Given the significant economic impact of the liquidity crunch in the Non-Banking Finance Companies (NBFCs), regulators must employ Health Score Methodology Analysis to detect early warning signs of impending liquidity issues, according to the Economic Survey 2019-2020 tabled in the Parliament on January 31.
An index is developed to estimate the financial fragility of the NBFC sector and it was found that it can predict the constraints on external financing (or refinancing risk) faced by NBFC firms.
This index is called the Health Score, which ranges between -100 to +100 with higher scores indicating higher financial stability of the firm/sector.
The Health Score employs information on the key drivers of refinancing risk such as Asset Liability Management (ALM) problems, excess reliance on short-term wholesale funding (Commercial Paper) and balance sheet strength of the NBFCs.
The Survey investigates the key drivers of Rollover Risk, Asset Liability Management (ALM) Risk and Interconnectedness Risk of the shadow banking system in India in light of the current liquidity crunch in the sector.
The Survey computes a diagnostic (Health Score) by quantifying the Rollover risk for a sample of HFCs and retail-NBFCs, which are representative of their respective sectors.
The Score of the Retail-NBFC sector was consistently below par for the period 2014 -19. Larger Retail-NBFCs had higher Health Scores but among medium and small Retail- NBFCs, the medium size ones had a lower score for the entire period of 2014-19.
The Survey prescribes analysis to efficiently allocate liquidity enhancements across firms with different Health Scores in the NBFC sector, thereby arresting financial fragility in a capital-efficient manner.
According to the Survey, the Health Score can serve as an important monitoring mechanism to prevent such liquid crisis in the NBFC space in the future.
Other than its utility as a leading indicator of stress in the NBFC sector, the Health Score can also be used by policymakers to allocate scarce capital to stressed NBFCs in an optimal way to alleviate a liquidity crisis.
After the liquidity crunch, several firms, including Dewan Housing Finance, Reliance Home Finance, and Essel Infraprojects were downgraded by several rating agencies prompting MF investors to redeem from schemes which had investments in the beleaguered companies.
The redemption pressure in mutual funds gave rise to refinancing risk (rollover risk) for NBFCs, thereby affecting the real sector.
The extent of refinancing risk faced by NBFCs was largely driven by their reliance on short-term wholesale funding.
NBFC-CRISIS HIT MFs
On June 4, 2019, the net asset value of debt funds, which held debt instruments issued by the stressed NBFCs, fell by 53 percent in one day when news about its default became public.
The drop in net asset value was due to the twin effects of debt mutual funds writing off their investments in stressed NBFCs and asset sales at fire sale prices to meet unexpected high redemptions. 8.4 The impact of these defaults were not limited to debt markets.
There was a sharp decline in the equity prices of stressed NBFCs as equity market participants anticipated repayment troubles at these firms a few months in advance of actual defaults.
Debt suffered a massive erosion in wealth due to the defaults The quantum of losses, debt mutual funds with exposure to stressed NBFCs lost around Rs 4,000 crore after adjusting for recoveries in the aftermath of defaults.
Debt mutual funds faced increased redemptions and were hesitant to finance the NBFC sector.
This, in turn, led to the difficulty for NBFCs to raise funds, which took a toll on the overall credit growth in the Indian economy and a decline in GDP growth.