economic-survey-vol-1-chapter-8-financial-fragility-in-the-nbfc-sector

This chapter highlights that problems faced by the NBFCs stemmed from their over-dependence on short term wholesale funding from the Liquid Debt Mutual Funds. It investigates the key drivers of Rollover Risk of the shadow banking system in India. 

Introduction: 

  • The liquidity crunch in the shadow banking system in India took shape in the wake of defaults on loan obligations by major Non-Banking Financial Companies (NBFCs). 
  • Two subsidiaries of Infrastructure Leasing & Financial Services (IL&FS) defaulted on their payments, while Dewan Housing Finance Limited (DHFL) did so later. 
  • Both these entities defaulted on non-convertible debentures and commercial paper obligations.

Shadow banking

It comprises a set of activities, markets, contracts and institutions that operate partially (or fully) outside the traditional commercial banking sector and are either lightly regulated or not regulated at all.

It can be composed of a single entity that intermediates between end-suppliers and end-users of funds, or it could involve multiple entities forming a chain. 

Shadow banks do not have explicit access to central bank liquidity. The shadow banking system is highly levered with risky and illiquid assets while its liabilities disposed to “bank runs”.

Impact of these defaults

  • The sharp decline in the equity prices of stressed NBFCs
  • Both debt and equity investors suffered a massive erosion in wealth due to the defaults.
  • Led to the difficulty of NBFCs to raise funds, which took a toll on the overall credit growth in the Indian economy and a decline in GDP growth.

Steps were taken to estimate the financial fragility of the NBFC sector

Health Score

  • An index is developed to estimate the financial fragility of the NBFC sector and it was found that it can predict the constraints on external financing (or refinancing risk) faced by NBFC firms. 
  • This index is called the Health Score, which ranges between -100 to +100 with higher scores indicating higher financial stability of the firm/sector. 
  • The Health Score employs information on the key drivers of refinancing risks such as Asset Liability Management (ALM) problems, excess reliance on short-term wholesale funding (Commercial Paper) and balance sheet strength of NBFCs.
  • The Health Score of the Retail-NBFC sector was consistently below par for the period 2014 till 2019.

Conceptual framework of Rollover risk

The survey investigates the key drivers of Rollover Risk of the shadow banking system in India in light of the current liquidity crunch in the sector.

Key drivers of Rollover Risk:

Asset Liability Management (ALM) Risk 

  • This reliance on short-term funding causes the asset-liability management (ALM) problem because asset side shocks expose financial institutions to the risk of being unable to finance their business.
  • This risk arises in most financial institutions due to a mismatch in the duration of assets and liabilities. 
  • Liabilities are of much shorter duration than assets which tend to be of longer duration, especially loans given to the housing sector. 
  • This mismatch implies that an NBFC must maintain a minimum amount of cash or cash-equivalent assets to meet its short-term obligations.

Interconnectedness Risk

Interconnectedness Risk is a measure of the transmission of systemic risk between an NBFC and the Liquid Debt Mutual Funds (LDMF) sector that arises from two factors. 

  • The first factor is measured by the LDMF sector’s average exposure to CP issued by the NBFC.
  • The second factor highlights that low levels of cash holdings in the LDMF sector, on average diminish the ability of the LDMF sector to absorb redemption pressures.

The combined impact of these two factors is referred to as the Interconnectedness Risk.

Financial and Operating Resilience of an NBFC:

  • Liquidity crunch in debt markets often leads to credit rationing
  • Credit rationing results when firms with robust financial and operating performance get access to credit while the less robust ones are denied credit. 
  • Firms with robust financial and operating performance can withstand a prolonged period of liquidity crunch if they choose not to raise funds from debt mutual funds.

Over-dependence on short-term wholesale funding:

  • It is argued that the fundamental factor that influences Rollover Risk can be traced to the over-dependence of the NBFC sector on the short- term wholesale funding market. 
  • To develop policy implications, financial metrics were employed to estimate the drivers of Rollover Risk and weigh them appropriately based on their relative contribution to Rollover Risk. This procedure helps to generate a measure of the health of an NBFC. 

Policy Implications

The above analysis suggests that firms in the NBFC sector are susceptible to rollover risk when they rely too much on the short-term wholesale funding market for financing their investments in the real sector. 

The following policy initiatives can be employed to arrest financial fragility in the shadow banking system:

  1. Regulators can employ the Health Score methodology presented in this analysis to detect early warning signals of impending rollover risk problems in individual NBFCs.  
  2. When faced with a dire liquidity crunch situation, as experienced recently, regulators can use the Health Score as a basis for optimally directing capital infusions to deserving NBFCs to ensure efficient allocation of scarce capital.
  3. The above analysis can also be used to set prudential thresholds on the extent of wholesale funding that can be permitted for firms in the shadow banking system. 

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