Cutting Corners through RBI’s Special Liquidity Scheme

[Shreya Dagar is a 3rd year B.A., LL.B. (Hons.) student at National Law University Jodhpur]

In order to provide relief to non-banking finance companies (“NBFCs”), housing financing companies (“HFCs”) and microfinance institutions against the pandemic struck economy, the Government has approved a special liquidity scheme providing short-term liquidity to these entities. Earlier, the Reserve Bank of India (“RBI”) had introduced the Targeted Long-Term Repo Rate Operations to increase the liquidity in the financial market, particularly in the corporate bond market.  The special liquidity scheme can only be availed by certain financial entities. The relevant NBFCs and HFCs must be registered under the Reserve Bank of India Act, 1934 and the National Housing Bank Act, 1987, respectively. They are required to be investment-grade to avail this scheme, and they must satisfy the criteria pertaining to the net non-performing assets and the capital adequacy ratio. These entities must have made a net profit in at least one of the last two financial years. These are some of the stringent conditions laid down for the concerned purpose.

In this post, the author argues that the special liquidity scheme fails to provide a full-proof plan to protect the shadow banking sector from the shackles of the pandemic struck economy. The scheme merely provides short-term liquidity shot instead of a long-term cushion against the blow.

What does the scheme entail?

Under the special liquidity scheme, a special purpose vehicle (“SPV”) has been set up by SBICAP, which is a subsidiary company of State Bank of India. The SPV will purchase securities in the form of short-term papers from the NBFCs or HFCs, as the case may be. They will use the proceeds of the sale to extinguish their existing debts. This liquidity scheme will only be available for papers issued until September 30, 2020, following which the SPV will not make any fresh purchases. The financial instruments shall include investment-grade commercial papers (“CPs”) and non-convertible debentures (“NCDs”) and will mature within three months of their purchase. All dues arising from this facility will have to be paid by December 31, 2020.

Why was it required?

Like other entities in the financial market, NBFCs and HFCs too have been hit hard by the Covid-19 pandemic. Prior to this, the IL&FS crisis had adversely impacted the shadow financing sector. The result is a deficiency of funds.

A mortgage firm, Indiabulls Housing Finance filed a writ petition in the Delhi High Court in Indiabulls Housing Finance v. Securities and Exchange Board of India, seeking relief against the servicing of their bonds. Indiabulls argued before the Court that it is providing the moratorium granted by the RBI and, thus, not receiving any payments from its borrowers. An interim relief was granted by a single judge allowing them to postpone the payment to their debenture-holders as long as the moratorium declared by the RBI continues. However, a division bench of the Delhi High Court set aside the interim relief when challenged by the Securities and Exchange Board of India (“SEBI”), Association of Mutual Funds (“AMF”) and Industrial Development Bank of India (“IDBI”). This proves that the NBFCs and HFCs are left with no alternative against the reluctance of their lenders to grant them a moratorium.

NBFCs and HFCs are providing the benefit of the six-month moratorium declared by the RBI to their borrowers; however, the same benefit does not extend to them against their lenders. Only a few of their lenders are providing them any such moratorium. Moreover, these entities usually deal with commercial papers and NCDs, which are ineligible for obtaining any moratorium. Considering the present situation, these entities may very well default in the discharge of their debt obligations. The borrowings close to over 100,000 crores are expected to mature within the next few months. This would be worrisome for the financial markets. Therefore, the special liquidity scheme aims to isolate any such potential risk to the financial market by injecting short-term liquidity. This liquidity is to be used by the NBFCs and HFCs to pay off their existing debts.

A myopic approach

The success of this liquidity scheme will depend on the rate and amount received by the financial entities from the limited Rs. 30,000 crore bounty. The scheme will cater to only certain NBFCs and HFCs that fulfill the conditions laid out by the RBI. The eligibility requirement in the present scheme is very stringent. This could lead to depriving certain entities that are in a crucial need of liquidity but fail to fulfill the requirements under the scheme. It is evident from the criteria laid out that the move seeks to help entities that have a better financial condition. The query that still remains to be determined is whether the benefit of the scheme will extend to even those entities which are not in a dire need of liquidity but fulfill all the conditions. However, it is uncertain that this scheme will provide a long-term succor to the NBFCs and HFCs.

The liquidity scheme provides a short-term liquidity solution to be used by the NBFCs and HFCs in order to discharge their existing debts. The dues arising under the scheme will have to be discharged by the entities within a span of three months. Therefore, it appears to be an indirect extension of the debt for three months. The NBFCs and HFCs shall use the proceeds of the scheme to extinguish their existing liabilities and, then, will have to arrange a loan to pay off the dues arising under this scheme. This would only create a vicious cycle of loans. The financial system is suffering a setback due to the pandemic that does not seem to improve. Therefore, any expectation that these entities would be able to improve their financial condition in this three-month period by investing in better securities is far from practical. However, the scheme will certainly aid in extinguishing the existing liabilities of NBFCs and HFCs, but it will not provide a long-term solution to the problem. The industry is in the need of long-term funds to sustain it through the troubling times. Moreover, a short-term liquidity could lead to an asset liability mismatch. The fact that the total borrowing by the NBFCs is more than Rs. 1 lakh crore creates a further doubt on the effectiveness of the SPV, which will be active until 30 September, 2020.

Concluding remarks

The RBI’s special liquidity scheme fails to conquer the bigger picture. A short-term liquidity will take care of the situation of the NBFCs and HFCs for only three months. Moreover, the criteria to avail this facility are too stringent. This appears to be a quick fix for the issues, which require long-term care. In order to preserve the health of the financial system, a long-term scheme is required, which would shield the financial entities against the pandemic struck economy, moratorium on the payment of their borrowers and any other forces.

Shreya Dagar

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