After months of dithering and allowing the financial sector, especially non-banking financial companies (NBFCs), to thrash about in deep waters, the government has finally thrown a lifeline to the industry. The sector, used to borrowing short to finance long-term assets, has been lobbying for a bailout ever since the tide turned and defaults in a handful of companies froze up funding for the rest of the industry. The logjam acquired crisis proportions when many NBFCs were forced to sell profitable assets to generate cash to repay maturing debts. The defaults came around the same time as systemic liquidity moved from neutral to deficit, and banks, already reeling under the weight of legacy debts, became exceedingly risk-averse. A temporary systemic mismatch, which should have been nipped in the bud, was allowed to snowball into a crisis. Initial appeals to both the Reserve Bank of India (RBI) and the government asked for a liquidity window, indicating that NBFCs needed access to money, rather than concessional rates or any other variety of regulatory forbearance. The RBI, naturally, baulked because creating a liquidity window for one class of financial intermediaries could set a precedent. More importantly, NBFCs do not have access to the central bank’s liquidity operations, which are restricted to commercial banks. The onus thus fell upon the government, which has now announced a slew of measures in the budget: A partial guarantee for a ₹1 trillion pool of NBFC assets that can be sold to banks, reduction in the money NBFCs need to set aside every time they raise debt from the market, parity with banks on accounting treatment accorded to bad loans, and access to the centralized bill discounting platform.
This sounds like a neat package and should have warmed NBFC hearts. Unfortunately, the package unmistakably looks like it has been put together hurriedly. Too many fault lines and an unfortunate bureaucratic approach to the problem seem to overshadow some of the timely initiatives. The proposal to scrap the debenture redemption reserve, which NBFCs needed to create every time they issued bonds to the public, will inevitably lead to some cost saving. This is also likely to impel the better-rated NBFCs to launch retail bond issues. However, there are problems with the budget’s marquee NBFC liquidity solution. One, the government’s partial guarantee predefines assets in the pool as having to be “high-rated" and from “financially sound" NBFCs. There is an inherent contradiction here. If the assets are high-rated, NBFCs may not feel the need to pool them at all. Two, the government’s guarantee has a six-month expiry date, which may not be enough to instil confidence in banks to venture out and purchase these assets. Three, there is no clarity on what exactly constitutes “high-rated", or what boxes should a “financially sound NBFC" actually tick.
Hopefully, the final circular will iron out the glitches and present a more credible package. The problem is not so much of liquidity as of confidence. Banks should be comfortable lending to NBFCs. However, there is a bigger problem that will insidiously erode the industry’s ethical fabric: The problem of moral hazard, or how NBFCs might expect a government lifeline every time they disregard the fundamental concepts of corporate finance and rack up risks on their balance-sheets.