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NBFC crisis: CEA for stricter compliance norms

The Chief Economic Adviser in the finance ministry Krishnamurthy Subramanian said (April 09, 2019) that the Non Bank Financial Companies are facing the problem of adverse asset-liability mismatch of firms and there are genuine fears that more non-banking financial companies (NBFCs) may default like IL&FS due to a growing liquidity crunch. According to him the issue is actually one of solvency and very few of them are solvent. He asserted that  the entire shadow-banking space needs to be “very tightly and carefully monitored” to ensure the crisis doesn’t recur or flare up. He added, “Assets of some NBFCs are long-dated while liabilities are short-term. When the going gets tough, those NBFCs that are not solvent enough find it difficult to roll over (payment obligation). So what is typically a solvency issue appears to have been a liquidity issue.”

He said that the role of credit rating agencies is very important perhaps because they help knowing which the firms in which insolvency problems are brewing. The onus of ensuring the quality of ratings lies solely with the rating agencies; they can’t just crib that companies didn’t provide enough information to them to be able to discharge their duty efficiently. Similarly, auditors, being the first line of information intermediaries, can’t complain they couldn’t detect irregularities early because they went by what the company’s management told them. Also, they must not be self-regulated, so the National Financial Reporting Authority (NFRA) has to be strengthened. Even some of the developed countries like the US were forced to shun self-regulation after the Enron scandal in 2001. The CEO prescribed the option of a seven-day default rule for lenders if the one-day default rule is too difficult to be implemented. However, such strict default-reporting mechanisms are essential, he viewed. Commenting on some of the mutual funds delaying full redemption for investors due to a delay in recovery of their funds lent to NBFCs, the CEA said investors need to be made aware of risks.

What is meant by NBFCs?

Non Bank Financial Companies are kind of nonbank financial institutions. The World Bank Group defines Non Bank Financial Institutions as follows:

“A nonbank financial institution (NBFI) is a financial institution that does not have a full banking license and cannot accept deposits from the public. However, NBFIs do facilitate alternative financial services, such as investment (both collective and individual), risk pooling, financial consulting, brokering, money transmission, and check cashing. NBFIs are a source of consumer credit (along with licensed banks). Examples of nonbank financial institutions include insurance firms, venture capitalists, currency exchanges, some microloan organizations, and pawn shops. These non-bank financial institutions provide services that are not necessarily suited to banks, serve as competition to banks, and specialize in sectors or groups.”

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property. A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments by way of contributions or in any other manner, is also a non-banking financial company (Residuary non-banking company).

A NBFC’s financial activity is taken as principal business when a company’s financial assets constitute more than 50 per cent of the total assets and income from financial assets constitute more than 50 per cent of the gross income. A company which fulfils both these criteria will be registered as NBFC by RBI. The term ‘principal business’ is not defined by the Reserve Bank of India Act. The Reserve Bank has defined it so as to ensure that only companies predominantly engaged in financial activity get registered with it and are regulated and supervised by it.

Difference between banks & NBFCs

  • NBFC cannot accept demand deposits;
  • NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself;
  • Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.

Types of NBFCs

By the kind of activity they conduct NBFCs may be Asset Finance Company (AFC) , Investment Company (IC), Loan Company (LC), Infrastructure Finance Company (IFC; Which deploys at least 75 per cent of its total assets in infrastructure loans,and minimum net owned fund Rs. 300 crore; a minimum credit rating of ‘A ‘or equivalent  and a CRAR of 15%.), Non-Banking Financial Company  Infrastructure Debt Fund, Mortgage Guarantee Companies (MGC) etc.

Some Examples of NBFI

 Insurance companies underwrite economic risks associated with death, illness, damage to or loss of property, and other risk of loss. Another example is Contractual savings institutions (also called institutional investors) provide the opportunity for individuals to invest in collective investment vehicles in a fiduciary rather than a principle role. Collective investment vehicles invest the pooled resources of the individuals and firms into numerous equity, debt, and derivatives promises. The two two main types of mutual funds are open-end and closed-end funds. Open-end funds generate new investments by allowing the public buy new shares at any time. Shareholders can liquidate their shares by selling them back to the open-end fund at the net asset value. Closed-end funds issue a fixed number of shares in an IPO. The shareholders capitalize on the value of their assets by selling their shares in a stock exchange.

Market makers are broker-dealer institutions that quote both a buy and sell price for an asset held in inventory. Such assets include equities, government and corporate debt, derivatives, and foreign currencies. Once an order is received, the market maker immediately sells from its inventory or makes a purchase to offset the loss in inventory. The difference in the buying and selling quotes, or the bid-offer spread, is how the market-maker makes profit. Market makers improve the liquidity of any asset in their inventory.

Specialized sectoral financiers provide a limited range of financial services to a targeted sector. For example, leasing companies provide financing for equipment, while real estate financiers channel capital to prospective homeowners. Leasing companies generally have two unique advantages over other specialized sectoral financiers. They are somewhat insulated against the risk of default because they own the leased equipment as part of their collateral agreement. Additionally, leasing companies enjoy the preferential tax treatment on equipment investment.

Other financial service providers include brokers (both securities and mortgage), management consultants, and financial advisors. They operate on a fee-for-service basis. For the most part, financial service providers improve informational efficiency for the investor. However, in the case of brokers, they do offer a transactions service by which an investor can liquidate existing assets.

How the problems arose in NBFCs in India: The IL&FS’ Issue

Since August 2018, several NBFCs in India including debt-ridden Infrastructure Leasing and Financial Services (IL&FS), in which various corporates, as well as mutual funds and insurance firms, had invested through short-term instruments like commercial papers and non-convertible debentures (NCDs), has been defaulting on its several debt-obligations. The ongoing liquidity crisis in the NBFC industry is the result of asset-liability mismatch (ALM). Since the NBFCs cannot raise retail deposits from the general public, they depend on wholesale lending for their capital requirements. As a result, the cost of funds for NBFCs is higher than that of banks.

The biggest error that the majority of NBFCs and housing finance companies (HFCs) committed with regards to the real estate sector is that they ventured into long-term lending to builders and also into underwriting loans with very long-term repayment tenures. As a result, the NBFCs short-term borrowing was channelised towards financing long-term loans. They were heavily dependent on banks, mutual funds and private placements to meet their capital requirement as well as for refinancing of loans.

Driven largely by global factors – chiefly rising crude oil prices, rising interest rates in the U.S., and trade tensions – Indian interest rates started to rise. The yield on the benchmark 10-year government bond moved up from around 6.8 percent to over 8 percent in a period of about three months. Fresh inflows into mutual funds, especially into debt funds, slowed, and debt fund managers began to adopt a “wait and watch” policy on deploying fresh funds. Liquidity supply to NBFCs began to dry up rapidly. Fresh bond issuances by NBFCs declined and the costs of borrowing rose. All this preceded the spate of defaults by IL&FS.

Infrastructure Leasing and Financial Services (IL&FS) defaulted on short-term debt obligations.  According to the Ministry of Corporate Affairs (MCA), IL&FS’ borrowings from banks and financial institutions added to nearly Rs 63,000 crore as per the balance sheet of 2017-2018. There were concerns that many NBFCs could have their funds stuck in IL&FS debt instruments. Reportedly, approximately Rs 2 trillion ($27.23 billion) of NBFC and HFC debt was due for redemption by the end of December 2018. Also, funding costs of NBFCs were likely to go up and could lead to a sharp decline in their margins. And then the news of IL&FS defaults broke. It had two immediate implications. First, there was a fear of large scale redemptions in debt mutual funds. So some funds resorted to panic selling of debt securities which sent a negative signal to the entire market. Second, the defaults shattered faith in ratings of debt securities. IL&FS debt had the had the highest rating just a couple of weeks before the default. The rating was revised to the lowest default grade (“D”) after the default occurred. This raised doubts about the quality of other issuers assigned similarly high ratings. The reaction in the market was vicious. Yields on corporate bonds went up and the debt market almost stalled. The RBI acted quickly and took steps to inject liquidity via open market operations. Since then calm has returned to the market for securities of less than one year but the market for medium-term securities remains tight.

Steps taken to resolve NBFCs crisis in India

The central bank has been taking several initiatives, including intermittent open market purchase of government securities, ever since the occurrence of a series of payment defaults by IL&FS and its arms which had culminated in the Centre disbanding the entire board of the infrastructure company and appointing a new one in its place under the leadership of Uday Kotak.

On September 27, the RBI permitted  banks to avail higher liquidity with effect from October 1 as it had enhanced the Facility to Avail Liquidity for Liquidity Coverage Ratio (FALLCR) from the existing 11% to 13% of their deposits. Liquidity coverage ratio refers to highly liquid assets that financial institutions need to hold in order to meet short-term obligations. The Reserve Bank has also permitted banks to use government securities, equal to their incremental outstanding credit to NBFCs, over and above their outstanding credit to them as on October 19,to meet the liquidity coverage ratio requirement. This would be in addition to the existing FALLCR of 13% of NDTL and limited to 0.5% of the bank’s NDTL (net demand and time liability), the RBI said. The additional window will be available up to December 31, 2018, the notification said.

On October RBI The Reserve Bank of India (RBI) decided to increase the single- borrower exposure limit of banks for non-banking finance companies (NBFCs) which do not finance infrastructure, to 15% from the existing 10% of their capital funds. This was to remain effective till December 31. While the Reserve Bank of India (RBI) and the Government have taken steps to ring fence the NBFC crisis and support its financing needs by providing additional liquidity to banks and credit enhancement for refinancing needs.

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