market rates have softened, which might have benefited NBFCs as well. Commercial banks, maintaining NBFC accounts, may possibly provide limited short-term liquidity to NBFCs as per needs at their own risk, provided NBFCs have high quality collaterals.

Unless there is an exceptional circumstance, there is no case for opening a special liquidity window for NBFCs. Even if a special window is opened for NBFCs, it may not be attractive as the penal rate may be higher than the CP rate or yield on corporate debt. Moreover, this may create distortion in the money market if the RBI penal rate is not aligned to the CP rate or yield on corporate debt of similar maturities. There is a growing perception that only a handful of NBFCs face liquidity problem due to weaknesses in their balance sheets arising from imprudent lending. In the absence of AQR, it is not clear whether such NBFCs face temporary liquidity problem or insolvency problem?

There is a thin line of difference between the problem of illiquidity and insolvency. A potentially insolvent NBFC may face liquidity problem to begin with. This needs to be studied through AQR of NBFCs, which is overdue. As far as IL&FS is concerned, it looks more like an insolvency problem (involving close to Rs 1 trillion) than a liquidity problem. Due to spillover effect from IL&FS, the possibility of other NBFCs facing temporary liquidity problem cannot be ruled out altogether. In either case, NBFCs have been paying a price in terms of spread over risk-free rate depending upon the strength of their balance sheets and corresponding credit ratings obtained by them for issuing CPs or debt instruments. Let the imprudent NBFCs be penalised by market discipline.

The problem of NBFCs is not limited to credit risk only. The asset-liability management (ALM) of NBFCs seems to be disappointing as they are not regulated as stringently as banks. Financing long-term assets through short-term borrowing is not sustainable. A similar business model, relentlessly pursued by shadow banks in Western countries, led to the global financial crisis. In India, as NBFCs have acquired a sizeable proportion of the financial sector, they can cause financial instability if they do not change their business model well in time.

NBFCs face stringent regulatory headwinds, going forward. RBI may tighten NBFC regulations to the extent large NBFCs carry the seeds of financial instability. It has already asked large NBFCs to appoint a Chief Risk Officer as a preventive measure. On May 24, 2019, RBI has come out with a draft circular on liquidity-risk management framework for NBFCs for public comments. Proposals include, inter alia, introduction of the liquidity coverage ratio (holding of high-quality liquid assets like G-Secs), disclosure of funding concentration, Board-approved comprehensive risk-mitigation policies, etc.

There is no specific mention about AQR for NBFCs other than broad ALM guidelines. The liquidity coverage ratio is proposed to be fully operational over a period of four years starting April 2020, which can be shortened appropriately to, say, 2-3 years. Measures proposed in the draft circular look more like a health advice to NBFCs and their Boards, rather than specific targets, except the liquidity coverage ratio, to be achieved in a time-bound manner. The whole gamut of prudential regulations relating to NBFCs needs to be revisited, including AQR, provisioning/capital adequacy, besides supervisory review of ALM. Alternatively, NBFCs, more interested to have access to public deposit, may be converted into banks and adhere to banking regulations.

Get live Stock Prices from BSE, NSE, US Market and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Financial Express is now on Telegram. Click here to join our channel and stay updated with the latest Biz news and updates.

Next Stories
1DATA DRIVE: Huge pendency in green cases
2Beyond India’s Coronavirus Unlock 1.0: An age of innovation
3Promoting Ayush: Govt must take a cue from China’s efforts on ‘Traditional Chinese Medicine’