Non-banking financial companies (NBFCs) have been under the scanner of regulatory bodies, market analysts and other stakeholders for the past couple of months over the issue of non-performing loans in the financial services sector. In the wake of the flurry of theories and speculation surrounding the so-called ‘liquidity crunch’ in NBFCs, the Reserve Bank of India (RBI) and the Government have been examining ways to tackle the situation and have taken steps towards it.
Soon after speculation unfolded on the market numbers, RBI came out with a reassuring press release on 23 September stating that it is closely monitoring the activities and developments in the financial services sector and is ready to take appropriate action.
In fact, even before this statement, RBI had fuelled collaboration between banks and non-deposit taking systemically important (ND-SI) NBFCs by issuing guidelines on co-origination of loans (Guidelines) by banks and NDSI NBFCs for lending to the priority sector (including housing, education etc). Under these Guidelines, banks and ND-SI NBFCs can contribute credit jointly and share risks and rewards in a manner such that their respective business interests are aligned.
Further RBI has taken steps towards incentivising banks to allow flow of funds to NBFCs and housing finance companies (HFCs). RBI has allowed banks to reckon government securities held by them, up to an amount equivalent to the incremental outstanding credit disbursed by them to NBFCs and HFCs between 19 October and 31 December 2018, as level 1 high-quality liquid assets (required by financial institutions to meet short-term obligations), within the mandatory statutory liquidity ratio requirement. This move will incentivise banks to lend more to NBFCs and HFCs to meet their own statutory requirements and will also give more funds to lend.
For lending by banks, RBI has also increased the single borrower exposure limit for NBFCs which do not finance infrastructure from 10 to 15 per cent of capital funds. This means that banks can lend more to large, healthy NBFCs without breaching the regulatory limit. However, with an optimistic assumption of the financial market recovering by December 2018, this increase in exposure has been limited till 31 December 2018.
Another recent measure to battle speculations is the move to allow banks to provide partial credit enhancement (partially stand-in as guarantors) to bonds issued by ND-SI NBFCs and HFCs. Credit enhancement is a method by which a bond issuer improves its creditworthiness through a third-party guarantee and the bond purchaser gets a re-assurance that the repayment obligations will be honoured.
This partial credit enhancement is, however, subject to certain conditions. The tenor of such bonds cannot be less than three years and the proceeds of such bonds can only be used for refinancing the existing debt of the NBFCs or HFCs. Further, the exposure of a bank to such partial credit enhancement is limited to 1 per cent of the capital funds of the bank within the extant single/group borrower exposure limits.
In addition to the aforesaid measures, few public sector banks have also proposed to increase purchase of the assets standing on the books of NBFCs (in the form of loans advanced). This move (commonly referred to as the portfolio buyout route) is expected to go a long way in bringing about liquidity in the financial services sector.
The NBFCs will get instant liquidity and the risk for the purchasing bank for such portfolio buyout will also be minimal. Apart from aid from regulators, reports suggest that certain NBFCs have approached large private equity players for funding, which are ever hungry for low cost capital.
Amidst all these measures, there is an ongoing discussion between the Government and the RBI over other steps to boost this sector. One of the proposals from the Government is for RBI to open a special liquidity window to provide liquidity to all NBFCs approaching it for funds during such window. However, the RBI has expressed reservations in adopting this approach as it is likely to get a huge number of applications, and ascertainment of the quality and level of non-performing assets during such window will be challenging.
The Government has also proposed that RBI should relax the Prompt Corrective Action (PCA) norms that impose operational and lending restrictions on certain weak banks. RBI, so far, has pulled up 11 public sector banks under PCA with different degrees of restrictions. When RBI initiates PCA against a bank, it applies restrictions on issuance of fresh loans and dividend distribution. The Government has proposed relaxation of PCA to enable more sanction of credit to help the liquidity issues in NBFCs. The RBI was not very forthcoming regarding this proposal.
In the backdrop of these incongruities between the RBI and the Government, in a meeting held on 19 November 2018, the central board of the RBI (Board) comprising representatives of the Government, RBI and independent members, discussed several points of differences between the Government and RBI. It appears that at least for the time being, there is a clear direction and action plan in place to restore investor confidence in NBFCs and HFCs and bring the financial services sector back on track.
Amongst other things, the discussion points were the ‘Economic Capital Framework’ (ECF) of RBI, the existing Basel regulatory framework, the restructuring scheme for stressed micro, small and medium enterprises (MSMEs) and relaxation of PCA norms. ECF is essentially a framework which has been in place for the past four years, that determines the share of RBI’s reserves and surplus which is to be passed on to the Government. Post discussions in the meeting, the Board has decided to constitute an expert committee to examine the ECF. The Government and the RBI will jointly determine the terms of reference of the ECF.
On the Basel regulatory framework, while the Board has decided to retain the existing capital adequacy reserve ratio at 9 per cent, it has extended the transition period for implementing the last tranche of 0.625 per cent up to 31 March 2020. This implies that banks will now have time till 31 March 2020 to implement the capital adequacy ratio target. This will undoubtedly reduce cost of borrowing and release more capital in the system.
Additionally, the Board has decided to allow the RBI to consider a scheme for restructuring stressed assets of MSME borrowers with aggregate credit facilities of up to INR 250 million. On the question of relaxation of PCA norms, it has been decided to allow the Board for Financial Supervision of RBI to examine this issue in depth. The proposal of having a special liquidity window for NBFCs was not addressed by the Board.
The Board will meet again on 14 December 2018 for a reality check of the actual outcome of the measures proposed as well as to discuss certain other issues which could not be taken up at the meeting held on 19 November (such as liquidity for NBFCs). The constant measures by the Government and the RBI (while they may not be in sync) to ensure capital flow to NBFCs goes to show the importance that this sector holds in the Indian economy and the support that this sector attracts from the stakeholders. The regulators are not leaving any stone unturned in keeping the financial services sector afloat, and the market perception of low confidence should disappear soon.
The writers are, respectively, Principal Associate and Senior Associate at Khaitan & Co. The views of the authors are personal and do not constitute legal/professional advice of Khaitan & Co. the writers can be reached at [email protected]