The Non-Banking Financial Companies ("NBFCs") have been playing a very important role from the macroeconomic perspective by delivering the capital support to the last mile and to the smaller businesses. Following the defaults by Infrastructure Leasing and Financial Services and Dewan Housing and Finance Limited, and with the surface of asset-liability mismatch in the NBFCs sector, it became inherently difficult for any shadow banks including NBFCs to raise funds from the market, which in turn questions their survival in the financial sector. This mandated the largely unregulated NBFCs sector in need of a stringent framework to prevent any future liquidity crisis.
The Reserve Bank of India ("RBI") on May 24, 2019 issued a draft circular on 'Liquidity Risk Management Framework for Non-Banking Financial Companies (NBFCs) and Core Investment Companies (CICs)' ("Circular") which are to be adopted by all (i) deposit taking NBFCs, (ii) nondeposit taking NBFCs with an asset size of Rs.100 crore and above, and (iii) core investment companies (CICs) registered with the Reserve Bank ("Applicable Entities"), once implemented.
A) The Circular proposes the following updated regulatory frameworks for the effective assetliability management of the NBFCs, to avoid any liquidity constraints in future:
- Liquidity Risk Management Policy, Strategies and Practices: The Applicable Entities are advised to adopt a robust liquidity risk management framework to ensure liquidity sufficiency for stressed events. The Circular lays down the blueprint for the role of the board of directors, asset-liability management committee, risk management committee and assetliability management support in the asset-liability management of the NBFCs.
- Management Information System (MIS): The Circular proposes for the maintenance of an effective MIS system by the Applicable Entities which should detail all the liquidity risks, contingent risks and other risks, and should provide minute and time-sensitive information to the board and asset-liability management committee.
- Internal Controls: All the Applicable Entities should have appropriate internal controls, systems and procedures in place to ensure effective adherence to the liquidity risk management policies and procedures.
- Granular Maturity Buckets and Tolerance Limits: The '1-30' day time bucket provided in the Statement of Structural Liquidity is proposed to be bifurcated into smaller time buckets of 1-7 days, 8-14 days, and 15-30 days, with an upper limit for the net cumulative negative mismatches in the cumulative cash outflows for each time bucket. Further, the Applicable Entities are suggested to adopt internal prudential limits to monitor their cumulative mismatches across all time buckets upto a period of 1 (One) year.
- Liquidity Risk Management - Stock Approach: The Applicable Entities are required to adopt a "stock" approach, and define ratios and limits to monitor the liquidity status, in terms of the following matrices - short-term liability to total assets; short-term liability to long term assets; commercial papers to total assets; non-convertible debentures (NCDs) (original maturity of less than one year) to total assets; short-term liabilities to total liabilities; long-term assets to total assets; etc.
- Liquidity Risk Monitoring Tool: The Circular proposes for adoption of the following new tools to monitor liquidity risk by the Applicable Entities: a) Concentration of funding; (b) Available unencumbered assets; and (c) Market related monitoring - tools, which can raise early signals for occurrence of any liquidity issues.
B) One of the most important frameworks introduced by the Circular is the concept of Liquidity Coverage Ratio ("LCR"), which are to be implemented by all the Applicable Entities in a phase wise manner, commencing from April 2020 and going upto April 2024. The key features of LCR framework are as follows:
- The Applicable Entities are required to maintain a LCR cover commencing from April 2020 in a phase wise manner to endure any acute liquidity stress for upto 30 days.
- The LCR cover shall be in the form of unencumbered high-quality liquid assets ("HQLAs") that can be readily sold or converted into cash at little or no loss of value or used as collateral to obtain funds in a range of stress scenarios. The Circular lays down the different kinds of securities which can be classified as HQLAs.
- The requirement of maintaining the minimum LCR shall commence from April 2020 and shall progressively increase in the following manner: a) From April 2020 - 60%; b) From April 2021 - 70%; c) From April 2021 - 80%; d) From April 2023 - 90%; and e) April 2024 100%.
- The Circular provides for a proper reporting by the Applicable Entitles for any usage of their LCR cover, along with reasons for such usage and corrective steps initiated to rectify the situation.
The frameworks and the guidelines proposed by the Circular would ensure an effective assetliability management by the Applicable Entities and would help them to monitor and/or foresee any liquidity crisis in advance. The LCR provisions will enable the Applicable Entities to meet any expected and unexpected financial stress for at least 30 days. However, on a broader view, the Circular will have the following impacts on the financial sector, specifically in the NBFCs sector:
1. Consolidation of the NBFCs:
Following the increased incidents of asset-liability mismatches in the NBFC sector, the costs of borrowings of the NBFCs have exponentially shot up. Smaller NBFCs are finding it difficult to raise funds from the market, and therefore are reeling under an acute liquidity crisis, resulting into higher risks of defaults on their debt obligations. At the same time, NBFCs which are backed by large parent groups and/or family offices, have steady flow of funds from their group companies and/or the family offices. This strong background of the NBFCs also helps them to raise funds from the market at comparatively cheaper rates. This will lead to the large group backed NBFCs outperforming the smaller ones, and which in turn will lead to a consolidation in the NBFC sector. Further, even before the draft Circular was introduced by the RBI, some of the properly managed NBFCs had already started to maintain a liquidity
buffer to meet any liquidity crisis in near future. With the Circular coming effect, they would just have to make minimum changes to be in compliance with the Circular. However, the NBFCs with higher liabilities and lesser liquid assets, will have a lot of difficulty in meeting the new regulatory frameworks, specially the maintenance of LCR cover. This will further result into a consolidation in the NBFC sector.
2. Reduced Margin and Returns
The LCR framework proposed in the Circular, requires an NBFC to maintain adequate HQLAs for at least 30 days. Owing to the lower risks associated with the HQLAs, they have a lower rate of return as compared to the assets of the lower quality. Therefore, the compulsory holding of an adequate amount of HQLAs by the NBFCs will significantly reduce their returns, and will eat into their already diminishing margins resulting from the higher costs of borrowing. This in turn will speed up the consolidation in the NBFC sector.
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