Financial year 2019 has been a year to remember, as the NBFC sector, which caters to a significant portion of the financial needs in the economy, almost choked due to lack of liquidity. While there was an undercurrent already, but the fall of the mammoth ILFS group, ignited the crisis. Resultantly, the banks stopped taking fresh exposures on the NBFCs, the mutual funds pulled out plug, and other investors also became wary of the financial services sector. Businesses of all almost of all the NBFCs came to a standstill.
Considering the sensitivity of the situation, the RBI had to step in and take initiatives to address the concerns. Relaxations with respect to minimum holding period, for direct assignments and securitisation transactions, was one of them. This measure was however, temporary in nature.
In order to address the issues that pop up in the longer run, the RBI has framed a draft framework, which is now open for comments, to deal with liquidity risk. The draft framework was placed on the RBI’s website on 24th May, 2019 and is open for comments till 14th June, 2019.
The framework is divided into two parts – a) liquidity risk management framework; and b) liquidity coverage ratio. While the first part is a mix of new and existing provisions of asset liability management; the latter is a new requirement altogether.
In this write-up we intend to discuss about this framework.
The first part of the framework, that is the liquidity risk management framework, shall be applicable to the following classes of NBFCs:
- Non-deposit taking NBFCs with asset size of ₹ 1 billion or above (₹ 100 crores or above);
- Systemically important core investment companies (CICs with asset size of more than ₹ 100 crores and having public funds)
- Deposit taking NBFCs
The second part of the framework, which introduces the concept of liquidity coverage ratio among NBFCs shall be applicable to the following classes of NBFCs:
- Non-deposit taking NBFCs with asset size of ₹ 50 billion or above (₹ 5000 crores or above);
- Deposit taking NBFCs
Liquidity risk management framework
The liquidity risk management framework is divided into the following parts –
a. Liquidity risk management policy, strategies and practices:
This requires formulation of risk management framework, which should be much more comprehensive than the existing one, and should address the following:
- Governance related issues –
- The Board of Directors of the NBFC must retain the overall responsibility of liquidity risk management and the same shall also be responsible of laying down policies, strategies and practices to be followed by the company.
- The Risk Management Committee shall report to the Board of Directors of the Company. The Committee must be constituted with CEO/ MD and the heads of the various risk verticals of the company. The existing Corporate Governance framework requires formation of RMC, however, the same does not specify desired constitution of the Committee. In fact, companies which have Chief Risk Officer, should also appoint CROs as a part of the RMC.
- Asset Liability Management Committee – There is a slight change in the composition proposed under this framework against the existing provisions relating to formation of ALCO. As per the existing regulations, the ALCO must consist of senior management including CEO. However, this framework states that the committee must be headed by CEO/ MD or Executive Director and may have the Chiefs of Investment, Credit, Resource Management or Planning, Funds Management / Treasury (forex and domestic), International Banking and Economic Research as members. Also, the scope of ALCO has also been modified to include – taking decisions on desired maturity profile and mix of incremental assets and liabilities, sale of assets as a source of funding, the structure, responsibilities and controls for managing liquidity risk, and overseeing the liquidity positions of all branches.
- Asset Liability Management Support Group – Formation of this group is a new requirement. The group should be consisted of operating staff of the organisation and shall be responsible for analysing, monitoring and reporting the liquidity risk profile to the ALCO.2. Off balance sheet exposures and contingent liabilities must be given desired level of attention so that risks arising from all off-balance sheet exposures, be it securitisation, financial derivatives, guarantees or other commitments. The focus should be on assessment of inherent risks that can cause problems at times of stress.
3. Diversification of funding sources must be achieved by the NBFCs. This is a qualitative requirement where RBI has urged the NBFCs to establish strong connection with each of its funding sources and to keep itself active in the funding market. Over reliance on a particular source has been condemned.
4. The NBFCs must have a proper collateral management system where it should be in a position to distinguish between encumbered and unencumbered assets.
5.Stress testing must be inculcated as an important exercise in the overall governance and risk management culture in the NBFC. Stress testing must be conducted on a regular basis for a variety of short term, entity specific and market specific situations. The various activities of the business and their vulnerabilities must be taken into consideration so that the stress testing scenarios can cover every aspect of market risk and major funding risks that the NBFC is exposed to.
6. A contingency funding plan must be formulated which can be followed while responding to severe disruptions in the funding abilities of the NBFCs. It should contain the available r potential contingency funding sources and the estimated amount which can be drawn from these sources, clear escalation or prioritisation procedures detailing when and how each of the actions can and should be activated, and the lead time needed to tap funds from each of these sources.
7. Intra group transactions and exposures must be under special supervision and the Group CFO should develop and maintain liquidity management process and funding programs that are consistent with the activities of the group.
8. Other issues like liquidity risk tolerance, liquidity costs, internal pricing must be properly framed by the senior management.
9. Public disclosure on liquidity risk, the NBFC is exposed has to be made on regular basis. The disclosure should include –
- Funding concentration based on significant counterparty,
- Top 20 large deposits,
- Top 10 borrowings,
- Funding concentration based on significant products/ instruments,
- Stock ratios with respect to commercials, NCDs and other short term liabilities each as a percentage of total assets, total liabilities and total public funds
- State of the institutional setup for liquidity risk management
b. The Management Information System (MIS) should be structured in a manner that is capable of generating information both in normal and stress scenarios.
c. Internal controls of the NBFCs must be strong enough which can ensure adherence to policies and procedures with respect to liquidity risk management. The internal controls must be independently reviewed on a regular basis.
d. The assets and liabilities must be monitored based on the time buckets they fall in. As against the existing framework, the framework requires micro monitoring, that is, the time brackets have been broken further. The proposed time brackets as well as the current set of time brackets have been provided below:
|Time brackets as provided in the existing guidelines||Time brackets proposed in the framework|
|1 day to 30/ 31 days||1 day to 7 days|
|Over one month and upto 2 months||8 day to 14 days|
|Over two months and upto 3 months||15 days to 30/31 days (One month)|
|Over 3 months and upto 6 months||Over one month and upto 2 months|
|Over 6 months and upto 1 year||Over two months and upto 3 months|
|Over 1 year and upto 3 years||Over 3 months and upto 6 months|
|Over 3 years and upto 5 years||Over 1 year and upto 3 years|
|Over 5 years||Over 3 years and upto 5 years|
|Over 6 months and upto 1 year|
|Over 1 year and upto 3 years|
|Over 3 years and upto 5 years|
|Over 5 years|
The maximum mismatches allowed in the 1-7 days, 8-14 days and 15-30/31 days bracket are 10%, 10% and 20% of the cumulative cash flows in the respective time brackets.
The investments in securities must be classified into “mandatory” and “non-mandatory” categories. Mandatory category is that where the securities acquired under legal obligation must be classified and anything apart from these must be classified under non-mandatory category.
e. Stock approach must be adopted in the NBFCs’ liquidity risk management. Certain critical ratios must be monitored in this regard by putting in place internally defined limits as approved by their Board. The ratios and the internal limits shall be based on an NBFC’s liquidity risk management capabilities, experience and profile.
f. Liquidity risks arising out of other risks like currency risk and interest rate risk must also be managed.
g. Monitory tools like statement of structural liquidity and others, prescribed by the RBI should be used.
Liquidity coverage ratio
The concept of liquidity coverage ratio adopted here is similar to this concept under Basel III: International framework for liquidity risk measurement, standards and monitoring. This requires NBFCs with specified asset size, to maintain specified level of LCR. The framework currently proposes following levels of LCR:
The formula of LCR has been defined in the framework to mean:
Stock of High Quality Liquid Assets(HQLAs) / Total Net Cash Outflows over the next 30 calendar years
In simple terms, LCR represents the readily available cashflows/ cash equivalents as a proportion of the total net cash outflows over the next 30 calendar days. Ideally, the LCR should be more than 100%. The manner of computation of each of these have been elaborately discussed in the framework.
While calculating the stock of HQLA, certain items like cash, government securities and certain specified marketable securities without any haircut. However, other assets, including corporate bonds, equity shares etc. are to be considered after considering haircuts ranging from 15% – 50%.
In the denominator, the net of cash outflows are to be considered, that is total cash outflows minus the specified cash inflows.
As per the RBI framework, “Liquidity Coverage Ratio (LCR) which will promote resilience of NBFCs to potential liquidity disruptions by ensuring that they have sufficient High Quality Liquid Asset (HQLA) to survive any acute liquidity stress scenario lasting for 30 days”.
This framework was a much awaited piece of legislation and the industry felt the dire need of such a guided document on the liquidity risk management. With the growing importance of this industry and amount of exposure they have on the economy, a strong liquidity management is the need of the hour. The nation certainly doesn’t want another ILFS or a similar crisis to happen.
 The RBI on 16th May, 209 required mandatory appointment of CRO by NBFCs having assets of ₹ 50 billion or above.