[Vineet Ojha is a Manager at Vinod Kothari Consultants Pvt Ltd]
In most developed nations, the bond market is often several multiples larger than the equity market. The same cannot be said about the India’s corporate bond market, as it is still underdeveloped and therefore unable to meaningfully share the credit burden of the banking system. To ease the funding strains non-bank lenders face and to enhance the Indian bond market, the Reserve Bank of India (RBI) has decided to allow the banks to provide partial credit enhancement (PCE) to bonds issued by systemically important non-deposit taking non-banking financial companies (NBFC-ND-SIs) registered with the RBI and housing finance companies (HFCs) registered with National Housing Bank, according to the RBI’s notification dated 2 November 2018. The objective behind the same is to offer added comfort to the investors and therefore leading to a possible enhancement in the credit rating of the bonds issued by the NBFCs/ HFCs. This move could provide some liquidity to the cash-starved NBFCs and HFCs in the wake of the IL&FS crisis.
Why is it required?
Following the IL&FS crisis, the RBI has time and again prompted banks to assist NBFCs to recover from the cash crunch and this move is yet another support in the same direction. In the three months from October 2018, NBFCs and HFCs together are up against redemption pressure of Rs 1.20 lakh crore due to maturing financial instruments. The RBI has allowed banks to use government securities as level 1 high-quality liquid assets equivalent to the bank’s incremental lending to NBFCs and HFCs. The apex bank has also allowed banks to lend up to 15% of their capital funds to a single non-infra funding NBFC from the earlier 10%. The reason why RBI is taking numerous precautions is because corporate bonds issued by NBFCs comprise 70% of the corporate bond market in India. It is in this context that the RBI’s latest move gains significance.
Salient Features of the PCE facility
PCE is a mechanism through which a bond issuer attempts to improve its debt or creditworthiness by organising an additional comfort for the lender. It provides the bond purchaser reassurance that the borrower will honour its repayment through additional collateral, insurance, or a third party guarantee. With the facility, the RBI has laid down the following conditions:
- Tenor of bonds eligible for PCE shall not be less than 3 years;
- Bonds backed by PCE of banks shall only be used for refinancing. For this, banks shall introduce appropriate mechanisms to monitor and ensure that the end-use condition is met;
- Exposure to bonds issued by PCE should be restricted to 1 per cent of the bank’s capital funds within the extant single/group borrower exposure limits; and
- The exposure of banks by way of PCEs shall be within the aggregate PCE exposure limit of 20 per cent of its Tier 1 capital.
All other conditions stipulated in the circular DBR.BP.BC.No.40/21.04.142/2015-16 dated 24 September 2015 and subsequent circulars on partial credit enhancement to corporate bonds shall apply in the same manner to PCEs to bonds issued by NBFC-ND-SIs/HFCs.
Since the cascading impact of the IL&FS defaults, sentiments have been hit and investors are wary of subscribing to bonds issued by the NBFC sector. Prospects for partial credit enhancement for retail or SME funding for NBFCs can be somewhat better than the infrastructure sector, which did not take off, as an underlying NBFC’s credit can improve size, increase equity and demonstrate management capabilities. Unlike the infrastructure sector, NBFCs are heavily regulated in terms of adequate capital requirements. Hence, they are in a better position to pay the obligations accruing to the bonds. The CRAR requirements will give investors additional hope to receive the remaining 80% of the bonds not backed by banks.
Once banks extend PCE to the bonds, there remains a strong likelihood of enhancement in the bonds’ credit rating, enabling the companies to access funds from the bond market on better terms. The decision could have a strong signalling impact and be particularly beneficial for the smaller NBFCs who are rated around BBB and could have up to two or three notches higher in ratings.
The provision may also be more helpful for retail NBFCs with granular portfolios rather than those in corporate lending with concentrated portfolios as the diversification effect mitigates some of the risk. The result of this move may enthuse long-term providers of funds such as insurance and pension/ provident funds and others to invest in bonds backed by PCE.
The aftermath of the IL&FS crisis and a potential risk of a system breakdown due to asset-liability mismatches has forced the RBI to shift its gear to come up with progressive changes. With multiple undertakings by the central bank, be it open market operations or monetary policy changes, it has infused liquidity into the system. With the gargantuan amount of financial instruments nearing maturity, the PCE move by RBI is to ensure that the banking, financial services and insurance sectors do not relapse into crisis. The incoming liquidity will help the financial sector stabilize and bring investors back to the capital markets after few months of high volatility.
– Vineet Ojha