RBI’s latest Liquidity Risk Management guidelines for Non-Banking Financial Companies (NBFCs)
RBI in its wisdom issued detailed guidelines on liquidity risk management for NBFCs on November 4, 2019 with non-deposit taking NBFCs with asset size of Rs. 100 Crore and above, systematically important Core investment companies and all deposit taking NBFCs irrespective of their asset size. Consistent with the most uncertain charters of instability being faced from Dewan Housing to nearby jeweler who accumulated a huge deposit base to vanish, these guidelines will, if implemented properly and adequately supervised by regulatory authorities will usher in a safe heaven for poor, below middle class, middle class or higher strata of the society.
I have tried to explain the directives of RBI in a simple man’s language.
Before understanding the guidelines from RBI which always writes Victorian English directly from Oxford(USA authorities/English authorities have however, foregone their habits and write simple English for any one to understand and really apply in life) let us understand “Liquidity “ or “Liquidity Risk”, key words that lead us to deeper understanding.
What is “liquidity”?
I quote directly from RBI circular:
“Liquidity” means NBFC’s capacity to fund the increase in assets and meet both expected and unexpected cash and collateral obligations at reasonable cost and without incurring unacceptable losses.” For a simpleton, it means the company will not close its shutters but would have required funds to meet the immediate needs of its clients. Let us talk of Punjab and Maharashtra Cooperative (PMC) Bank. Instead of allowing many of its depositors to die, it would stand as a rock and pay their requirements. One can recall Punjab National Bank, once during its tenure as a private bank, had a run on it – meaning it was kept opened for a couple of days, 24 hours a day. Initially, people withdrew the money but after realizing that it continued to exist, deposited the money back. It is said that the genius Finance Minister Mr. Morarji Desai frequently announced on radio about its security and soundness of the bank.
As a Management trainee, I had read this story hundred times to become a good banker.
Now the term “liquidity risk”, the most dangerous term which played havoc with the deposit holders of Washington Mutual Fund, a glorious USA household bank with a great character of the past but disappeared without any whimper. Yes, a large number of deposit holders were left with tears only.
“Liquidity Risk means inability of an NBFC to meet such obligations as they become due without adversely affecting the NBFC’s financial condition.” It can be said of the current deposit holders of Dewan Housing that the company is struggling to meet the liquid requirements of its depositors. Obviously, effective liquidity risk management helps to ensure that NBFC develops a financial ability to meet its obligations as and when they fall due and reduces its possibility of an imminent closure. Effectively, like any organic substance, the financial institutions would have met the requirements of the clients seamlessly.
With the dark realities of today, let us give our sympathetic ears to the guidelines of RBI now. They deal with following aspects of Liquidity Risk Management framework. (LRM)
- LRM policy strategies and practices
- Management Information System
- Internal Controls
- Maturity profiling
- LRM-Stock approach
- Currency Risk
- Managing Interest Rate Risk
- LRM tools
Now is the time to understand in detail the prescriptions of RBI.
LRM policy strategies and practices
Expectedly, the Board of NBFC would frame an LRM framework which ensures that
- It will maintain unencumbered liquid assets readily available to mitigate the emergencies. I would have suggested to PMC bank to have a current or fixed deposit or even government securities to face the demands of its clients. Rightly said the history when PNB had enough deposits or cash deposited with RBI to meet its dooms day.
- Spelling out the strategies to maintain the funding sources, prudential limits for safety purpose.
- Framework for stress testing and actual trial for periodic usage
- Management reporting and
- Periodical review of assumptions used in liquidity projection.
Formation of Board of Directors group, Risk Management Committee, Asset-Liability Committee (ALCO), AND Asset Liability Management Support Group with active involvement of CEO/ED, Chiefs of Investment, Resource Management, Funds Management or Treasury Management are some of the suggested members at various levels to serve the organization for mitigation of liquidity risks.
Some of the other LRM framework are as under:
1. Liquidity risk tolerance: The required liquidity risk tolerance has to be set by top management in consultation with other experts, quantify them and review with further growth. Obviously, NBFC needs to maintain sufficient liquidity.
2. Liquidity costs and benefits: This has to be evolved company wise with the clear mandate to include the costs in product development. For a simple deposit and small loans-based structure, this would force the management to keep cost of deposit/advances composure to withstand the liquidity costs in product development.
3. Off-balance sheet exposures and contingent liabilities: Not a single NBFC has escaped the cost of meeting the demands under financial derivatives, pending court cases, and other guarantees gnawing at any economic crisis. Consistent failure to honor debentures, payment of bonds or timely clearance of guarantees are routine happening among NBFCs in resultant failure of investors to believe them on a longer time frame.
4. Diversified funding strategy: Once Sundaram Finance officials told me that senior citizens have unflinching loyalty towards them but younger generation have dispassionate attitude towards its financial products. Known for 100% honesty and never-failing attitude, the company will have to think of new ways to augment its resources.
5. Collateral position management: Mortgage of fixed assets like land, housing or joint registration with transport/government agencies are some of the commonest forms of securities which strengthen your case for loans from NBFCs so far. With the growth of digital registration of land and housing, it is natural the financial institutions may opt for more advanced states where the frauds of title deeds are getting unheard of. I have come across of many housing loans on the same property by many bankers and the resultant failure and disastrous consequences.
6. Stress testing: I explained actual stressful situation for PNB or other banks which survived turbulent waters. The modern management consultant insists on actual stress testing imagining failure or run on the institution for payment of dues. Any institution can develop its own prescribed scenarios and develop required financial remedies. This forces contingency funding plans too.
7. Public disclosure: Actual disclosure of realistic picture of financial position in public web site or filing of documents with regulatory authorities with the option of availability of the inspection by any one is now desideratum of modern regulatory compulsion. Yes, inter transfer of funds among group companies has witnessed massive frauds in recent times.
8. Management Information System: It is not unrealistic to have a robust MIS to meet the demands of all stake holders. This will also help in utilizing adequate internal control systems catered to every institution as per their Board’s instructions.
9. Maturity Profiling: The maturity profile may be used to measure future cash flows of NBFCs in different time buckets. Some of the prescribed time buckets, mind boggling is given below:
1-7 days,8-14, 15-30/31 1-2-month, 2-3 month, 3-6 months 6 months – 1 year, 1-3 years, 3-5 years and over 5 years. Compulsory matching of cash inflows and outflows enables the company to meet existential demands. Planning for mandatory and non- mandatory securities to meet emergencies is not nothing new.
Liquidity risk management shall opt for stock approach, as RBI calls it. Certain management ratios suggested includes short term liability to total assets, short term liability to long term assets, commercial papers to total assets, non- convertible debentures to total assets, short term liabilities to long term liabilities., etc.
Public disclosure on liquidity risk:
- Number of counter parties both for deposits/liabilities and their % to total.
- Top 20 large deposits/borrowings
- Various stock ratios
- Institutional set up for liquidity risk management
Interestingly, LCR requirement shall be binding on all non-deposit taking systematically important NBVFCs with asset size of Rs. 10,000 Crores and above and all deposit taking NBFCs irrespective of asset size from December 1, 2020 with minimum LCR to be 50%, with progressively increasing up to 100% by December 1, 2024.
RBI has suggested some of the high-quality liquid assets without any haircut as cash, government securities, marketable securities guaranteed by foreign sovereigns.
RBI has given detailed disclosure on margins to be maintained in various company securities/bonds. One can refer the relevant circular for detailed knowledge and follow up.
Conclusion
As an experienced banker/CPA/now an IP with more than 45 years of financial exposure, I have seen many situations where the regulatory authorities wake up on emergency, issue suitable instructions, and it is projected as if we have tamed the ugly and roaring tiger. Here, I call tIger as crooks. With all instructions in place, easily available for reference, one is tempted to ask who will supervise the instructions on anybody which accepts deposits without any asset size. For an elderly person who depends on regular income from banks and other financial institutions, who is to be blamed for colossal failure resulting even death of deposit holders. I sincerely wish the elected representative after getting educated on available material, put to mat the regulatory authorities, discuss, evolve and nominate or elect the authorities to function effectively. Why not prescribe massive rigorous jail terms for failed executives both from public/private or governmental authorities.
Reference
1. RBI Circular dated 4th November 2019- Liquidity Risk Management Framework for Non-Banking Financial Companies and Core Investment Companies
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