As recently introduced by the Reserve Bank of India (RBI), a new ‘liquidity management framework’ has been designed for Non-Banking Financial Companies (NBFCs). The decision comes in the wake of liquidity issues encountered by some NBFCs while meeting their recent repayment obligations. These challenges arose post the collapse of the Infrastructure Leasing and Financial Services (IL&FS) group.
Liquidity Coverage Ratio: Understanding the Concept
To ensure financial stability, the RBI has mandated all non-deposit taking NBFCs (NBFC-NDs) with an asset size of Rs 10,000 crore and above, along with all deposit-taking NBFCs, to maintain a liquidity buffer known as the Liquidity Coverage Ratio (LCR). However, this rule does not apply to Type I – NBFC-ND entities. These companies do not accept public funds, do not have customer interfaces, and do not plan to engage in such activities.
LCR is essentially a measure of the proportion of highly liquid assets held by firms to guarantee their capacity to meet short-term obligations. It’s expected to enhance the resilience of NBFCs against possible liquidity disruptions, ensuring they possess enough High Quality Liquid Assets (HQLA) to survive any severe liquidity stress scenario lasting for 30 days.
Defining High Quality Liquid Assets (HQLA)
High Quality Liquid Assets are liquid assets that can be quickly sold or immediately converted into cash at little or no loss in value. They can also be used as collateral to secure funds in a variety of stress scenarios. From 1st December, 2020, under the new framework, NBFCs are required to adhere to LCR requirements, with the minimum HQLAs to be held being 50% of the LCR. This will gradually increase to reach 100% by 1st December, 2024.
HQLAs comprise cash, government securities, and marketable securities issued or guaranteed by foreign sovereigns. These assets should be devoid of any financial liability.
| Term | Definition |
|---|---|
| Liquidity Coverage Ratio (LCR) | Proportion of highly liquid assets held by firms to ensure their ability to meet short-term obligations |
| Non-deposit taking NBFCs (NBFC-NDs) | These companies do not accept public funds, don’t have a customer interface and don’t plan to engage in such activities |
| High Quality Liquid Assets (HQLA) | Liquid assets that can quickly be sold or immediately converted into cash with little or no loss in value |
The Significance and Impact of LCR on NBFCs
Preserving a liquid reserve in form of HQLA significantly reduces the chances of an NBFC defaulting due to delays in inflows. This regulation is thus vital in ensuring the smooth functioning of NBFCs by enabling them to manage liquidity risks effectively. For optimal results, adopting liquidity risk monitoring tools and metrics is recommended to accurately capture any strains in liquidity position.
