Proposed Liquidity Framework for NBFCs Shifts Focus to Tangible Liquid Buffers - India Ratings and Research

India Ratings and Research (Ind-Ra) believes the proposed draft guidelines on creating a liquidity framework for non-banking financial companies (NBFCs) will enforce on-balance sheet liquidity maintenance through the cycle and be conducive for developing holistic liquidity management contour. The agency believes the guidelines will also disincentive NBFCs from relying heavily on short-term financing options. However, the proposed framework is unlikely to have any meaningful impact on addressing the current environment of high risk aversion.

Considering the existence of structural issues such as twin deficit, depleting household savings, limited avenues for alternative sources of financing and feeble capital market at the macro and micro levels, there could be higher occurrences of liquidity volatility in the medium term. However, the financially better placed non-banks (NBFCs and housing finance companies (HFCs)) with strong sponsor support and well-established positioning in the ecosystem may be able to withstand it better than others.

As per the proposed guidelines, NBFCs with an asset size of INR50 billion or above and all deposit taking NBFCs irrespective of asset size will have to maintain a liquidity buffer in terms of a liquidity coverage ratio (LCR) and maintain investment in high quality liquid asset (HQLA). The proposed framework allows NBFCs to maintain 60% of the required investment in HQLA starting 1 April 2020, and the required floor to go up by 10% in the subsequent years before it reaches 100% in April 2024. The agency believes, in the last six-to-eight months, non-banks generally have been cautious on their liquidity strategy with many raising a considerable amount of on-balance sheet liquidity. If this liquidity were to sustain, Ind-Ra believes, maintaining 60% by April 2020 should be largely achievable.

Also, as per the guidelines, bucketing the asset liability management (ALM) in one month tenor in the form of buckets (0-7 days, 7-14 days and 14 days-1 month) incrementally is unlikely to have any material impact on NBFCs and HFCs, as the gaps allowed would not contain risk during stressed times.

Impact on NBFCs: The proposed LCR framework by the Reserve Bank of India, once fully implemented, is likely to have an asymmetric impact on NBFCs, depending on the nature of their business (i.e; wholesale or retail) and their credit profiles (opportunity cost). The framework requires large NBFCs to carry on-balance sheet liquidity in the form of cash and bank balance or investments eligible under HQLA. As per Ind-Ra's assessment, large NBFCs in the asset financing space would find it less demanding to comply to the LCR norms with only a marginal impact on their profitability. However, NBFCs which have been witnessing sizeable asset liability mismatches or those largely operating in the wholesale or the semi-wholesale space on the asset side, may find the framework having a meaningful impact on their profitability. Additionally, few NBFCs that have been operating on a slightly aggressive liquidity strategy factoring in the liquidity support from their sponsors may need to realign their strategies.

Ind-Ra notes that financially stronger NBFCs would not run mismatches in the short-term buckets (up to one month) and hence the quantum of minimum HQLA needed to be maintained would be 25% stressed outflow in one month bucket. According to the assessment based on ALM at FYE19, the top 11 NBFCs rated by Ind-Ra would have required around INR66 billion and INR111 billion to maintain 60% and 100% LCR, respectively. The top nine HFC players would have required INR170 billion and INR283 billion to maintain 60% and 100% LCR, respectively, at FYE18. As suggested in the circular, the diversification of funding across instruments / counterparty / currency will lead NBFCs to maintain a balance funding approach across interest rate cycle, thereby increasing the funding cost for the entire system.

Adverse Impact on Mutual Fund Inflows: Ind-Ra believes the proposed LCR framework will reduce NBFCs' investment parked in mutual funds. In general, NBFCs maintain some cash & cash equivalent buffer for operational purposes. However, in the last few quarters, many NBFCs have increased their liquidity buffer by maintaining a considerable amount of liquid assets depending on the ability to mobilise funds. Ind-Ra believes more often than not, the amount parked in a liquid mutual fund or other related money market assets is to reduce opportunity cost. As per the proposed circular, investments in liquid mutual fund, bank fixed deposit or certificate of deposit are excluded from the list of HQLA, largely to contain industry-specific counter-party risk.

Corporate CP to Benefit: As opposed to the commercial papers (CPs) issued by NBFCs, CPs issued by corporates (by issuers rated AA- and above) are included in the HQLA basket with an applicable haircut of 15%. The agency believes NBFC will be more inclined to invest in corporate CPs given their limited duration and higher yield, which could reduce the opportunity cost of maintaining LCR. In that case, the spread between corporate CPs and the CPs issued by NBFCs will widen. Moreover, the incremental demand from NBFCs for money market instrument will be constructive for the money market yield curve.

Source : Equity Bulls

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