The liquidity crunch in the shadow banking system in India took shape in the wake of defaults on loan obligations by major Non-Banking Financial Companies (NBFCs). Two subsidiaries of Infrastructure Leasing & Financial Services (IL&FS) defaulted on their payments in the period from June to September 2018, while Dewan Housing Finance Limited (DHFL) did so in the period from June to August 2019.
- Two subsidiaries of IL&FS defaulted on their payments in the period from June to September 2018, while DHFL did so in the period from June to August 2019.
- The defaulted amount was approximately Rs. 1500-1700 crore. The associated debt mutual funds started writing off their investments in stressed NBFCs and the assets of these NBFCs were selling at fire-sale prices.
- This consequently led to a decline in equity prices of stressed NBFCs which decreased the capacity of NBFCs to raise funds. This resulted in decreased overall credit growth and a simultaneous decline in GDP growth.
The relation between Credit growth, NBFC, and liquidity?
When banks and NBFC lend money, it is considered as Credit growth. This credit provides liquidity (flow of money) in the market. If it is easily available, the rate of interest to obtain this credit is low. This helps MSME and others to scale up their investment.
If there is an investment in the economy, people get jobs. They earn, and hence there is an increase in demand for services and products like a new home loan, a car or holiday packages. A significant part of earning from job/work is also put to savings, which along with investment component is again put to productive use in the economy. Thus creating a virtuous cycle of investment -Jobs-earning-savings-demands-investments.
Since most of the banks are reeling under Basel norms and rising NPA, the lower spectrum of the economy was financed by NBFC. In the event of their failure, the opportunity of credit creation will take a hit. With no one left to give credit (money) to the investor at a cheaper rate of interest, the liquidity will not be easily available, thus impacting growth. And, that’s the relationship which exists between credit growth, NBFCs, and liquidity.
Rollover risk:- The NBFCs raise capital in the short-term market but the assets of NBFCs are of longer duration. Thus, there arises a need for refinancing the debt at short frequencies. The frequent repricing exposes NBFCs to the risk of facing higher financing costs. Such refinancing risks are referred to as Rollover Risk.
The rollover risk is a combination of risks associated with asset-liability management, Interconnectedness with Liquid Debt Mutual Fund (LDMF) Sector and Financial and Operating Resilience.
Risks from Asset-Liability Mismatch
- This risk arises in most financial institutions due to a mismatch in the duration of assets and liabilities. Generally, liabilities are of much shorter duration than assets which tend to be of longer duration.
Risks form Interconnectedness:
- This risk arises when the liability structure of NBFCs is over-dependent on short term wholesale funds. The LDMF sector is a primary source of wholesale short-term funding. This interconnectedness is a channel for the transmission of systemic risk from the NBFC sector to the LDMF sector and vice versa.
- If and when the LDMF sector is faced with redemption pressures, it is reluctant to roll over loans to the NBFC sector (Rollover Risk), causing a liquidity crunch in the NBFC sector. Redemption Pressure can be described as repayment pressure of any security at or before the asset's maturity date.
Financial and Operating Resilience (indicating balance sheet strength and associated risk of NBFCs)
- Measures of financial resilience of NBFCs are commercial paper (CP) as a percentage of borrowings, Capital Adequacy Ratio (CAR) and provisioning policy.
- While measures of operating resilience are cash as a percentage of borrowings, loan quality and operating expense ratio (Opex Ratio).
- Based on the relative contribution to Rollover Risk, the key drivers of Rollover Risk are combined for HFCs into a composite measure (Health Score). ALM Risk and Financial and Operating Resilience are the most important constituents of the Health Score of HFCs.
- The index ranges between -100 to +100 with higher scores indicating higher financial stability of the firm/sector.
- The Survey has observed that improvement in health score strongly correlates with an increase in the returns generated by NBFCs.
- The survey also has used the Health index to show how it would have been able to identify stress in the NBFC sector earlier.
Short-Term Volatile Capital – This is measured by CP as a percentage of borrowings of the NBFC.
Asset Quality – This is measured by the ratio of retail loans to the overall loan portfolio of the NBFC.
Short-term Liquidity – This is measured by the percentage of cash to the total borrowings of the NBFC.
Provisioning Policy – This is measured by the difference between provision for bad loans made in any financial year and the gross NPA in the subsequent financial year.
Capital Adequacy Ratio – This is the sum of Tier-I and Tier-II capital held by the NBFC as a percentage of RiskWeighted Assets (RWA).
Operating Expense Ratio – This is measured by the operating expenses in a financial year divided by the average of the loans outstanding in the current financial year-end and previous financial year-end.
- Regulators can employ the Health Score methodology presented in this analysis to detect early warning signals of impending rollover risk problems in individual NBFCs.
- Downtrends in the Health Score can be used to trigger greater monitoring of an NBFC.
- An analysis of the trends in the components of the Health Score can shed light on the appropriate corrective measures that should be applied to reverse the adverse trends.
- 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.
Liquid Debt Mutual Funds (LDMF)
Asset liability management risk (ALM)