GS3: Indian Economy and issues relating to planning, mobilization of resources, growth, development

 

What is the issue?

  • RBI has put up the draft circular, Liquidity Risk Management Framework for Non-Banking Financial Companies and Core Investment Companies.

BACKGROUND

Existing Liquidity risk management mechanisms

  • RBI notify Risk Management Systems in Banks which includes the multiple steps in different verticals of the banking.
  • Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational, etc.
  • These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories.
  • Thus, top management of banks should attach considerable importance to improve the ability to identify, measure, monitor and control the overall level of risks undertaken.
  • The primary responsibility of understanding the risks run by the bank and ensuring that the risks are appropriately managed should clearly be vested with the Board of Directors.
  • The Board should set risk limits by assessing the bank’s risk and risk-bearing capacity.
  • At organisational level, overall risk management should be assigned to an independent Risk Management Committee or Executive Committee of the top Executives that reports directly to the Board of Directors.

DISCUSSION

Need for present regulations

  • The recent incident of IL&FS has triggered the RBI to take a fresh look at the liquidity risk management at The NBFCs and Core Investment companies.
  • Many large NBFCs have come under severe liquidity pressure, compelling them to bring down their reliance on commercial papers following series of default by group companies of IL&FS beginning September last year.
  • Ever since the IL&FS crisis erupted, banks have been averse to lending to the sector, which has put them in a tight spot. There are concerns that NBFCs may run out of money, which will lead to defaults.
  • According to estimates, about Rs 1 lakh crore of commercial papers (CPs) raised by NBFCs from investors will come up for redemption in the next three months.
  • Recently, DHFL was downgraded on a concern of default in payment obligation towards CPs.
  • Further, RBI intends to prescribe stringent rules for liquidity risk management as many NBFCs were hit by a severe asset liability mismatch.
  • India’s shadow lenders have been under pressure since last year, when a series of defaults by Infrastructure Leasing & Financial Services forced the government to intervene and exposed weaknesses in the sector.
  • Since then, the banks and mutual funds which provided funding to the NBFCs have reduced their exposure, creating a cash crunch which caused the shadow lenders to sell assets and restrict new loans.
  • They ran their business using short term funds to give long term loans.
  • Most of the NBFCs working under the radar of the RBI tend to evade their liquidity position with them.
  • It further complicates the risk in the financial system, which is already strained by bad loans.
  • Hence the NBFCs, most of whom are cash strapped, want the RBI to implement liquidity risk management rules only in tandem with an arrangement for making available much needed funds.

What are the new rules?

  • LCR – Non-Banking Financial Companies (NBFCs) should maintain a liquidity coverage ratio (LCR) in line with banks.
  • [The LCR requires banks to hold enough high-quality liquid assets (HQLA) that can be sold to fund banks during a stress scenario.]
  • The LCR requirement shall be binding on NBFCs from April 01, 2020.
  • The liquidity rules were proposed for all NBFCs.
  • But for NBFCs with assets above Rs 5,000 crore and deposit-taking NBFCs, the LCR is mandatory.
  • HQLA – RBI has asked the firms to have sufficient High Quality Liquid Asset (HQLA) that would keep them liquid for at least 30 days.
  • HQLAs are generally cash or government securities that can be quickly sold in the market to raise cash.
  • The minimum HQLAs to be held from April 1, 2020 will be 60% of the LCR.
  • But by April 1, 2024, large and deposit-taking NBFCs should have HQLAs of a minimum of 100% of net cash outflows over the next 30 calendar days.
  • Collaterals – An NBFC must actively manage its collateral positions, differentiating between encumbered and unencumbered (free of liabilities) assets.
  • NBFCs should monitor such assets so that they can be mobilised in a timely manner.
  • All NBFCs must have contingency funding plans for responding to severe disruptions.
  • Liquidity position – Firms are to measure their liquidity in a granular manner, measuring as minutely as 1-7 days’, 8-14 days’, and 15-30 days’ period.
  • Asset-liability mismatches should not exceed 10-20% in the timeframes running up to a year.
  • Liquidity position has to be reported to the RBI, along with the interest rate sensitivity statement.
  • Liquidity positions should also be disclosed to the public for investors.
  • In addition to the structural and dynamic liquidity needs, a stock approach will also have to be maintained to gauge liquidity needs.
  • NBFCs were thus asked to maintain tools that would generate early warning on risk situations.
  • Under the revised framework, even if a borrower pays to an NBFC but has defaulted with a bank/small finance bank, the NBFC gets roped in signing the Inter Creditor Agreement and becomes part of the resolution plan.

Issues with the present guidelines

  • NBFCs may see profit margins squeezing from RBI draft liquidity norms.
  • Instead of providing a much-expected liquidity window to non-bank finance companies via the regular lenders, the central bank took a tougher stance
  • The proposed guidelines should be made concomitant with provision of a mechanism of liquidity support for NBFCs.
  • Currently, with the tight liquidity conditions in the industry have made generation of funds a very difficult task.
  • NBFCs request the RBI to kindly consider putting in place a suitable mechanism for such liquidity support.
  • Currently, tight liquidity conditions in the industry have made generation of funds a very difficult task, and we request the RBI to kindly consider putting in place a suitable mechanism for such liquidity support.
  • Alternatively, the implementation of these guidelines may kindly be deferred until return of normal liquidity conditions for the sector.
  • Credit growth is unlikely to pick up despite the three successive rate cuts by the central bank due to the capital constraints at banks and the deepening crisis in the non-banking lenders sector.

RBI’s proposal to introduce LCR for large NBFCs

  • The frequent incidents of the failures among the sytemetically important NBFCs triggered RBI to intervinee with a new proposal to large NBFCs.
  • RBI proposed introducing a liquidity coverage ratio (LCR) for large non-banking finance companies (NBFC) to help tackle liquidity problems in the sector.
  • The central bank said it planned to implement LCR, a liquidity buffer, “in a calibrated manner” over four years starting from April 2020.
  • The LCR is proposed for all deposit-taking NBFCs, and non-deposit taking NBFCs with an asset size of Rs 5,000 crore ($720 million) and above.
  • NBFCs will have to maintain minimum high-quality liquid assets of 100 percent of total net cash outflows over the following 30 calendar days.

Way forward

  • The regulator won’t bail out any particular company but will ensure the NBFCs are more disciplined and strong at the cost of some short-term pain.
  • If implemented, the draft guidelines could hit the NBFCs’ margins and business growth.
  • Imminent crisis” in NBFCs sector as misadventures by some large entities and credit squeeze present a perfect recipe for disaster.
  • Since the IL&FS crisis, there has been notable uncertainty in the NBFC market.
  • Over the past few months, many NBFCs have not been able to borrow from markets, including banks.
  • In this backdrop, the regulatory norms are good for the long-term sustainability of the NBFC sector.
  • With the RBI bringing in the guidelines to manage asset-liability mismatches, lenders will get more confidence.
  • It ensures that an NBFC has sufficient collateral to meet expected and unexpected borrowing needs.
  • This is a new requirement where the decision-making is not only linked to the quantum of loan extended by the lenders but also the number of lenders.

#Practice Questions

  1. NBFCs are inevitable for the economic growth in the country. Do you think the present credit risk management systems are supportive of these objectives? (200 words)
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