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 Banking in India 4A: NBFC & the liquidity crisis

Non-Banking Financial Companies (NBFCs)

It is a company registered under the Companies Act that provides

financial services without meeting the legal definition of a bank.
It can engage in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local
authority or other marketable securities, leasing, hire-purchase, insurance
business, chit business, etc.
It does not include any institution whose principal business is that of
Definition as agriculture activity, industrial activity, purchase/sale of any goods (other
per RBI than securities) and sale/purchase/construction of the immovable
property.
It can either be deposit-taking (need an RBI registration) or non-deposit
taking.
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).

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;
NBFC
ii. NBFCs do not form part of the payment & settlement system
different
and cannot issue cheques drawn on itself;
from Banks
iii. The deposit insurance facility of Deposit Insurance and Credit
Guarantee Corporation is not available to depositors of NBFCs,
unlike in the case of banks.

RBI regulates and supervises the NBFCs. RBI has the power to cancel
Regulator
the Certificate of Registration of NBFCs.

DIFFERENCE BETWEEN NBFCs AND BANKS

Basic NBFCs Banks
Meaning
It is a government
They provide banking services to authorized financial
people without holding Bank intermediary which
licenses. aims at providing
banking services to the
public.

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 Banking Regulation Act
Regulated under Companies Act of 2013
of 1949

Demand Deposit Cannot be accepted Can be accepted

Foreign Allowed up to 74% for

Allowed up to 100%
Investment private-sector banks

Payment and
An integral part of the
Settlement Not a part of the system.
System.
System

Maintenance of
Not required Mandatory
Reserve Ratios

Deposit Not available Available

insurance facility

Credit Creation NBFC does not create credit Banks create credit

Transaction
Provided by Banks
services Cannot be provided by NBFC

NBFC LIQUIDITY CRISIS

Types of NBFCs and their numbers

Total number:
As of 2020, there were a total of 9,642 NBFCs in India.
Deposit-taking NBFC (NBFCs-D):
Only 82 of India’s NBFCs were deposit-taking institutions (NBFCs-D)
permitted to mobilize and hold deposits.
Non-deposit taking NBFCs (NBFCs-ND):
The rest of the NBFCs which are not deposit-taking are categorized as non-
deposit taking NBFCs.
They did not have access to the savings of ordinary households.
For this reason, the majority of these institutions were not considered to be
entities that needed strict regulation
Systematically important (NBFCs-ND-SI):
Of a large number of non-deposit taking NBFCs (NBFCs-ND), only 274
were identified as being systematically important (NBFCs-ND-SI), by virtue
of having an asset size of ₹500 crores or more.

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Significance of NBFCs as expressed by assets holdings

A significant player in the financial markets:

As at the end of 2019, this two sets-NBFCs-D and NBFC-ND-SI- held assets that
amounted to almost a fifth of that held by the scheduled commercial banks.
This made them significant players in the web of credit, as well as large enough as
a group to affect the health of the financial sector.
Non-deposit taking NBFCs must rely on resources garnered from the “market,”
including the banking system, besides the market for bonds, debentures, and short-
term paper.
Extension of financial entities:
Individual investors would only be marginally involved in direct investment in
these instruments.
So, the NBFCs are essentially extensions of the activity of other financial entities
such as banks, insurance companies, and mutual funds.

Concentrated lending by NBFCs

Industry getting lion’s share:

Industry accounted for the biggest chunk of lending, amounting to 57% of gross
advances in September 2019.
Much of this lending to industry went to the infrastructural sector.
At second place-retail sector:
A second major target for lending by the NBFCs was the retail sector, with retail
loans accounting for 20% of gross advances.
Within the retail sector, vehicle/auto loans accounted for as much as 44% of loans.

What went wrong?

Diversification by commercial banks:

Following a surge in capital flows into India which began in 2004, banks were
flush with liquidity.
Under pressure to lend and invest to cover the costs of capital and intermediation
and earn a profit, banks were looking for new areas into which they could move
Increase in retail lending by banks:
The pressure resulted in a significant increase in retail lending, with lending for
housing, automobiles and consumer durables.
There was also a substantial increase in lending to the infrastructural sector and
commercial real estate.
Why NBFCs flourished even in the face of competition by banks?
What the growth of the NBFCs indicates is that banks were unable to exhaust the
liquidity at their disposal.
Banks were also unable to satisfy the potential for lending to these sectors,
providing a space for NBFCs to flourish.
The willingness of NBFCs suited the banks:
The willingness of the NBFCs to enter these areas suited the banks in two ways.
First, it permitted the banks to use their liquidity even when they themselves were
stretched and could not discover, scrutinize and monitor new borrowers.
Banks could lend to the NBFCs, which could then take on the tasks associated with
expanding the universe of borrowers to match the increased access to liquid funds.
The second was that it helped the banks to move risks out of their own books.
Short term lending to NBFCs, and long-term lending by NBFCs:
Banks accept short term deposits, so there is a limit in their ability to lend that short
term deposits as a long term debt.

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 On the other hand, these were the sectors to which additional credit could be easily
pushed.
Lending to NBFCs that in turn lent to these sectors, appeared to be a solution to the
problem.
Bank lending to the NBFCs was short term, and the latter used these short-term
funds to provide long-maturity loans
NBFCs expected that they would be able to roll over much of these loans so that
they were not capital short.
Role of rating agencies:
What they needed for the purpose were ratings that ranked their instruments as
safe.
The rating companies were more than willing to provide such ranks.
The two risks involved in this model:
The NBFC-credit build-up was an edifice that was burdened with two kinds of
risks.
First risk:
Possible default on the part of borrowers.
The probability of which only increases as the universe of borrowers is
expanded rapidly to exhaust the liquidity at hand.
The second risk:
The second was the possibility that developments in the banking sector
and other segments of the financial sector would reduce the appetite of
these investors for the debentures, bonds and commercial paper issued
by the NBFCs
Since the NBFCs banked on being able to roll-over short-term debt to
sustain long-term lending.
A slowdown in or halt to the flow of funds would lead to a liquidity
crunch that can damage the balance sheet of these institutions.
Which of the two risks is involved in the present crisis?
The crisis that affected the NBFCs as a result of both kinds of setbacks.
First setback:
Loans to areas like infrastructure, commercial real estate and housing
went bad.
Second setback:
With the non-performing assets problem in the commercial banking
sector curtailing their access to bank lending.
Why the problem turned systemic?
Given the importance of ratings and “image” in ensuring access to
capital, some firms with the requisite image were able to mobilize
large sums of capital and expand their business.
When entities like that go bust, the response of lenders and investors to
the event tends to be drastic, with systemic effects on the sector as a
whole.

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 SOLUTION FOR THE CRISIS

GUIDELINES:
It has said that the government credit guarantee on NBFC assets or loans will be
limited to 10% of the asset’s value, valid for 2 years from the purchase of the asset
by the bank.
The Budget has set aside Rs.1 lakh crore to refinance high-quality assets of
“financially sound” NBFCs.
It is unlikely that the fund transfer on this count will be substantial because assets
are likely to take some time to turn substandard.
Tall order:
The guidelines require the NBFCs to be AA-rated, with no asset-liability mismatch
(ALM) in any of the lending categories.
This is a tall order given that even high-rated NBFCs, such as those backed by
public sector banks, have ALM in some buckets.
The move does not address the existing skew of just a handful of NBFCs getting all
the bank funds.
According to the Financial Stability Report of June 2019, 30 out of 9,659 of them
registered with the RBI account for 80% of the total exposure.
This trend has worsened after the IL&FS — and now, DHFL — defaults, with
banks turning more risk-averse.
With mutual funds, insurance, and commercial papers too withdrawing from the
scene, NBFCs have returned to the bank window which, however, is open to just a
few.
What helps to solve the crisis?
Raising the exposure limit to a single NBFC too perpetuates the status quo, while
accommodating NBFC lending under priority sector targets may infuse some
liquidity.
However, the crisis calls for a determined response, with Rs.1 lakh crore of NBFC
dues coming up for redemption soon.
This has impacted markets, despite the repo rate cut this month.
NBFCs, strapped for funds, have in turn frozen lending to real estate and other
sectors, leading to a tightening of interest rates while PE funds gain ground.

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 The consumption and working capital crisis are explained by the domino effect of
banks and other investors closing the NBFC tap.

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