Regulating “Mis-regulated”

The NBFC fiasco which started with labyrinthine structured IL&FS defaulting in August last year doesn’t seem to be ending anytime soon. Recent delay by DHFL in interest payments worth INR960 crore on June 4, has flabbergasted the entire financial services industry.

It’s high time for the financial services industry’s watch dog to increase scrutiny over these shadow banks. RBI has lately proposed a draft liquidity management policy for these mis-managed NBFCs including core investment companies.

Below is a brief review and analysis of the same.

The draft proposal aims to amend the heavy mismatches in asset liability management (ALM) of NBFCs, which emanated from utilizing short term borrowings for long term investments.

1.) Liquidity Coverage Ratio (LCR) – In line with the “real” banks, NBFCs too will need to maintain a LCR, which essentially implies keeping requisite proportion of highly liquid assets to fund short term obligation. A 60% LCR is proposed commencing from April 2020 for NBFCs having assets greater than INR5,000 crore and gradually increasing it to 100% by 2024.

2. Maturity Profiling – RBI is seeking to impose strict rules for managing and measuring fund requirements. This requires statement of structural liquidity presented by NBFCs to not exceed cumulative negative mismatches to the tune of 10%, 10% and 20% of negative cash outflows in maturity buckets of 1-7 days, 8-14 days and 15-30 days respectively.

3. Liquidity Risk Monitoring: Consistent liquidity risk monitoring will be required of NBFCs which should cover but not be limited to any concentration in funding, availability of unencumbered assets and early warning market based signals.

4. Stock approach to liquidity: This requires management to persistently measure short term liquidity in the form of short-term liability to total assets; short-term liability to long term assets; commercial papers to total assets; non-convertible debentures (NCDs)(original maturity of less than one year) to total assets; short-term liabilities to total liabilities; long-term assets to total assets; etc.

5. Extension of liquidity risk management principles: NBFCs should adopt extended principles in the form of off-balance sheet and contingent liabilities, stress testing, intra-group fund transfers, diversification of funding, collateral position management, and contingency funding plan.

These measures will have a multiplicative effect on the financial services industry, such as:

a. Increasd confidence of debt market participants in the papers issued by NBFCs.

b. Lower margins for NBFCs, as holding liquid assets will lower their investment returns.

c. Surge in securitization to get access to immediate funding to adhere to liquidity norms.

d. Rise in interest rates offered to NBFC depositors due to higher requirement of funds to maintain sufficient funding profile.

e. Most importantly, a no-brainer effect – decline in default rates.

Despite the guidance, consequences of the proposal will depend much upon the nature of its implementation.

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