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Non-Banking Financial Company (NBFC) liquidity crunch

  Mar 09, 2020

Non-Banking Financial Company (NBFC) liquidity crunch

What is an NBFC?

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 of India, engaged in the business of giving loans, hire-purchase or chit-fund business etc. 

NBFCs are regulated by the Reserve Bank of India (RBI). All NBFCs are not required to be registered with the RBI. For example, Venture Capital Fund/Merchant Banking companies/Stock broking companies registered with SEBI, Housing Finance Companies regulated by National Housing Bank etc.  

Banks and NBFCs: The differences

NBFCs lend and make investments and hence their activities are akin to that of banks; however, there are a few differences as given below:

i. NBFC cannot accept demand deposits;

ii. NBFCs cannot issue cheques drawn on itself;

iii. deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks

iv. they do not have SLR and CRR obligations. 

NBFCs are a part of the shadow banking system-banking like activities performed by non-banking finance companies (NBFCs), which are not subject to strict regulation. 

Why are they important?

NBFCs play a critical role in ensuring availability of loans.

NBFCs have been disbursing loans at a faster rate than banks over the past few years. They promote consumption and capital formation. 

NBFCs had maintained high credit growth at a time banks have gone slow on lending owing to ongoing asset quality concerns and corrective actions.

However, since 2018, there has been an NBFC crisis in India.  

What is the problem?

There is a credit squeeze (not being able to lend enough due to paucity of funds) over-leveraging (excessive borrowing from banks and mutual funds and not able to return in time) massive mismatch between assets and liabilities. 

Elaborate on the liquidity crisis of the NBFCs

NBFCs borrow money from banks or sell commercial papers to mutual funds to raise money. They on-lend these money to small and medium enterprises, retail customers and so on like auto and housing loans. Some lent to infrastructure sector for long term and are not able to recover the loans due to economy being in crisis. That has reduced their credit giving capacity. When NBFCs don’t have money to lend, that reduces the credit flow to the economy, dents economic growth and causes many borrowers to default on loans.

NBFCs are facing a liquidity crunch. In other words, they don’t have money to lend or are facing enormous difficulties in raising funds. 

What led to this? 

Two factors. One, the NBFC business model itself is flawed, to begin with. It relied on raising short-term funds which were then lent as long-term loans. This leads to a situation called an asset-liability mismatch. For example, an NBFC raises money by selling 6-month debt papers and on-lends this as a car loan for a period of 5 years. This leads to a situation where the NBFC has to roll over (or renew) the 6-month debt paper or raise fresh loans to repay the debt paper. When economy is growing, this happens as a matter of course. But when economy is slowing, this cycle is broken.

Second. The cycle was broken by a default of some firms of the IL&FS group. There were fears that this would turn out to be a contagion. Banks, mutual funds and their investors were afraid that more such entities would default. As this fear took hold, many institutions refused to give money to NBFCs. The cost of funds rose by as much as 150 basis points for NBFCs.

How did the NBFCs get so much fund?

In the last few years, especially after demonetisation, there was excess money in the banking system which was lent to mutual funds. As fund managers of debt schemes deployed the funds in money markets, NBFCs were able to access cheap funds easily. They were able to grow their loan portfolios at double the pace of banks.

But having raised these loans, they lent long in a slowing economy where recovery of loans posed huge problems. Thus, their creditworthiness fell.

How will the NBFC liquidity crunch impact the wider economy?

Now that NBFCs are finding it difficult to raise money or having to pay a huge cost for doing so, this will choke the flow of credit to the economy. It hit the MSME sector which is already suffering from the twin blows of demonetisation and the goods and services tax.

It damaged consumption demand in the economy. With investment demand yet to pick up and exports flagging, consumption was the primary engine driving the economy. A reduction in credit further adds to economic slowdown pressures, which are already visible.

Besides, a slowdown in credit could lead to accumulation of non-performing assets in sectors such as commercial real estate and infrastructure, which could have economy-wide domino effects.

Remedies

In the last financial year, the Reserve Bank of India bought government debt paper worth Rs 3 lakh crore from the market. Basically, this meant that so much money was given to the banking system to on-lend. This is the only way for RBI to help NBFCs since the central bank can’t lend directly to the latter as they don’t hold government paper for use as collateral.

But the cost of borrowing for NBFCs is still high as banks are risk averse or have reached exposure limits.

What did the Union Budget do to help the NBFCs?

Even though NBFCs are regulated by the RBI, it has limited authority over the sector, therefore appropriate proposals for strengthening the regulatory authority of RBI over NBFCs are made in the Finance Act 2019.

National Housing Bank (NHB), besides being the refinancer and lender, is also regulator of the housing finance sector. This gives a conflicting and difficult mandate to NHB. Budget returned the regulation authority over the housing finance sector from NHB to RBI.