The future posits that NBFCs will continue to experience robust growth with minimal instances of delinquencies if the credit flow doesn’t stop and the risk mitigation mechanisms improve.
Over the last decade, India’s non-banking financial companies (NBFCs) have assumed critical importance in the financial system. The total asset size of all NBFCs in India is more than $370 billion and they provided close to 20 per cent of all credit in India till March 2018 versus 15 per cent three years ago. The importance of such a strong credit system in a growing economy like India can’t be overemphasized.
The industry is growing from strength to strength by serving the underserved and often ignored retail and MSME segments which are the backbone of India’s growth story. For instance, credit to MSMEs grew at a rate of 12 per cent year-on-year in June at a time when credit to larger firms was slowing down massively. NBFCs play a huge role in the growth of this sector as the lending book of NBFCs has grown at around 18 per cent annually over the last five years.
However, over the last year, the sector saw some hiccups in the form of a liquidity crunch when the failure of IL&FS unraveled. The failure of IL&FS to service its liabilities led to caution across the financial system about the strength of the sector. As funding became harder to come by, the total NBFC sanctions fell to INR 1.9 lakh crore this September compared to INR 2.9 lakh crore recorded in the same period last year, according to CRIF High Mark.
Because of the IL&FS incident, a temporary shock appeared in the NBFC circuit as banks tightened credit flows and liquidity squeeze reduced the pace of acceleration of credit as entities chose to focus on asset-liability management rather than just growing their books.
Additionally, mutual funds reduced NBFC exposure by 30 per cent in the last year and various leading entities in the sector moved over this challenge by increasing bank funding and managing external and internal borrowings through a tightrope. This enabled the funds to keep flowing to India’s entrepreneurial MSMEs where even a temporary liquidity squeeze can halt business activities and hurt the topline as well as the bottom line.
It helped that the government took quick cognizance of the troubles in the sector and launched initiatives to provide relief. The Reserve Bank of India announced in August that banks can have an exposure of up to 20 per cent of their Tier 1 capital to a single NBFC as compared to the 15 per cent limit earlier. This helped boost credit flow as bank funding to NBFCs grew by 30 per cent year on year. At the same time, the regulator also eased the priority sector lending norms by allowing banks to provide funds to NBFCs for on-lending to agriculture up to INR 10 lakh, MSMEs up to INR 20 lakh and housing up to INR 20 lakh per borrower to be classified as priority sector lending.
New Risk Management Framework
However, another green shoot that emerged from the regulatory intervention as the RBI introduced a new liquidity risk management framework to holistically counter future risks in the sector.
Under the new framework, non-deposit taking NBFCs with asset size of more than INR 10,000 crore and all deposit taking NBFCs will have to maintain a liquidity coverage ratio (LCR) requirement of 50 per cent by December 1, 2020, and progressively increase it to 100 per cent by December 2024. Similarly, non-deposit taking NBFCs with asset size between INR 5,000 crore and INR 10,000 crore would be required to have a minimum LCR of 30 per cent by December 1, 2020.
This might have produced short-term pain in the industry but it’s an excellent long-term measure to protect the sector from externalities and improve the overall risk management frameworks across the industry. This will not only boost the confidence in the robustness of the sector, but it could also potentially lower the cost of funds for NBFCs as their risk perception goes down massively due to the new LCR reporting framework.
Moreover, the RBI’s emphasis on its commitment to not let any NBFC fail came as a strong signal from the government that it firmly stands behind the sector. Due to the easier liquidity provisions, the flow of funds to NBFCs from banks improved by over 30 per cent in just a year.