FINANCIAL FRAGILITY IN THE NBFC SECTOR

JUN 24

Mains   > Economic Development   >   Indian Economy and issues   >   NBFCs and other banking

WHY IN NEWS

  • Government eases norms of partial credit guarantee scheme and extended its time period in order to resolve liquidity crisis in NBFCs and HFCs.

EVOLUTION OF THE NBFC CRISIS:

  • The liquidity crunch in the shadow banking system India took shape in the wake of defaults on loan obligations by major NBFCs.
  • Two subsidiaries of Infrastructure Leasing & Financial Services (IL&FS) defaulted on their payments in 2018 and Dewan Housing Finance Limited
  • (DHFL) defaulted in 2019.
  • Both these entities defaulted on non-convertible debentures and commercial paper obligations for amounts of approximately 1500-1700 crore.
  • So, mutual funds started selling off their investments in the NBFC sector to reduce exposure to stressed NBFCs.
  • Panic-stricken investors in debt mutual funds started pulling out their investments in these funds rapidly.
  • On June 4, 2019, the net asset value of debt funds, which held debt instruments issued by the stressed NBFCs, fell by 53 per cent in one day when news about its default became public.
  • The drop in net asset value was due to the twin effects:
    • Debt mutual funds writing off their investments in stressed NBFCs

DIFFERENCE BETWEEN BANKS AND NBFCs

NBFCs lend and make investments and hence their activities are akin to that of banks; however there are a few differences as given below:

1.NBFCs are registered under the Companies Act. Commercial Banks are regulated under Banking Regulation Act

1.NBFC cannot accept demand deposits;

2.NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself;

3.Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.

4. Certain categories of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI

    • Asset sales at fire sale prices to meet unexpected high redemptions.
  • The impact of these defaults was not limited to debt markets. There was a sharp decline in the equity prices of stressed NBFCs as equity market participants anticipated repayment troubles at these firms a few months in advance of actual defaults
  • Many NBFCs witness a sharp fall in market cap.
  • Therefore, both debt and equity investors suffered a massive erosion in wealth due to the defaults
  • Debt mutual funds, facing increasing redemptions, were hesitant to finance the NBFC sector.
  • The exposure of debt mutual funds to the sector drops by 20% year-on-year.
  • Bond prices fall due to the sell-off and yields continue to rise, making it more expensive for NBFCs to borrow.
  • This, in turn, led to the difficulty of NBFCs to raise funds, which took a toll on the overall credit growth in the Indian economy and a decline in GDP growth

CAUSES OF NBFC CRISIS

  • Flawed business model of NBFCs:
    • It relied on raising short-term funds which were then lent out as long-term loans. This leads to a situation called an asset-liability mismatch.
    • For example, an NBFC raises money by selling 6-month debt papers and on-lends this as a car loan with a tenure of 5 years. This leads to a situation where the NBFC has to roll over (or renew) the 6-month debt paper or raise fresh loans to repay the debt paper. In good times, this happens as a matter of course. But when times are tough, this cycle is broken (In 2018, the cycle was broken by a default of some firms of the IL&FS group).
  • Low financial liquidity:
    • Most NBFCs do not have substantial on-balance sheet liquidity because they primarily manage liquidity by matching cash inflows from loan repayments by customers with cash outflows to repay their own liabilities
  • Over-dependency on short-term wholesale funding
    • NBFC’s liability structure is over-dependent on short-term wholesale funding such as commercial paper. When an asset-side shock happens, it gets amplified due to this over dependency.
  • High interconnectedness with Liquid Debt Mutual Fund (LDMF) sector:
    • The Liquid Debt Mutual Fund (LDMF) sector is a primary source of short-term wholesale funds in the NBFC sector.
    • This interconnectedness causes the transmission of systemic risk from the NBFC sector to the LDMF sector.
    • Shocks in the NBFC sector may lead to pulling out money by investors at fire sale prices resulting in liquidity crisis in the NBFC sector. Liquidity crunch in one NBFC adversely affects risk perceptions about other NBFCs as well.
  • Poor quality in NBFC’s underwriting standards:
    • In the last few years, especially after demonetisation, there was excess money in the system.
    • That is because a lot of cash was deposited with banks and investors parked more money with mutual funds.
    • NBFCs were able to access cheap funds easily and they were able to grow their loan portfolios at double the pace of banks.
    • But on the flip side, note that mutual fund managers were chasing high returns for their investors and so too were NBFCs and banks. This led them to take risks and put pressure on the quality of their underwriting standards

IMPACT OF THE CRISIS:

  • Reduced credit flow in the economy:
    • NBFCs are playing an increasingly important part in the economy. Their share of credit has increased because they were lending in sectors where banks refused to go or did not want to go. The used commercial market is a good example here.
    • Hence crisis in NBFC sector will choke the flow of credit to the economy.
  • Impact on MSME sector:
    • Since MSMEs largely depends on NBFCs as an essential mode to avail funds, the sector takes a huge hit due to the crisis.
  • Reduced consumption demand in the economy:
    • 40% of the incremental consumer financing in 2019 was done by the NBFCS
    • NBFC’s are largely involved in providing vehicle loans, Consumer durables, Gold loans etc. Around 95% of vehicles may have been financed by the NBFCs or by agents
    • Hence, a lack of credit outflow from NBFC will hit consumption demand
  • Impact on real estate sector:
    • Real estate companies were getting money largely from the NBFCs because they were not getting any lending from the banks.
    • The NBFCs were giving these companies funds to start new projects, construction and financing etc. After RERA, they depended on NBFCs even for their working capital requirements.
    • The real estate companies are now shutting down their projects due to the NBFC crisis.
  • Increased NPAs:
    • A slowdown in credit could lead to another pile of non-performing assets in sectors such as commercial real estate and infrastructure, which could have economy-wide knockdown effects.
  • Stock market crisis:
    • NBFC crisis makes investors nervous and the market capitalization of many major NBFCs is decimated, resulting in downward trend in stock market.

GOVERNMENT INITIATIVES TO TACKLE THE CRISIS

  • Launched ‘Health Score’ index:
    • The Economic Survey 2020 unveiled an early-warning system, 'Health Score'
    • It is developed for NBFC and housing finance company (HFCs) sectors.
    • It can help detect early-warning signals of impending liquidity problems facing the companies in the sectors.
    • Health Score employs information on the key drivers of refinancing risk such as Asset Liability Management (ALM) problems, excess reliance on short-term wholesale funding (Commercial Paper) and balance sheet strength of the NBFC
  • Initiatives from RBI:
    • Liquidity management framework
      • RBI has introduced ‘liquidity management framework’ for NBFCs.
      • This aims to strengthen their asset-liability management following the liquidity crisis faced by these firms in the past year
      • Under this framework, NBFCs are mandated to maintain liquidity coverage ratios (LCR).
      • LCR refers to the proportion of highly liquid assets held by companies to ensure their ongoing ability to meet short-term obligations.
    • Increased threshold on bank’s exposure to NBFCs:
      • RBI has decided to increase the cap on a bank’s exposure to a single NBFC to 20% of its tier-I capital from 15% now.
    • Priority sector tag:
      • RBI has decided to give ‘priority sector’ tag for bank lending to NBFCs, for on-lending to farm, small and medium enterprises and housing sector.
    • Long-term repo operation:
      • The central bank announces long-term repo operation (offering money at a cheaper price to banks for lending to a particular sector) targeted at shadow bankers with a condition that half of the funds availed by banks must go to small and mid-sized NBFCs.
      • This attempt fails as the RBI receives a subdued response from banks, which are trying to stay away from risky moves.
  • Initiatives from Government:
    • Partial Credit Guarantee Scheme: It allows for purchase of high-rated pooled assets from financially-sound non-banking financial companies (NBFCs) and housing finance companies (HFCs) by public sector banks (PSBs).
    • This guarantee support aims to help address NBFCs/HFCs resolve their temporary liquidity or cash flow mismatch issues.

INTERNATIONAL EXPERIENCE:

  • In 1997-98 the world’s largest hedge fund Long-Term Capital Management (LTCM) in the US was going bankrupt. The US administration forced 14 investment banks to lend money to the hedge fund to keep it alive.
  • It’s some of these 14 lenders to LTCM who went bankrupt in the 2008 crisis, the seeds of which were sown in 1998 in the LTCM crisis.
  • IL&FS has the potential to be India’s LTCM and not only Lehman Brothers.

WAY FORWARD:

  • Regulators can employ the Health Score methodology to detect early warning signals of rollover risk problems in individual NBFCs.
    • Downtrends in the Health Score can be used to trigger greater monitoring of an NBFC.
  • Optimal capital infusion:
    • When faced with a dire liquidity crunch situation, regulators can use the Health Score as a basis for optimally directing capital infusions to deserving NBFCs to ensure efficient allocation of scarce capital.
  • Reducing NBFCs over-dependency on wholesale funding:
    • Prudential thresholds should be set up on the extent of wholesale funding that can be permitted for firms in the shadow banking system
  • Bring NBFCs under RBI’s ambit:
    • The RBI should monitor the total lending including NBFCs apart from the banks on a fortnightly basis.
    • RBI only monitors banks currently.
    • It should also oversee the NBFCs and look at the system liquidity including both NBFCs and banks so that the borrowings can pick up in the economy
  • Offering moratorium:
    • Public Sector Banks could offer a moratorium on repayment of loans to shadow bankers.

PRACTICE QUESTION:

Q. How far NBFCs contributes to improve financial inclusion in India? Does the recent crisis in the NBFC sector can be attributed to poor regulatory framework in India’s non-banking financial system?