UPSC: LIQUIDITY SQUEEZE HURTS NBFCS
- Recently, shares of NON-BANKING FINANCIAL COMPANIES (NBFCs) have witnessed a steep fall in recent weeks after concerns over whether they can successfully meet their short-term dues.
- Housing finance companies (HFCs) in particular were worst affected.
- The current crisis began with the default of Infrastructure Leasing and Financial Services (IL&F) on several of its dues last month.
- The Union government subsequently decided to step in and assure lenders to the company that their money would be paid back safely without any default.
- A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other business institutions.
- It does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods or providing any services and activities related to 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).
- NBFCs lend and make investments and hence their activities are similar to that of banks; however there are a few differences as given below:
- NBFC cannot accept demand deposits
- NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself
- Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.
Problem in NBFC
- Many NBFCs use short-term loans borrowed from the money market to extend long-term loans to their customers.
- This leads to a mismatch in the duration of their assets and liabilities and exposes NBFCs to the substantial risk of being unable to pay back their lenders on time.
- NBFCs usually resort to rolling over, or refinancing, their old short-term debt with new short-term debt to compensate for the mismatch in duration.
- But even though NBFCs usually manage to roll over their short-term debt smoothly, there are times when they may fail to do so.
- Such risk is high particularly during times of crisis when lenders are affected by fear.
- In such cases, they may have to resort to sale of their assets at distress prices to meet their dues.
- This can turn a liquidity crisis into a more serious solvency crisis, wherein the total value of the assets of a company falls below the value of its total liabilities.
- Further, NBFCs also face the risk of having to pay higher interest rates each time they refinance their short-term debt.
- As interest rates rise across the globe, equity investors believe that the cost of borrowing of NBFCs will rise and affect their profit margins.
- Investors may be pricing in the prospect of falling profits for NBFCs in the coming quarters.
It is hoped that banks will offer a helping hand to NBFCs to meet their short-term dues to lenders like mutual funds. Many further believe that a widespread financial panic may not be on the cards as the government will act as a lender of last resort. Such bailouts create the risk of moral hazard in the wider financial system. NBFCs, for instance, may continue to borrow short-term to extend long-term loans to their customers because they expect the government to bail them out if they get into trouble.
In fact, some believe that financial institutions in general have traditionally resorted to borrowing short-term to finance long-term loans simply because there is an implicit guarantee extended by the government. As the cost of borrowing funds rises, NBFCs may have to settle for lower profits unless they find a way to pass the burden of higher rates on to borrowers.