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Why Do NBFCs Have To Maintain Liquidity Coverage Ratio And High-Quality Liquid Assets?

Ridhima Jain

| Updated: Apr 16, 2020 | Category: NBFC

Liquidity Coverage Ratio

What Are Nbfcs?

The Reserve Bank of India defines a Non-Banking Financial Company (NBFC) as:

A company registered under the Companies Act engaged in the business of:

  • Loans and advances
  • Acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature
  • Leasing
  • Hire-purchase
  • Insurance business
  • Chit business

 But does not include any institution whose principal business is:

  • agriculture activity
  • industrial activity
  • purchase or sale of any goods (other than securities) or
  • providing any services and sale/purchase/construction of immovable property.

A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in instalments by way of contributions or in any other manner is also a non-banking financial company (Residuary non-banking company).

In terms of Section 45-IA of the RBI Act, 1934, a Non-banking Financial company cannot commence or carry on the business of a non-banking financial institution:

  • without obtaining a certificate of registration from the RBI
  • without having a Net Owned Funds of ₹ 25 lakhs (₹ 2 crores since April 1999).

However, to obviate dual regulation, certain categories of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI.

What Is The Liquidity Coverage Ratio?

Liquidity Coverage ratio refers to the proportion of the High-Quality Liquidity Assets (HIGH-QUALITY LIQUID ASSET) an NBFC has to maintain in order to meet the net cash outflows over a period of 30 calendar days, in case the markets face a liquidity crisis.

Numerically,

It is given by

Stock of HIGH QUALITY LIQUID ASSET
Total Net cashflows over the next 30 days

Important Financial Institutions (SIFI),” are required to maintain a 100% LCR.

By the above definition, we may infer that Liquidity Coverage Ratio has the following two components:

HIGH QUALITY LIQUID ASSETS

It refers to the Assets which are unencumbered and can be converted into cash easily and immediately at little or no loss to cover the net cash outflows during a liquidity stress period of 30 days.

TOTAL NET CASH OUTFLOWS

It is refers to the difference between total expected cash outflows and total expected cash inflows during a liquidity stress period of 30 days.

High-Quality Liquid Assets – An Analysis

Basel III Framework on Liquidity Standard classifies High quality liquid assets as:

High-Quality Liquid Assets

Level 1 asset may be in any proportion in the Total stock of High Quality Liquid Assets. However, Level 2 assets are to be restricted to maximum 40% of the overall stock requirements after taking into consideration the applicable haircuts.

Level 1 Asset:

These assets, for the purpose of Liquidity Requirements may be taken at their market value without any applying any haircut (Haircut refers to the reduction in market value taking into consideration the associated risk factor).

  • Cash and cash reserves in excess of required Cash Reserve Ratio
  • Government securities in excess of the minimum Statutory Liquidity Ratio requirement
  • Within the mandatory SLR requirement, Government securities allowed by RBI under Marginal Standing Facility (MSF)
  • Marketable securities by foreign sovereigns fulfilling ALL the following conditions:
    1. assigned a 0% risk weight under the Basel II standardized approach for credit risk;
    2. Not issued by a bank/financial institution/NBFC or any of its affiliated entities.
    3. Traded in large and active repo or cash markets; and has been proven to be a reliable source of liquidity in the markets even during tensed market conditions.

Level 2A Assets:

A minimum haircut of 15% in the market value should be applied to these assets.

  • Marketable securities representing claims guaranteed by
    1. Sovereigns
    2. Public Sector Entities
    3. Multilateral development banks

That are given a 20% risk weight under the Basel II Standardised Approach for credit risk and provided that they are not issued by a bank/financial institution/NBFC or any of its affiliated entities.

  • Corporate bonds, not issued by a bank/financial institution/NBFC or any of its affiliated entities, with a rating of AA4 or above by an Eligible Credit Rating Agency.
  • Commercial Papers not issued by a bank/PD/financial institution or any of its affiliated entities, which have a short-term rating equivalent to the long-term rating of AA4 or above by an Eligible Credit Rating Agency.

Level 2B Assets

A minimum haircut of 50% in the market value should be applied to these assets. Level 2B assets should be maximum 15% of the total stock of High-Quality Liquid Assets.

  • Marketable securities representing claims on or claims guaranteed by sovereigns having credit rating not lower than BBB.
  • Common Equity Shares which satisfy all of the following conditions:
    • not issued by a bank/financial institution/NBFC or any of its affiliated entities;
    • Included in NSE CNX Nifty index and/or S&P BSE Sensex index.

How Do The Nbfcs Function And What Led To The Liquidity Crisis?

The NBFCs primarily function by borrowing from Financial Institutions such as banks and Mutual funds and providing loans to borrowers in the market. It may be shown as:

loans to borrowers in the market

The problem arises in the model of NBFCs that India follows. In our system , the NBFCs borrow short term loans from institutional investors usually with a maturity of 6 months- 1year and issue commercial papers to such lenders promising a fixed rate of interest on the money lent by the investors.

However, when it comes to lending, they disburse long term loans to borrowers usually with a maturity of 5 years. As a consequence, the NBFCs resort to renewing their commercial papers for repaying the matured loans.

This NBFC model would perfectly function in a healthy economy. However, the problems may set in when the economy is going through a crisis. When the economy is going through such a phase, there might be defaults on part of the borrowers who borrowed from the NBFCs.  Which may result in shortage of funds with the NBFCs and thus, making them unable to repay their own debt.

This may be explained as:

shortage of funds with the NBFCs

The NBFC liquidity crisis stemmed out of the Infrastructure Leasing and Financial Services (IL&FS) episode.

The IL&FS is an NBFC with State Bank Of India and Life Insurance Corporation Of India as some of its shareholders. It is huge in size, with about more than 200 subsidiaries on board.

The IL&FS group had taken huge amounts of loans from financial institutions and when it came to the repayment of the same, many of its subsidiaries defaulted on the payment of the said loan.

As a consequence, many Financial institutions developed a fear to lend money to the NBFCs apprehending default on repayment on the loans in a manner similar to the IL&FS group, resorting to a curb on the granting loan to the sector and so, the NBFCs exhausted their major source of funds resulting a steep decline in their liquidity position, pushing the industry into a liquidity crisis.

Rbi’s Urge To Introduce Liquidity Coverage Ratio And The Need For Lcr

The financial institutions form the backbone of our economic structure. To save such Institutions during economic downfall becomes crucial to prevent further economic degradation. In such cases, the institutions become vulnerable and have a high potential of running into liquidity crunch, or even losses.

The IL&FS crisis urged the RBI to take certain steps to avoid such a situation in the future as a defence to potential onset of financial crisis.

The RBI, by this measure strives to ensure that in case of any stress period, the NBFCs have an adequate buffer stock of High Quality Liquid Assets which may be realised into cash quickly even in times of crisis for a minimum period of 30 days. This would ensure survival of the company at least for 30 days, so that meanwhile the company may find a solution to the problem.

Furthermore, following points may be noted in respect of Need for Liquidity Coverage Requirements:

  • IL&FS episode has created uncertainty in the banking institutions. An assurance that the NBFC has an adequate stock of High-Quality Liquid Assets would to a great extent reduce this uncertainty.
  • It ensures that NBFCs have adequate collateral in stock.
  • The NBFCs were not able to extend loans to borrowers due to inadequacy of funds. Maintenance of High Quality Liquid Assets ensures smooth flow of operations.
  • There is an increased Lender Confidence due to better Asset Liability Management.

What Is The Liquidity Coverage Requirement Prescribed By The Rbi To Be Followed By Nbfcs?

Firstly, in order to understand the applicability of Liquidity Coverage requirement, we have to bifurcate the NBFCs into 2 sections, which may be illustrated as follows:

Liquidity Coverage Requirement

RBI vide notification dated November 04, 2019 introduced Liquidity coverage requirements for the above categorised NBFCs.

  • CATEGORY 1 AND CATEGORY 2.2

NON DEPOSIT TAKING NBFCs HAVING ASSET SIZE MORE THAN Rs. 10000 CRORE AND DEPOSIT TAKING NBFCs IRRESPECTIVE OF ASSET SIZE:

The minimum buffer of HIGH QUALITY LIQUID ASSETs to be maintained by the company is 100% of the net cash outflows for a minimum period of 30 calendar days.

The requirement of 100% HIGH QUALITY LIQUID ASSET stock is to roll out in phases, starting from December 1 2020 and progressively increasing to required level of 100% by December 1, 2024.

A company is required to maintain at least 50% of Net cash outflows from December 2020 onwards and increasing in the following manner set out in the table set out below

  • CATEGORY 2.1

NON DEPOSIT TAKING NBFCs HAVING ASSET SIZE MORE THAN Rs. 5000 CRORE BUT LESS THAN 10000 CRORE:

RBI mandates such companies to maintain the minimum buffer commencing from required by such companies December 1 2020 at a level of 30% of net cash outflows.

It is presented in the following table:

DATES CATEGORY 1 AND CATEGORY 2.2 CATEGORY 2.1
December 1, 2020 50% 30%
December 1, 2021 60% 50%
December 1, 2022 70% 60%
December 1, 2023 85% 85%
December 1, 2024 100% 100%
  • The following NBFCs are exempt from the HIGH QUALITY LIQUID ASSET requirement:
    • Core Investment Companies
    • Type 1 NBFC-NDs
    • Non-Operating Financial Holding Companies
    • Standalone Primary Dealers

Section 45 IB Of The RBI Act, 1934

Section 45 IB provides for maintenance of liquid assets in a deposit-taking non-banking financial companies, long before the introduction of liquidity coverage ratio by the RBI.

It prescribes that a deposit taking NBFC shall maintain minimum level of liquid assets of 15% of public deposits outstanding as on the last working day of the second preceding quarter.

 Of the 15%, NBFCs are required to invest:

  • Minimum 10% in approved securities
  • The remaining 5% can be in unencumbered term deposits with any scheduled commercial bank.

Conclusion

As we have seen, The RBI has made the norms for liquidity stricter in order to meet out the potential liquidity stress scenario in a bid to keep up with the changing economic situation and its possible outcomes.

As we have seen, the RBI started off by making liquidity requirements mandatory for the Deposit taking NBFCs only by incorporating Section 45 IB in the RBI Act. By introducing Liquidity Coverage Requirements, the RBI intends to include a wider category of NBFCs to maintain a stock of liquid assets.

 Moreover, in the new Liquidity Coverage Requirements, the RBI has prescribed for maintaining HIGH QUALITY LIQUID ASSETS, a stepped up version of the LIQUID ASSETS that were to be maintained under section 45 IB of the Act. The former provides more liquidity over the latter.

Keeping in mind the patterns above The RBI may make its norms more stringent in upcoming phases of the economy. Strict compliance by the NBFCs, in true letter and spirit, of the Liquidity Coverage ratio, is essential for saving from a possible economic degradation in tough times.

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Ridhima Jain

Ridhima is a commerce graduate and aspires to be a Company Secretary. Her interest in exploring new domains of corporate laws drives her towards this field.

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