NBFC Crisis - The Role of RBI and Credit Rating Agencies

NBFC Crisis-The Role of RBI and Credit Rating Agencies

NBFC CRISIS-a role of RBI and Rating Agency

The broad history of NBFC (Non-Banking Financial Companies) in India shows the clear picture that they emerge and evolve to fill the gaps left by banks. In the past many years NBFCs showed an extremely good growth rate in loan books. This result in a market share of NBFCs in the overall financial system increases rapidly and reaches around 20% to the total loan book of the bank.

This growth is fuelled by the large amount of borrowing created by NBFCs from various ways like commercial paper, bank borrowings, debentures, etc. Now come to point that the major reason for the NBFC crisis is inside these borrowings. What NBFCs does is that - they give loans to the different client for machine leasing, house buying, vehicle buying, etc. for the tenure of around 5 to 25 years against the short term borrowing of 3 to 6 month by issuing commercial paper to the mutual fund and other investors and roll it over after the maturity of paper because it has low interest compared to long term borrowings to earn more net interest margin.

 This is a flaw in their business model because in good condition of the economy this transition of paper is smooth but in the last one year after the IL&FS crisis market sentiment of the market becomes severe so this transition becomes difficult and no one is ready to buy this commercial paper. So that there is a large “liquidity crisis” created in the market. Due to the difficulty of raising funds “Asset Liability Mismatch” created in NBFCs which resulted in the “NBFC crisis”.

The RBI has taken some steps to stop the conversion of this NBFCs crisis into a full-fledged financial crisis. The RBI has changed its rules to make it easier for NBFCs to raise capital. Banks were earlier restricted to lend a maximum of 10% of their loans to NBFCs but this limit has been temporarily raised to 15% for the coming few months. 

The immediate effect of this step has resulted in an extra $10 billion liquidity available into the market but there are many problems that banks are not in the good financial condition as it was before due to their higher NPA of their last lending cycle so that they only lend to the well-established NBFCs.

If we observe carefully about the market conditions and the past steps taken to solve this crisis, then in a present condition we can improve on the following aspects —

 Sorting out a liquidity crisis.

Firstly, there are around 100 deposit-taking NBFCs that are mandated to maintain SLR of 15% of their deposits which are mostly in terms of government securities. So RBI could allow these NBFCs to temporarily borrow from its LAF (Liquidity Adjustment Facility) facility which gives some relief to these lenders. 

Secondly, these NBFCs have some secure loans to MSME, housing loans, and others. RBI can lend these NBFCs against their secure loans in place of government security but for this proper investigation could be required. It will give some time to this company to readjust Asset and liability mismatch.

Thirdly, 

• The time has come to make one SPV(special purpose vehicle) for NBFCs who are struggling to get liquidity. This SPV gave short term financing to lenders which could be regulated by RBI. NBFCs can pledge three or six-month commercial papers and non-convertible debentures with this SPV to get financing.
•  Same thing RBI did in 2009 during the financial crisis. This had given a boost up to the confidence of investors on NBFCs and the situation converted.
•  Viewing the current situation -                                                                                        “There is a fear factor. The element of Fragility in the fin system.” — Uday Kotak, Founder and MD & CEO, Kotak Mahindra Bank. 
• If  RBI succeeds to remove this fear from the investor's mind, the availability of liquidity will ease. Another benefit is that, if investor’s confidence recoils then this can improve the valuation of this company so this makes it easy to get private investment by diluting equities. 

Fourth, if RBI doesn't want to interrupt directly, it can do so by pushing the bank to do above mentioned things. It is difficult for private sector banks but currently, the government has invested money into PSU banks to ease the liquidity situation for NBFCs. One solution is that banks can buy a good loan from them and give them money and this will be a good option for NBFCs to raise money but they have to compromise with their future earnings coming from that loan account. As Milton Freidman said: "There isn’t no such thing as a free lunch."

2. Long term solution: Tight the regulation by making a new committee for the current crisis and regulating credit rating agency and auditing agency by collaborating with SEBI.

Firstly, in recent times, RBI came up with a draft on the liquidity risk management framework. In this RBI says, NBFC-ND has over 5000 loan books to maintain LCR (Liquidity Coverage Ratio) minimum of 60% after April 2020 and reaches 100% by 2024. These moves will be acceptable. It will tightly regulate the current major problem of ‘Asset-Liability Mismatch’ in the long run but the problem is that RBI doesn’t give guidelines for other major problems like the role of the rating agency, poor debt market for low rated paper. For this, there is a need of forming a new committee and another is to make such a liquidity window that avails different options for stress NBFCs and for raising debt also. 

Secondly,

• After demonetization demand for NBFCs increased and banks were full of cash lending more and more to this NBFCs via. different options. Figure shows at which level lending to NBFC-ND was increased in this period. 
• So, NBFCs had lent much money by non-discipline to the real estate sector, infrastructure sector, and many other sectors which create lots of NPA which we have seen in IL&FS, DHFL, and other NBFCs. Indirectly this NPA has to be transferred to the bank, which creates a problem for the bank.
•  So like SLR, RBI should mandate this company to maintain 10 to 15 % of bank loans as the highly liquid asset which can become reserve against the bank loan to save the bank from a large NPA.

Third, except some large NBFC others are lagging in technology so RBI can create some guidelines to help these NBFCs for technological advancement. By using these technologies, every NBFCs can make their own methodology like ‘Alternative Credit Scoring’ by using the transaction data of borrowers; what many big NBFCs around the world are doing. Here is one methodology –

Role of rating agency :

After the 1998 Asian crisis and 2008 American subprime mortgage crisis these agencies were the Centre of controversy. These rating agencies gave high ratings to the low-quality bonds. Just like in the IL & FS case, the crisis started on 14th September before this IL&FS was rated with the highest rating ‘AAA’ and after in September it was directly converted to ‘D’ rating. This shows that rating agencies must come under scrutiny by SEBI.

 A forensic audit by Grant Thornton of IL&FS shows that there was clear mutual cooperation between the top management of IL&FS board and top executive rating agencies. This executive was influenced by the gifts and trips given to them. The result was that from 2013 to 2018, four firms rated it with the highest rating through it raised 20000 Cr. from insurance, mutual fund, and other companies.

Uday Kotak, Chairman of IL&FS said that “This is the time to Question how trustworthy are balance sheets of Indian companies, fund flows will return when investors trust financial”. After this SEBI comes up with guidelines and norms which result in transparency in their working and increased trust which is likely welcomed. 

There are some structural problems on which SEBI has to focus on long term sustainability.

 Firstly, 

• A credit rating agency is paid by the company to whom it rates, so that rating agency is more bound to this company for giving a good rating but in actuality, they must have to bind the investor who invests in it by reading the rating.
•  So one solution is - Change in the business model. For this SEBI mandate that credit rating agencies charge a very small amount from the company and earn money from the investor by charging a fixed amount. This Agency will improve its reliability to earn more money which in turn benefits the investor and economy. SEBI can do one another thing that at least 2 agencies must rate a company and it’s a debt instrument. 

Secondly, RBI and SEBI make an independent regulatory body for credit rating agencies for tight regulation. The same type of body is there in London and their retail investors participate in debt instruments by mutual funds.

Thirdly, when the fraudulent rating is found, give them a heavy penalty so that other players will not do this again. 

Thus the role of RBI and Credit rating agency is very crucial for the whole NBFC sector to prevent another crisis in the future. By improving the above discussion parameters we can make the NBFC sector self-reliance and strong which in the long run benefit our economy.