Liquidity crisis in NBFCs: Way Out

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The latest addition to a series of crises spawned by the Coronavirus pandemic is the liquidity crunch, and NBFCs (Non-Banking Financial Companies) have taken the brunt of it. The reason for that is that NBFCs, also known as shadow banks are the prime lenders to MSMEs and real estate – two sectors that have been very severely impacted because of the pandemic and the subsequent lockdown that it has spawned. Before we discuss the problems caused by liquidity crunch and the probable solutions on the table, let’s understand what liquidity means and what could be the impact of a liquidity crunch.

What is liquidity?

Presented as the fourth ‘l’ along with “land, labour and laws” in the latest 20 lakh crore relief package proposed by the government of India, liquidity refers to the ease of access to cash. A liquid asset is one that can easily be sold and replaced with cash. NBFCs are supposed to be liquid firms that can provide access to cash or to assets that are convertible to cash, to their clients.

The crux of the problem

The NBFCs are currently suffering on two fronts. On one side, they have lost the collections from their borrowers which would otherwise have been received if not for COVID-19 pandemic; while on the other hand, they have provided the RBI mandated 3-month moratorium relief to a lot of their borrowers. This problem is further compounded by the fact that while they are providing a relief to their borrowers, they haven’t gotten any from their lenders such as banks, mutual funds etc.

To put it in simple terms, while the cash inflows have plummeted severely, cash outflows are continuing at the previous pace.

The solutions being offered

In its recent announcement of the relief package, the government has proposed to transmit liquidity to NBFCs, who were already showing abysmal balance sheets even before the Coronavirus pandemic struck the world and grew to the scale that it has. The NBFCs were having trouble rolling over the short term debt they had incurred in order to be able to finance long-term goals – which includes lending to MSMEs and real estate companies. Given the fear that the clients of these NBFCs could become defaulters, the banks were hesitant to lend money to them. Naturally, the situation could only get progressively worse in the wake of a global catastrophe.

In an effort to encourage the banks and the NBFCs to lend to the clients that are under severe stress themselves, the government is offering PCGS 2.0 (Partial Credit Guarantee Scheme) worth Rs 45,000 crore. Under the revised PCGS, a sovereign guarantee of up to 20% of first loss will be provided to state-controlled banks for purchase of bonds or commercial papers (CPs) of NBFCs, MFIs (Microfinance Institution) and HFCs (Housing Finance Companies) having a credit rating of AA or lower. The time period of the scheme, which was initially up to 30 June, 2020 has also been extended to 31 March, 2021 by the Cabinet.

Besides this, the Cabinet also proposed the launch of a new liquidity scheme, especially for the NBFCs and HFCs, in the hopes that it will improve the current liquidity position of these lending institutions. The government will also contribute Rs 5 crore as equity for an SPV (Special Purpose Vehicle), whose creation would be in the hands of a large bank, ran by the state.

“An SPV would be set up to manage a Stressed Asset Fund (SAF) whose special securities would be guaranteed by the government and purchased by the Reserve Bank of India (RBI) only. There is no financial implication for the government until the guarantee involved is invoked,” the GOI stated in a press release.

“The proposed scheme would be a one-stop arrangement between the SPV and the NBFCs without having to liquidate their current asset portfolio. The scheme would also act as an enabler for the NBFC to get investment grade or better rating for bonds issued. The scheme is likely to be easier to operate and also augment the flow of funds from the non-bank sector,” the release further stated.

There is, however, much debate as to whether these measures would work or not. Many economists are of the view that they won’t as they are only minimally effective even when the economy is doing well.

Consider this scenario for a better understanding: Imagine a bank or an NBFC is willing to lend money to a small business. Given the current state of the economy where sales and footfalls for businesses have dropped to zero, the business owner would either not borrow or even if he borrows, he’d do so to protect himself, and wouldn’t use that credit to pay the employees or to buy and stock inventories.

Even after the lockdown lifts, the demand in the market would creep for a while because of the loss of jobs and rampant unemployment. Surviving on minimal sales and a creeping demand, firms would probably fail to meet their payment commitments and the fact that they have access to credit wouldn’t matter much. This puts a big question in the room as to whether or not these policies would help in mitigating the liquidity crunch. Only time will tell.

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