Economic Survey Vol.1 Ch.8: Financial Fragility in the NBFC Sector

September, 2020 UPSC
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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. 

What happened? 

  • 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).  

Health Score 

  • 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.
Important metrics used in the Health Score

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. 

Concluding remarks

  • 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.
Terms

NBFC:

  • Financial institutions that offer various banking services but do not have a banking license.
  • They are primarily responsible for making investments but do not have the authority to accept deposits.
  • NBFCs cannot form part of the payment and settlement system.
  • The deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in the case of banks.

Mutual Fund

  • A mutual fund is a type of investment vehicle consisting of a portfolio of stocks, bonds, or other securities. Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.

Liquid Debt Mutual Funds (LDMF)

  • The LDMF sector is a primary source of short-term wholesale funds in the NBFC sector. This means that the NBFC sector is intricately interconnected with the LDMF sector.

Provisioning Norms

  • Provisioning is a part of the RBI’s prudential regulation norm. Under provisioning, banks have to set aside or provide funds to a prescribed percentage of their bad assets. The assets are classified by the RBI in terms of their duration of non-repayment.

Basel Norms

  • These norms provide banks with a common goal of financial stability and standards of banking regulation.
  • The purpose of the Basel norms is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.
  • India has accepted Basel accords for the banking system.
  • In fact, on a few parameters, the RBI has prescribed stringent norms as compared to the norms prescribed by BCBS (Basel Committee on Banking Supervision).

Bank Run

  • A bank run occurs when a large number of customers of a bank or other financial institution withdraw their deposits simultaneously over concerns of the bank’s solvency. As more people withdraw their funds, the probability of default increases, prompting more people to withdraw their deposits.

Rollover risk

  • Financial institutions rely on short-term financing to fund long-term investments. This reliance on short term funding causes an asset-liability management/Mismatch (ALM) problem because asset side shocks expose financial institutions to the risk of being unable to finance their business.

Asset liability management risk (ALM)

  • This risk arises in most financial institutions due to a mismatch in the duration of assets and liabilities. Liabilities are of much shorter duration than assets which tend to be of longer duration, especially loans given to the housing sector. This mismatch implies that an NBFC must maintain a minimum amount of cash or cash-equivalent assets to meet its short-term obligations.

Shadow banking

  • Shadow banking comprises a set of activities, markets, contracts and institutions that operate partially (or fully) outside the traditional commercial banking sector and are either lightly regulated or not regulated at all.
  • A shadow banking system can be composed of a single entity that intermediates between end-suppliers and end-users of funds, or it could involve multiple entities forming a chain.
  • NBFCs are considered as an important segment of the shadow banking system in India



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