News Analysis

Why RBI’s move to allow banks to provide partial credit enhancement to NBFC bonds offers little respite

Radhika Merwin | Updated on November 05, 2018 Published on November 05, 2018

Risk aversion and capital constraint of banks could play spoilsport

BL Research Bureau

In a bid to ease the liquidity concerns faced by non-banking finance companies (NBFCs) and housing finance companies (HFCs), the RBI has allowed banks to offer partial credit enhancement (PCE) to bonds issued by some of them.

While the growing clamour around the brewing liquidity crisis appears to have prompted the RBI’s move, it may offer only little respite to the cash-crunched NBFCs. Capital constraints for PSU banks, risk aversion among most banks and investors in such bonds and the fact that the relief is offered only for a small section of NBFCs somewhat dampen the reprieve.

What is it?

Credit enhancement is a facility through which a corporate can improve the rating of the bonds issued by it, by securing a backing from other institutions like banks. Essentially PCE is a contingent line of credit which is drawn in case of shortfall in cash flows for servicing the bonds. Hence this helps improve the credit rating of the bond issue, in turn aiding corporates to raise money from the bond market. For example, if a bond is rated BBB, credit enhancement can improve the rating to say AA.

The intent is to bring in long-term investors such as insurance and pension/provident funds to invest in such bonds.

Post the IL&FS crisis, NBFCs have been facing liquidity squeeze as investors have turned averse to buying bonds issued by them. The RBI’s move is intended to draw investors to PCE-backed bonds and ease up liquidity strain for the sector.

However, market players and bankers are uncertain about the extent of relief the move can offer.

Capital issue

The RBI’s measure comes with various strings attached. For one, the exposure of a bank by way of PCEs to bonds issued by NBFCs is restricted to one per cent of capital funds of the bank within the single/group borrower exposure limits.

What this implies is that if a bank has Rs 10,000 crore of capital, it can offer PCE to bonds upto Rs 100 crore for each NBFC/HFC. Theoretically, if a bank has sufficient capital adequacy and risk appetite, it can take exposure to many NBFCs/HFCs, in reality, capital constraints can play spoilsport.

Market reports suggest that over Rs 1 lakh crore of bonds by NBFCs and HFCs will mature in the three months from October 2018. Most public sector banks have weak capital ratios and hence may be constrained to provide PCEs to such bonds immediately.

While the RBI has been providing liquidity (open market operations purchases of Rs 36,000 crore for the month of October 2018 and Rs 40,000 crore for November 2018), banks have been constrained by capital to lend. Also, given the run down in confidence post the IL&FS crisis in the NBFC sector, banks have been averse to lend to NBFCs.

Bankers believe that the latest move by the RBI may not necessarily push banks to offer PCE to such bonds. After all, if they have ample liquidity (loan to deposit ratio for many PSU banks is below 70 per cent, while for private banks its high at around 80-85 per cent) why not lend to NBFCs directly than go through the PCE route?

Conversations with market players suggest that since the RBI’s announcement on Friday, banks are still waiting for larger banks to make the first move before making PCE deals.

A small section

The RBI’s move also applies only to a small section of NBFCs. The PCE is for bonds issued by systemically important non-deposit taking NBFCs registered with the RBI and HFCs registered with National Housing Bank.

As of March 2018, of the 11,402 NBFCs registered with the RBI, only 249 were systemically important non-deposit accepting NBFCs. NBFCs whose asset size is of ₹ 500 cr or more are considered as systemically important NBFCs.

While activities of such NBFCs have a strong bearing on the financial stability of the overall economy, default by other NBFCs (not systemically important) can also lead to contagion risk for the sector.

The RBI has also mandated that the bonds issued by such NBFCs/HFCs for which PCEs are provided should not be less than three years. Given the negative sentiment and risk aversion, it needs to be seen whether banks are willing to take exposure to such long term bonds.

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