NBFCs (Non Banking Financial Company) play a crucial role in enabling credit delivery to the last mile. NBFCs typically specialize based on either the demographic they serve, need they finance or the product they offer. NBFCs strive to close the large missing middle between creditworthy customers and the ones that banks are actually able to serve. The NBFC sector is growing fast – as per RBI data, retail loans of NBFCs grew at a robust 46.2% during 2017-18 on top of a growth of 21.6% during 2016-17. In parallel, as RBI has stepped up NBFC cleanup more aggressively, the number of NBFCs has reduced each year over last 5 years – meaning the pie is getting bigger but the eaters may remain the same. As NBFCs become larger and more critical components of Indian financial system, their risks need to be evaluated more closely. A critical piece of NBFC business that has not been given the importance it deserves is its Asset Liability Management or ALM.
What is Asset Liability Management or ALM?
NBFCs typically borrow from banks or debt markets (e.g. bonds or commercial papers which Mutual Funds buy. These mutual funds are funded by large corporates or even individuals who are seeking more returns than FDs or government bonds). Imagine an NBFC which borrows by issuing a 3 month commercial paper to a mutual fund house carrying 8% annualized interest. It lends to end customers at say 17% and incurs cost of say 4% in doing that. Looks like a good business model right? Not necessarily! It depends on the duration of end customer loans the the NBFC is financing. Assume the NBFC is lending to its end customers for 3 year duration. So if it raises Rs 100 cr from the debt markets at 8% for 3 months, it has to repay Rs 102 cr at the end of 3 months (the “Liability”). But soon after raising the Rs 100 cr, it would have lent it out to end customers for a 3 year duration (these loans are “Assets” for them, which will yield interest over 3 years). So, on the Liability side you have Rs 100 cr principal due to be paid in 3 months, but the Asset will return the principal only over 3 years. How do you repay the Liability in the next 3 months? This is an example of Asset Liability mismatch. If not managed well, the NBFC may default on its Liability. And if the NBFC is large, it may cause the Mutual Fund investors to panic and move the money out, making it harder for other NBFCs to borrow, and hence making them default on their obligations as well, due to a systemic risk aversion & liquidity crunch. In words of RBI,
“The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system.”
This problem is very real and was at the core of the recent IL&FS crisis. IL&FS borrowed large amounts of money which had to be repaid within 1 year (Liability) but it used that money to finance infrastructure projects of long duration of more than 5 years (Asset). It defaulted on some of the Liabilities which triggered a market panic.
One pillar of ALM is calculating the mismatches between liabilities becoming due and expected inflows from assets over different time buckets. E.g. 7 days, 14 days, 30, 60, 90, 180, 270, 365 days etc. 30 day mismatch would represent the mismatch between repayments due to lenders over next 30 days vs the repayments expected from end customers over next 30 days. The idea is to calculate this for each time bucket and ensure caps on the mismatches at each time bucket as well as ensure a cap over the cumulative mismatch.
RBI in it’s recent notification on 24th May 2019. came up with draft guidelines for ALM management by NBFCs. Here are the salient points from the directions:
1. RBI has recommended to measure the ALM mismatches at more granular time buckets. First bucket starts from 1-7 days. Measuring at more granular time buckets helps identify liquidity issues early.
2. There should be a cap on the cumulative negative mismatch in 1-7 day bucket (10% cap), 8-14 days (10% cap), and 15-30 days (20% cap). This means for e.g. that in next 1-7 days, if Rs 100 cr is due to be repaid, then at least Rs 90 cr should be expected in terms of inflows or equity capital that the NBFC has.
3. Introduction of Liquidity Coverage Ratio (LCR) – applicable NBFCs should have high quality liquid assets which cover requirements for next 30 days by 2024 (progressively increasing requirements from 2020 to 2024).
4. Use of more comprehensive metrics for capturing the liquidity situation. This is along the classic adage “If you can’t measure something, you cannot improve it”
While the above guidelines are for NBFCs with asset size more than Rs 100 cr, systemically important Core Investment Companies and all deposit taking NBFCs, we believe that all NBFCs must follow them. Adopting these would mean keeping more cash at hand and may mean little higher borrowing costs as longer term debt is costlier. Hence these may affect profitability negatively, but it makes the lending businesses more resilient to market liquidity changes.
In our view, the RBI guidelines are prudent and necessary to ensure stability of the financial system. In fact, these is only the starting point – more closer scrutiny and more frequent recommendations from RBI on the same are needed.
How we manage ALM at Credy
The core of the ALM problem is a large mismatch between Asset and Liability tenors. The sustainable way to solve it is to have funding source that matches in duration with your asset duration, and a little higher if possible. Even before the recent crisis we have been very clear that using short term funding to fund longer terms loan is a risk that cannot be hedged. And the best way to deal with risks that cannot be hedged is to not take them. Here are some salient points of ALM at Credy,
- We finance end customer loans for average duration of 9-10 months and have made sure our funding is always matched with end customer loans or higher than that. As mentioned above, this prudence may come at the cost of slightly modest profit margins, but it ensures the a lender does not go belly up, compromising the trust of all stakeholders, including the end customers.
- In addition, we have internal guidelines on leverage ratio which ensures that we have sufficient equity at all times, over and above the positive mismatch in all ALM tenor buckets.
- Heavy use of data and automation in treasury to maximize return on capital deployment and save cost leakage via PnL bleed on idle assets. At any given point capital should be optimally deployed – either generating returns or providing the right amount of buffer against risks taken.
As the demand for credit keeps increasing, NBFCs who manage risks and ALM well stand to gain significantly. What are your thoughts on the RBI ALM guidelines? Please leave comments, we will be happy to discuss.