Liquidity Crunch in the NBFCs in India: Post Pandemic Effects
Written by Shagun Sharma
Fifth Year, BBA LLB. Symbiosis Law School, Pune
Source: The Indian Wire
Disclaimer: Please note that the views expressed below represent the opinions of the article's author. The following does not necessarily represent the views of Law & Order.
The Non -Banking Finance Companies (hereinafter referred to as NBFCs) in India have become a major sector in the Indian Economy, especially booming in the past decade. But the last few years have seen this sector embroiled in a maze of problems, which was kicked off by the default of the Indian infrastructure development and finance company, Infrastructure Leasing and Financial Services (hereinafter IL&FS) . This default has now snow-balled into a major liquidity issue for the sector, which is now threatening to fashion itself as a solvency issue for the economy. There are a prevalent recognition and acknowledgement by the market experts and economists about the ever-looming mismatch of the asset-liability ratio in the sector, but the current pandemic has only acted as a trigger which now seems to be worsening the situation with no effective remedy to the problem in the near future. This crisis has shed light on the lack of practical association on the part of the economic regulators in our country to avert this ‘systematic failure’ on such a large scale. This “crisis” has left the sector unable to manage its input-output ratio while balancing the risk ratio.
The rise in the credit rates has stranded the NBFCs in a very uncomfortable position, leaving them unqualified to honour their obligations. And this has squealed into the current “adverse cash crunch”.
“Shadow Banking” In India And the 2018 Catastrophe
‘Shadow Banking’ and its connotations in the Indian economic structure:
‘Shadow Banking’ as a term was first used in the Annual Economic Policy Symposium of the Federal Reserve Bank of Kansas, to refer to the NBFCs. Although it can have different manifestations in different economic situations, but it can be understood to refer to an institution that provides a place to institutional investors and corporations to park liquid funds that provide quicker access and pays higher interest rates. The term was especially popularized after the Global Economic Crisis in 2008.
In India, it refers to the NBFCs which can be defined as ‘financial intermediaries, serving as an alternate source of credit flow in the commercial sector’ which are registered under the Companies Act, 2013. The operation of NBFCs was encouraged in the Indian economy by the regulators because they had emerged as a strong alternative to the other financial institutions, since their business is to raise capital from the public, which then can be given as loan, which are regulated and monitored by the RBI.
One of the key reasons why NBFCs were and are promoted is because of the lower number of non-performing assets (NPAs) as compared to those of the banking institutions.
Analyzing the IL&FS debacle : And its butterfly effects:
The downfall of this shadow bank was triggered by their default on multiple obligations and the shortage in their cash flow. Despite the new projects they had at hand, they were hindered by the cost overruns and delays, which eventually led to them being downgraded by ICRA (formerly Investment Information and Credit Rating Agency of India Limited, an independent and professional investment information and credit rating agency in India). This was a major shock, displaying on a national scale the level of the risks involved in the NBFC Sector. This created a gargantuan credit crunch, from which our economy has still not reeled completely. IL&FS defaulted on payments and failed to service the commercial papers in September 2018. The first indication of the scale of the default was recognized when the company postponed USD 350.00 million bonds issuance in March 2018 due to demand for a higher yield from investors. Another reason that was attributed to this default was the slump in infrastructure projects and disputes over payments due from the government.
After the IL&FS crisis, the stocks Dewan Housing Finance Limited (a shadow NBFC in India, hereinafter referred to as DHFL), also took a major hit. They saw their commercial papers downgraded to a ‘default status’. The company had to sell a number of its businesses, eventually failing to pay Rs. 900 Crore. The trigger was identified as a mismatch which occurred when it raised funds with short maturity periods at cheap rates, which built up to an asset-liability mismatch, which was further triggered by the IL&FS crisis and the corresponding slump in the infrastructure sector.
How does the NBFC Sector directly affect the Banking system
How are NBFCs interlinked to the economy?:
It is imperative to understand that short-term securities (like commercial papers) are funded by large corporations, along with Mutual Funds, and these Mutual Funds gather their investments from the general public and invest them for returns. This involves the cash flow of the general public into the chain.
The NBFC sector has been perceived to have a higher risk factor which was cemented when the IL&FS bonds which were rated AAA (the highest possible credit rating that can be assigned to an issuer’s bonds by a credit rating agency, implying a high degree of creditworthiness and low risk of default), fell overnight and were downgraded to eventually holding almost negligible value. This affected other NBFCs too, leading to an overall loss of trust in the sector, resulting from continuous fall in prices and crashing of the stocks. Thus, investors lost their money and the flow in the economy was hit hard.
Reasons behind the NBFC ‘liquidity squeeze’:
The NBFCs rely on the issuance of short-term securities, like Commercial Papers. CRISIL (it is an Indian credit rating agency, a subsidiary of American S&P Global Company) estimates that around Rs. 50,000/- Crore are still to be redempted which reduces their credit-worthiness further. And this lack of trust has discouraged the capital market investors from taking risks in the sector, resulting in a freeze in the credit flow.
In India, NBFCs only deal with lending and speculation in the high cost of funds, resulting in a high mismatch on assets-liabilities ratio.
The NBFCs in the last four years have seen a steep rise in the Non-Performing Assets, which has adversely affected the business and has created a fear of sustainability of the sector among the investors.
Coping with the Pandemic and the new Way Forward
Economic effects of the Pandemic:
The COVID-19 Pandemic has brought the whole world to a standstill, while people and businesses cope and figure out a new way to function. But apart from the different way of functioning, our banking sector, which had never fully recovered from the 2018 debacle, has become more vulnerable to further fluctuations. Since the market is so affected by the value of assets, which depreciates on an everyday basis, and the increasing pile of bad loans, the unavailability of new capital is just adding to the already prevalent liquidity stress.
The Sector was slowly getting back on its feet, when the pandemic hit. And the lockdown is seen to hit some industries more severely than the others, affecting their cash-flows and credit worthiness. The NBFC sector is more SME and large corporation based and the lockdown is expected to affect this sector harder. As the lockdown restrictions are lifted and business comes back to rails, what will also be important is government spending and pickup in economic activity.
The RBI Relief Package:
The RBI in view of the Pandemic announced the COVID-19 Regulatory Package on March 27, 2020, with supplementations and additions on later dates. This package was aimed to relieve the institutions from the enormous stress they were under and hence the NBFCs were granted a moratorium (which was extended for another 3 months, as per the RBI Circular) on payment of all installments. NBFCs use the cash from the payments made to repay the liability owed. Granting a moratorium to its borrowers on payment of loan installments spells trouble for the sector as the NBFCs operate on very thin short-term liquidity on their balance sheets.
The RBI Package has further impaired the Sector to generate cash flow, because while the NBFCs are required to provide the benefit of the relief to its debtors, its lenders have been reluctant to extend the same treatment.
The challenges are even graver for NBFCs with high share of capital market borrowings because no moratorium has been announced for capital market borrowings (such as bonds and commercial paper) and repayments on these will have to be made on time, during a period when collections would be impacted significantly.
The package also announced the TLTRO (Targeted Long-term Repo Operations) to channel the liquidity in order to provide relief to the smaller institutes. Almost half of the TLTRO was directed towards the NBFC sector, but the banks are not interested to invest in more risky ventures. Thus, the Court has been quoted on stating on this matter, “taking note of how the liquidity infused under the repo operations undertaken by the RBI was inaccessible to the sectors which were the most impacted by the pandemic, the RBI is directed to give effect to the RBI Relief Package in its ‘letter and spirit”.
The NBFCs prayer before the Courts:
In ‘Indiabulls Housing Finance vs. SEBI a prayer for interim relief of postponement of service of commercial papers was sought before the Delhi High Court. Although in May the petition was withdrawn, it highlighted a very significant problem the sector is dealing with, in view of the Relief Package. In another case, HDFC Bank was permitted by the Court to “appropriate the fixed deposit maintained by the NBFC towards the installment which was due during the moratorium period”.
The major issue that the Banks have is that if NBFCs are provided the moratorium they will use the cash-flow to meet their obligations instead of on-lending. But some Banks have started considering requests from NBFCs for moratorium on “a case-to-case basis”.
Recommendations And Conclusion
(I) The government needs to introduce a practical scheme which allows the NBFCs to sell their assets to raise liquidity.
(II) The NBFCs which have a good “due diligence” report must be provided with a rating that allows them to avail a moratorium from the Banks, allowing them to lend as well.
(III) The NBFCs can be provided with partial relief which allows them to lend a smaller sum, over a period of time in the form of instalments, with the Bank releasing the other instalments once it is satisfied with its creditworthiness.
Former RBI Governor Raghuram Rajan had stated that “bold government reforms are essential for India to come out of the COVID-19 setback”. Focusing on small businesses that are in the gripping chokehold of the pandemic is the need of the hour. Strengthening and focusing on the NBFCs is the only way forward, making them resilient should be one of the major targets to start fixing our market problem. The NBFC crisis is not something which can be dusted and ignored, because they form a rather large and more importantly a pretty significant part of our economic sector. NBFCs have been credited to bring in efficiency to the financial sector and make it more ‘customer-friendly’. They play a vital role in resource mobilization in the Indian economic setup and enable credit flow, and thus is something which we need to address and fix.
 Bijetri Roy, Swarnendu Chatterjee. Shadow Banking in India in Relation to the IL&FS Crisis. Journal of Banking and Insurance Law. 2018; 1(2): 1–6p.  RBI Press Release on December 24, 2019 bearing reference no. 2019-2020/1504, “Report on Trend and Progress of Banking in India 2018-19”.  Standard, B., 2019. What Is IL&FS Crisis | IL&FS Crisis Explanation | IL&FS Crisis Latest News. [online] Business Standard; https://www.business-standard.com/about/what-is-il-fs-crisis [Accessed 16 October 2020].  Venkataramakrishnan, R., 2019. Scroll Explainer: What Happened To Finance Firm DHFL – And What That Means For The Indian Economy. [online] Scroll.in https://scroll.in/article/926444/scroll-explainer-what-happened-to-finance-firm-dhfl-and-what-that-means-for-the-indian-economy#:~:text=DHFL%20is%20a%20non%2Dbanking,known%20as%20a%20shadow%20bank.&text=In%20September%202018%2C%20after%20the,scam%20to%20siphon%20off%20money [Accessed 16 October 2020].  Riya Raju George. Two Decades of Faulty Credit Policy Later, An Unending Rippling Effect of Financial Crisis and a Staggering Economy: Indian Financial System in a Catch 22 Situation?, Journal of Engineering Sciences, 11(8), August, 2020. CRISIL. 2020. CRISIL NBFC Sector Report. [online] Available at: https://www.crisil.com/en/home/our-analysis/reports/2020/08/crisil-nbfc-sector-report.html [Accessed 16 October 2020].  Dhanorkar, S., 2019. NBFC (Non Banking Financial Company) | Defaults Aplenty: What Is Ailing India's NBFC Sector?. [online] The Economic Times. Available at: https://economictimes.indiatimes.com/wealth/personal-finance-news/defaults-aplenty-what-is-ailing-indias-nbfc-sector/articleshow/70001015.cms?from=mdr [Accessed 16 October 2020].  Assets.ey.com. 2020. Are Indian Banks And Nbfcs Ready To Absorb COVID-19 Impact?. [online] Available at: https://assets.ey.com/content/dam/ey-sites/ey-com/en_in/topics/financial-services/nbfc/are-indian-banks-and-nbfcs-ready-to-absorb-covid-19-impact.pdf [Accessed 17 October 2020].  Sadhu, S., Sarin, V. and Teewari, S., 2020. Battling Covid-19 And Liquidity– The Twin Crisis Of NBFC Sector | India Corporate Law. [online] India Corporate Law. Available at: https://corporate.cyrilamarchandblogs.com/2020/06/battling-covid-19-and-liquidity-the-twin-crisis-of-nbfc-sector/ [Accessed 17 October 2020].  CRISIL. 2020. Credit Alert: Lockdown, Moratorium And Nbfcs. [online] Available at: https://www.crisil.com/en/home/our-analysis/views-and-commentaries/2020/03/lockdown-moratorium-and-nbfcs.html [Accessed 17 October 2020].  Kamal Kumar Kalia vs. Union of India, WP/10955/20.  W.P.(C) 2963/2020 & CM APPLs. 10281-85/2020.  Indiabulls Housing Finance v HDFC Bank Limited, W.P.(C) 3033/2020.  Lele, S., 2020. SBI To Grant Moratorium To Nbfcs On Case-By-Case Basis Amid Covid-19 Crisis. [online] Business-standard.com. Available at: <https://www.business-standard.com/article/finance/sbi-weighs-25-fresh-credit-proposals-from-nbfcs-amid-covid-19-crisis-120050601802_1.html> [Accessed 17 October 2020].
(i) Karunagaran, A., 2012. Inter-connectedness of Banks and NBFCs in India: Issues and Policy Implications (No. id: 4692).
(ii) Manda, V.K. and Rani, P.S., Crisis in the Indian Non-Banking Finance Companies (NBFC) Sector.
(iii) Roy, B., 2019. Shadow Banking in India in relation to the IL&FS Crisis. Journal of Banking and Insurance Law, 1(2), pp.1-6.
(iv) Kumar, R.B. and Ayeswarya, R., 2017. A Study on Current Liquidity crunch faced by NBFC’s & HFC’s in India. International Journal of Innovative Research and Advanced Studies, 12(14), pp.25-32.
(v) George, R.R., TWO DECADES OF FAULTY CREDIT POLICY LATER, AN UNENDING RIPPLING EFFECT OF FINANCIAL CRISIS AND A STAGGERING ECONOMY: INDIAN FINANCIAL SYSTEM IN A CATCH 22 SITUATION?.
(vi) Report of the Expert Committee on Resolution Framework for COVID-19 related stress, RBI Report, RBI Archives, Published – September 4, 2020. The publication can be accessed through Internet at https://www.rbi.org.in
(vii) RBI Financial Stability Report (Issue No. 19), RBI Archive, Published – June, 2019. The publication can be accessed through Internet at https://www.rbi.org.in
(viii) Anshuman, V.R. and Sharma, R., 2020. Financial Fragility in Retail-NBFCs. IIM Bangalore Research Paper, (604).