Recently, the Non-Banking Financial Corporation (NBFC) sector, that services a significant portion of the credit needs of corporate India, suffered miserably due to the lack of liquidity. Due to the massive collapse of the IL&FS group, the financial markets slumped and hit the NBFCs hard. As a result, traditional banks stopped taking fresh exposures on the NBFCs. Even mutual fund and other institutional investors lost faith in the financial services sector. NBFCs also faced the problem of asset and liability mismatch as these companies used to borrow in the short term to lend for the long term.
The urgency of the situation prompted the Reserve Bank of India (RBI) to step in and take initiatives to address the concerns of the lenders. RBI announced relaxations with respect to minimum holding period, for direct assignments and securitization transactions etc. With a long term perspective, the RBI announced a new liquidity framework to deal with liquidity risk.
RBI’s Liquidity Framework
The new liquidity framework comes divided into two parts:
- Liquidity risk management framework.
- Liquidity coverage ratio.
- RBI requires the NBFCs to maintain a liquidity buffer of high-quality liquid assets to meet short-term obligations. This will help them survive any acute liquidity crisis.
- Liquidity Coverage Ratio is the proportion of highly liquid assets set aside to meet short-term obligations. The non-deposit taking NBFCs with an asset size of Rs 10,000 crore and all deposit-taking NBFCs, irrespective of the asset size, need to maintain a liquidity buffer in terms of Liquidity Coverage Ratio (LCR) from December 1, 2020. The non-deposit taking NBFCs with an asset size of more than Rs 5,000 crore and less than Rs 10,000 crore, need to maintain a minimum of 30 per cent of liquid assets as LCR, starting from December 2020.
- NBFCs need to maintain the stock of high-quality liquid assets amounting to a minimum of 100 per cent of total net cash outflows over the next 30 calendar days.
- The NBFCs need to adopt liquidity risk monitoring tools to detect strains in the liquidity position. They need to track particular metrics like ‘concentration of funding’ to identify significant sources of funding to avert liquidity issues. Tools like ‘available unencumbered assets’ can be used to raise additionally secured funding in secondary markets.
- NBFCs must adopt a ‘stock’ approach for liquidity risk measurement, as per the guidelines of the RBI. The liquidity ratios proposed include short-term liability to total assets; short-term liability to long-term assets; commercial papers to total assets; non-convertible debentures (NCDs) to total assets; short-term liabilities to total liabilities; and long-term assets to total assets.
- For strengthening the asset-liability mismatch that NBFCs currently face, the RBI has segregated 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. This limits the extent of mismatch permitted during these periods.
What Does RBI’s New Liquidity Framework Mean for NBFCs?
The regulatory measures that NBFCs are required to integrate into their working include comprehensive and robust liquidity risk management architecture that makes a stronger base for sustained growth. RBI’s new liquidity framework requires NBFCs to perform significant modifications to their existing business portfolios which can be a difficult thing to do. NBFCs facing liquidity mismatch will have trouble incorporating the new guidelines into their working; however, this is an opportunity for them to work on the pain points. Implementing the new liquidity framework is meant as a corrective mechanism to avoid crisis situations. Configuring asset-liability mismatches and realigning the business to the realistic cost and revenue levels can be challenging objectives for NBFCs. However, the provisions mention ‘gradual implementation’ of the framework, which comes as a relief to NBFCs. There is time for NBFCs to push for scalability as they adopt the new framework. They also go a long way in regaining the confidence of investors and their lenders.
NBFCs that deal in high-quality liquid assets can seek to use them to meet their liquidity needs. They need to begin by informing the regulator about the reason behind the need to use the high-quality liquid assets and also detail the steps taken to address the problems. NBFCs with low capitalization need to either pivot their business models or seek investors who believe in the vision they have.
In conclusion, given the recent IF & LS crisis that struck the Indian NBFC sector, the new liquidity framework reforms aim to overhaul the entire legal framework pertaining to NBFCs. While it’s agreeable that the new liquidity framework brought about by RBI brings short term pain to NBFCs, it also holds the promise of better order and governance to the crisis-hit sector. It would affirmatively strengthen the NBFC market. Short-term ramifications such as compliance costs and time associated with implementation are just minor impediments to a brighter future of the NBFC market.
Market experts are of the opinion that the gradual shift to liquidity coverage ratio (LCR), liquidity risk monitoring tool and adoption of the “stock” approach to liquidity will benefit the market in significant ways.
- This new asset-liability management framework ensures that the NBFC businesses are not entirely dependent on external borrowing to repay their maturing debt. This avoids the prospect of cyclical debts in the industry.
- The proposal to introduce the ‘stock approach’ to liquidity instead of the ‘cash flow’ approach, ensures that there is ample asset adequacy for NBFCs to repay debts.
- The RBI proposed a framework for quarterly disclosure of the liability profile of NBFCs. Even though this is challenging to implement, it is set to bring transparency for the investors, which in turn improves the liability management of NBFCs.
- Maintaining the Liquidity Coverage Ratio as prescribed in the new Liquidity Framework introduced by RBI can reduce margins for NBFCs as their interest earnings would reduce the amount that they are required to maintain in the form of high-quality liquid assets.
With this move, NBFCs should be able to exercise fiscal discipline, reduce bad debts and improve investor confidence in the long run.