Insights
June 4, 2019 10:40 am

RBI RELEASES DRAFT GUIDELINES TO BETTER REGULATE INDIA’S SHADOW BANKS IN THE AFTERMATH OF THE IL&FS CRISIS

On May 24, 2019, the Reserve Bank of India (the “RBI”) released a draft liquidity risk management framework (the “Proposed Framework”), which is proposed to be made applicable to all non-deposit taking non-banking financial companies (“NBFCs”) with a minimum asset size of INR1 billion (US$14.42 million approximately), all deposit taking NBFCs and all systematically important core investment companies (collectively, the “Regulated Entities”).  This update analyzes the likely impact of the Proposed Framework on the lending market.

Background

In August 2018, Infrastructure Lending and Financial Services Limited (“IL&FS”), a core investment company (“CIC”) and one of the largest funders of infrastructure projects in India, defaulted on its payment obligations on multiple bank loans, deposits and commercial papers.  The defaults occurred despite the fact that, in March 2018, the board of directors of IL&FS had affirmed in its annual report that it had sufficient liquidity to meet its obligations.

Given that IL&FS funds most infrastructure projects in India and it raises funds from a variety of investors, banks and mutual funds, the defaults caused widespread panic in the Indian credit markets, which in turn led to credit agencies downgrading the credit ratings of NBFCs and CICs across the board.

Once the dust settled, the defaults were attributed to the following key reasons:

  • IL&FS’ high debt-equity ratio, which significantly increased the exposure for both, its investors and creditors;
  • IL&FS’ poor management of its asset-liability ratio which resulted in huge short-term liabilities that could not be cleared on account of long-term revenue cycles; and
  • A lack of responsibility shown by IL&FS’ board of directors in allowing the mismatch between assets and liability, and in affirming the misleading annual report.

Attempts to increase liquidity in the immediate aftermath 

The defaults caused a huge loss of investor confidence, which had ripple effects on India’s securities market too.  The Indian government and IL&FS’ shareholders stepped in to reassure investors that IL&FS would not be allowed to collapse, and the government invoked a seldom used provision of the Companies Act, 2013 to reconstitute IL&FS’ board of directors and take over its management.

The RBI recognized the need to stabilize the lending market and ease the sudden liquidity crunch.  Consequently, it intervened and adopted the following temporary measures:

  • It raised exposure limits permitting banks to increase their exposure towards a single NBFC client (except NBFCs in the infrastructure sector) from 10% to 15% of their loan books;
  • It allowed banks to classify government securities held by them as High Quality Liquid Assets (“HQLA”) and claim benefits on the basis of such securities. However, such a classification could only make up an amount equal to the outstanding credit extended by the bank to NBFCs and housing finance companies; and
  • It reduced the minimum loan holding period for securitization applicable to NBFCs. Prior to the change, NBFCs could only securitize their loans after holding them for a minimum period of one (1) year.  However, pursuant to the change, NBFCs could securitize their loans of original maturity over five (5) years after holding them for a period of six (6) months.

The foregoing changes were aimed at incentivizing banks to increase lending to NBFCs and permitting NBFCs to securitize a greater portion of their loan books.  However, while the measures mitigated the impact of the IL&FS defaults in the short-term, they were unable to completely ease the liquidity crunch faced by NBFCs.  This is because the underlying market risks continued to exist for investors as no reforms were introduced to improve the functioning of NBFCs.  Given the spectacular collapse of IL&FS, both, investors and lenders, remained understandably wary.  Therefore, it became apparent that RBI would need to convince lenders and investors of the creditworthiness of NBFCs themselves.

The Proposed Framework

Recognizing that its measures were unlikely to resolve the institutional problems plaguing NBFCs and CICs, RBI released the Proposed Framework, which is aimed at improving the functioning and management of all Regulated Entities.  The Proposed Framework seeks to introduce the following key changes:

  • It prescribes a mandatory liquidity coverage ratio (“LCR”), which is to be maintained by all deposit taking NBFCs and those non-deposit taking NBFCs that have a minimum asset size of INR5 billion. In essence, LCR is the ratio of an NBFC’s stock of unencumbered HQLAs at any given point of time to the total net cash outflow estimated over the next thirty (30) calendar days.  From April 1, 2020, NBFCs will be required to maintain a LCR of 60%, which will ensure that they set aside sufficient HQLAs to meet short-term payment obligations.  The LCR is proposed to be increased in a phased manner and NBFCs will be required to maintain a LCR of 100% by April 1, 2024.
  • It requires the board of directors of each Regulated Entity to formulate a liquidity risk management policy to ensure that the entity is able to meet its obligations when they become due without adversely affecting its financial condition. The policy is required to provide for, inter alia, a minimum cushion of unencumbered HQLAs, the entity’s level of risk tolerance, the entity’s funding strategies, systems to assess and review the entity’s liquidity, and the nature and frequency of reporting by the entity’s management.
  • It requires Regulated Entities to formulate a maturity profile to measure its future cash flows in terms of different time buckets. These time buckets must mandatorily be bifurcated into granular buckets of one (1) to seven (7) days (“TB1”), eight (8) to fourteen (14) days (“TB2”) and fifteen (15) to thirty (30) days (“TB3”).  While the Proposed Framework recognizes that there could be mismatches in an entity’s cash inflows and outflows, it aims to enable Regulated Entities to identify early warning signs by monitoring their mismatches in granular time buckets.  Additionally, it mandates that the net cumulative negative mismatches must not exceed 10%, 10% and 20% of the cumulative cash outflows in TB1, TB2 and TB3, respectively.
  • It requires Regulated Entities to adopt a “stock” approach to assess liquidity risk. To achieve this aim, the Proposed Framework obligates the board of directors of each Regulated Entity to put in place certain critical ratios and internal limits.  The ratios and limits must be determined on the basis of the entity’s risk management capabilities, experience and profile.
  • It requires Regulated Entities to adopt liquidity risk monitoring tools to identify strains in the entity’s liquidity position at an early stage. Under the Proposed Framework, these tools/metrics include: (i) identifying concentrated sources of funding to enable such entities to protect these sources while also encouraging them to diversify funding sources in the long run; (ii) monitoring available unencumbered assets to identify a basket of assets which can be used as collateral to raise funds; and (iii) monitoring certain market-based indicators to identify factors which may potentially affect liquidity.

In addition to the foregoing measures and the obligations imposed on the board of directors, the Proposed Framework also requires each Regulated Entity to constitute an Asset Liability Management Committee.  This requirement will ensure that the entity’s top-level management is responsible for adhering to the risk tolerance limits set by the board of directors, and responding to liquidity disruptions.

Our Comments

NBFCs and CICs are a crucial part of India’s lending markets.  At a time when banks are burdened with bad debts and wary of opening their purse-strings, well-managed NBFCs and CICs can ensure that there is sufficient liquidity in the market and businesses are able to obtain the necessary funding.  However, for a long time, these entities (aptly called “shadow banks”) have circumvented the regulatory reach of the RBI and acted recklessly in managing their finances.

In our view, the Proposed Framework, which forces Regulated Entities to be conscious of potential disruptions to their liquidity, is a step in the right direction.  Moreover, by making the board of directors and top-level management responsible for ensuring compliance, the Proposed Framework ensures greater accountability, which, in turn, will prevent directors from sweeping potential liquidity risks under the carpet.

More importantly, however, the Proposed Framework signals RBI’s intent to resolve the systemic problems plaguing the sector.  It is telling that the proposed measures specifically target the flaws which caused IL&FS to default on its payment obligations.  By refusing to provide NBFCs with a separate liquidity window and introducing mandatory requirements to maintain a sufficient LCR, the RBI is clearly focusing on the long-term well-being of the sector.  While it is true that these measures are likely to increase the liquidity crunch faced by NBFCs in the near term, one hopes that the sector will stabilize and see better managed NBFCs in the long run.

At the same time, it is important to bear in mind that the success of the Proposed Framework depends on the RBI’s ability to enforce these obligations.  In the absence of an effective enforcement mechanism, the Proposed Framework risks being left toothless.  Additionally, it is also important to remember that the IL&FS crisis was also attributable to its auditors, credit rating agencies and other market participants.  Therefore, there is a need to identify safeguards for the system at large.

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Banking and Finance