Liquidity Issues can Still Hurt Some NBFCs

RBI Highlights Potential Liquidity Challenges for Some NBFCs Ensuring Financial Stability for Non-Banking Financial Companies

Source: Article by ET Bureau published on Dec 29, 2023, in Economic Times titled “Liquidity Issues can Still Hurt Some NBFCs”

Analysis for a Layman

It seems that some non-banking financial companies (NBFCs), which are essentially lending startups, could face challenges in managing their funds if economic conditions worsen. The Reserve Bank of India (RBI) has conducted assessments and identified potential liquidity issues in a number of these firms.

Previously, many NBFCs heavily relied on short-term loans to finance long-term assets like housing loans. This approach created cash flow problems when lending slowed down.

However, there have been improvements in the funding mix for NBFCs. Larger NBFCs now depend less on short-term funding and have shifted towards longer-term bonds and deposits to finance their assets. This aligns their funding periods more effectively with customer dues.

Despite these improvements, the RBI estimates that around 34 mid-sized and small NBFCs may still face liquidity pressures if economic conditions deteriorate. Even under moderate stress scenarios, 6 to 17 firms could be affected.

This is likely because smaller firms may lack strong credit ratings or a substantial customer base to easily replace funding if investors withdraw their support. To address these concerns, the RBI may require such NBFCs to maintain higher cash reserves.

For larger NBFCs, the efforts to address asset-liability gaps seem to be paying off. It remains to be seen if they can navigate any future financial crises without requiring special support measures, as was the case in late 2018.

Liquidity Issues can Still Hurt Some NBFCs

Impact on Retail Investors

For retail investors in NBFC stocks, the potential liquidity challenges highlighted by the RBI have specific implications:

Safer Options: Larger and better-managed NBFCs, such as Bajaj Finance and LIC Housing Finance, with stringent asset-liability management (ALM) controls, strong credit access, and efficient technology for collections, appear to be safer investments. Their valuations may remain stable even if they face higher funding costs, which can impact the overall sentiment in the sector.

Mid-sized Firms: Among mid-sized NBFCs, those with a niche focus, such as Shriram Transport and M&M Finance, which target specific customer segments, may be better equipped to withstand moderate funding shocks. However, it’s important to note that specialized loan portfolios also carry risks related to asset quality.

Smaller NBFCs: Smaller NBFCs, particularly those with strong parental backing like Tata Capital or JM Financial, may be able to weather short spells of capital market volatility. However, standalone second-tier companies that heavily rely on access to wholesale debt markets may face challenges if investor sentiment deteriorates. Weak firms faced existential crises back in 2018, leading to mergers.

For investors, this suggests a strategy of mixing top-tier NBFCs with selective investments in niche operators with strong parental support. Prioritizing higher quality is essential, even if it means paying slight premiums to avoid unexpected liquidity shocks that could erode portfolio returns.

Impact on Industries

While larger NBFCs appear to be more resilient, the presence of lingering weaknesses related to asset-liability management (ALM) poses the risk of liquidity contagion affecting interconnected financial industries if sentiment sours:

Wholesale Funding Markets: Second-tier NBFCs still depend on non-bank channels like corporate bonds, commercial paper, and non-convertible debentures (NCDs) for their funding needs due to limited retail deposit franchises. Prolonged risk aversion among mutual funds, insurers, and other investors could lead to funding squeezes.

Counterparty Exposures: Banks and housing finance companies have significant co-lending partnerships with mid-sized NBFCs. The asset quality and growth prospects of these institutions are directly linked to the stability of the underlying NBFCs they partner with, given the lower risk oversight of smaller players.

Consumption Financing: The bulk of consumer lending in discretionary segments such as mobiles, jewelry, or durables is still led by NBFCs. They play a crucial role in providing credit to the broader economy. Funding issues for even smaller players could disrupt overall consumption demand, which relies on financing options.

Therefore, strengthening the resilience of the loosely regulated NBFC sector, including peer-to-peer lending platforms, is crucial to safeguard the credibility and interconnectedness of India’s financial sector as a whole.

Long Term Benefits

Over the long term, addressing the pockets of weakness related to asset-liability management (ALM) in India’s NBFC sector can structurally enhance stability across interconnected financial industries:

Reduced Contagion Risks: Developing funding markets to attract long-term capital, even for second-tier NBFCs, can reduce systemic vulnerability to market sentiment shifts. This safeguard can protect the growth potential of an economy that heavily relies on shadow banking credit flows.

Strengthened Balance Sheets: Improving liability structures, building liquidity buffers, and avoiding risky term-asset financing without matching tenures can lead to healthier NBFC balance sheets in the long run. This, in turn, supports overall credit quality flowing into banks through increased co-lending partnerships with NBFCs.

Financial Market Depth: Expanding the pool of institutional capital willing to invest in higher-yielding NBFC debt instruments can broaden access to alternative credit for enterprises that may not have access to risk-averse public sector bank balance sheets.

Therefore, the regulatory focus on addressing lingering NBFC liquidity management issues has the potential to elevate the stability credentials of India’s expanding credit ecosystem.

Short Term Positives

In the short term, the RBI’s emphasis on strengthening NBFC structures can yield several benefits:

Tighter Oversight: Closer monitoring of asset-liability gaps and mandatory disclosure requirements related to liquidity buffers may be imposed on smaller and mid-sized NBFCs that struggle to adapt to changing funding conditions. This reduces the risk of RBI interventions, such as borrowing prohibitions, for troubled entities.

Refinancing Options: Larger NBFCs that have surplus liquidity can support smaller ecosystem partners either directly or through investments in short-term debt instruments. This ensures that funding continues to flow even during periods of market volatility, maintaining the integrity of the broader sector.

Portfolio Optimization: The discipline of better asset-liability matching may incentivize NBFC treasury teams to allocate short-term funding only for working capital needs instead of using it to cross-subsidize long-term project loans. This minimizes the risk of sudden timing mismatches in repayments.

Consolidation Opportunities: Persistent funding structure weaknesses may lead struggling NBFCs to consider mergers with better-placed sector leaders. This consolidation can offer the benefits of scale, better funding rates, and centralized liquidity management systems, enhancing the overall maturity of players in the space.

However, the risk of over-regulation that curtails credit supply must be balanced with the need to ensure stability. Finding the right equilibrium between these considerations will be a key challenge for policymakers.

Companies Impacted by RBI Report on NBFC Liquidity and Bank Investments

Indian Companies Gaining:

  • Large, Well-Capitalized NBFCs with Diversified Funding Sources (Bajaj Finance (BAJAJFINSV:NS), HDFC Ltd. (HDFCL:NS), L&T Finance Holdings (LTFH:NS)): These companies have already reduced reliance on short-term borrowing and shifted towards longer-term funding, making them less vulnerable to extreme liquidity stress. This could position them to capture market share from weaker players and potentially enhance investor confidence.
  • NBFCs Focused on Long-Term Lending Businesses (LIC Housing Finance (LICHSG:NS), HDFC Housing Finance (HDFCHousing:NS)): The shift towards longer-term funding and asset maturity aligns well with their business models, potentially improving profitability and asset-liability matching.
  • Retail Loan Securitization Platforms: Increased focus on managing liquidity risks could drive demand for securitization services, benefiting specialized platforms like Edelweiss ARC and CRIF High Mark.

Indian Companies Potentially Losing:

  • Smaller NBFCs Reliant on Short-Term Borrowings: These companies remain vulnerable to sudden liquidity squeeze in extreme scenarios, potentially impacting loan disbursements, growth, and market sentiment.
  • NBFCs with Concentrated Exposures: Companies heavily invested in specific sectors like microfinance or infrastructure, which face economic headwinds, could be impacted if loan delinquencies rise.
  • Banks with High Investments in Held-to-Maturity Securities: While not marked-to-market, a prolonged period of rising interest rates could lead to unrealized losses in this portfolio, potentially impacting Tier-1 capital ratios and raising concerns about their resilience. This could be relevant for banks with large government securities holdings, like SBI and Bank of Baroda.

Global Companies Gaining:

  • International Investors with Focus on Indian Long-Term Assets: The stability of larger, well-managed NBFCs and their shift towards long-term funding could attract foreign investors seeking stable returns.
  • Global Risk Management and Restructuring Consultancies: Increased regulatory scrutiny and potential restructuring efforts within stressed NBFCs could create opportunities for global firms with expertise in these areas.

Global Companies Potentially Losing:

  • Global Investors Heavily Invested in Short-Term Debt of Indian NBFCs: These investors could face liquidity risks and potential losses if stressed scenarios materialize.

Market Sentiment:

  • Mixed for the NBFC sector, with potential benefits for well-capitalized players with diversified funding and concerns about smaller, vulnerable companies.
  • Neutral to slightly negative for banks, with potential impact depending on their investment portfolio composition and capital adequacy ratios.
  • Cautious for Indian financial markets in general, with increased focus on risk management and potential volatility in stressed segments.

Note: This analysis is based on the provided information and may not be exhaustive. Other companies could be impacted depending on their specific risk profiles, business models, and exposure to the NBFC and banking sectors. The actual impact will depend on the evolution of market conditions and regulatory actions.

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