A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares /stocks/ bonds/debentures/securities. Most of the NBFCs in India are regulated by RBI with some exceptions like HFCs and NIDHI companies. In the recent past NBFCs in India have seen a crisis on multiple fronts due to various reasons.
To begin with, NBFC’s in India have relied on raising money through short-term funds which were then lent out as long-term loans. This has resulted in Asset – Liability mismatch (ALM). Due to global slowdown and less demand of loans in financial markets, NBFCs have been unable to honor the payback of deposits. Due to slowdown in the infrastructure sector, the money lent to construction companies and housing finance companies have turned into bad debts. Due to the snowball effect from ALM, cash flows have dried up and NBFCs are now unable to repay their lenders, turning NBFCs into defaulters.
After demonetization, NBFCs were able to raise easy money on low interest rates. To take advantage of the situation, they lent aggressively, resulting in over-leveraging. As excess money dried up in the financial market, their cost of raising funds started going up. In order to stay profitable, NBFCs started lending funds in highly risky propositions, building up the bubble of default.
NBFCs have been excessively concentrated in risky areas like construction and housing finance companies. These sectors have long gestation periods. Due to economic slowdown post structural reforms like GST, which has affected real estate sector massively, the returns from loans to real-estate sector have dried up, ultimately affecting profits of NBFCs.
Due to the nation-wide economic slowdown, credit activity has dried up. With less demand for credit, there is less economic activity. The vicious cycle is ultimately affecting NBFCs as well as Banks. NBFCs, being riskier and more concentrated in their activity, are facing massive defaults.
Solutions:
RBI has taken various steps to resolve the NBFC crisis. In the last financial year, RBI bought government debt paper worth Rs 3 lakh crore from the market. Basically, this meant that so much money was given to the banking system and NBFCs to on-lend. This is the only way for RBI to help NBFCs since the central bank can’t lend directly to the latter as they don’t hold government paper for use as collateral.
RBI also came up with voluntary Asset quality review scheme wherein NBFCs who have opted to subject themselves to the RBI’s AQR were given a lower regulatory capital requirement (RCR) once the RBI had cleansed their balance sheet.
Recently RBI came up with the guidelines in which it declared that NBFCs and HFCs should not have net non-performing assets of more than 6% as on 31 March 2019 and the funds raised will have to be solely used to extinguish existing liabilities.
NBFCs can effectively use the debt markets to facilitate long-term availability of capital in projects. The financial system of India needs to deepen the debt markets so that banking system and NBFCs can be more productive and sustainable in their performance.
The NBFC sector is bound to become an important pillar of economic stability in India. In order to keep this pillar strong, the regulators need to ensure that it gets back on track and stays on track by following all regulatory guidelines. The deeper NBFC gets, the larger its impact would be on health on Indian economy.
OR:
NBFCs typically borrow money from banks or sell commercial papers to mutual funds to raise money. They on-lend these money to small and medium enterprises, retail customers and so on. They can face a crisis if their borrowers fail to pay back while the NBFC has to pay back its borrowings to the banks.
Presently, there is a credit squeeze, over-leveraging, excessive concentration, massive mismatch between assets and liabilities, coupled with some misadventures by some very large entities, leading to a crisis.
Asset Liability Mismatch- NBFCs had borrowed short term from banks and mutual funds while lending to developers of long-term projects, which got held up because of various factors. This is called as Asset Liability Mismatch. ALM can result in bankruptcy.
NBFCs lent to unscrupulous developers and wilful corporate defaulters indulging in round tripping of funds and ever-greening of loans. Concentration of lending to such borrowers put NBFCs out of business once the large borrowers fail to pay back.
Most banks have cleaned up their books and shored up balance sheets but NBFCs, which borrow from banks and mutual funds, are in trouble. Their costs, particularly those of smaller ones, have shot up as Banks want NBFCs to promise higher returns on the loans NBFCs buy from banks
The following steps have been taken to resolve the crisis-
The central bank has pumped a huge amount of liquidity into the system over the last eight months. It has also eased some norms to give NBFCs more room in fundraising.
The debt markets have been deepened to facilitate long-term availability of capital in projects for both NBFCs and private borrowers.
In the insurance space, we need to introduce Risk Based Solvency (RBS) so that insurance companies have to maintain reserves in proportion to the risk they undertake, which will facilitate true comparison across insurance companies based on their financial strength.
NBFC crisis has shown lack of required regulatory frameworks by RBI, SEBI, IRDAI and other regulatory agencies. A better regulation combined with regular implementation can strengthen NBFCs in the long run.