A dedicated liquidity window mechanism for NBFCs is the need of the hour

A dedicated liquidity window mechanism or emergency lines of credit from financial institutions can go a long way in addressing NBFCs' concerns

Non-banking finance companies (NBFCs) have played a vital role in financial intermediation in the Indian economy to bridge the gap that the banking system couldn't bridge, either due to reach or due to risk appetite.

Given the limitations of the credit data available on many unbanked customers in India, NBFCs have played a key role in providing credit to such customers using alternate data.

NBFCs depend on market and bank borrowings as their key source of funds. Market borrowings come in from the public at large or from the mutual fund houses.

This background is important to understand the unique link of the NBFC ecosystem through its liabilities side of the balance sheet to the asset side of the balance sheet of the capital markets ecosystem and the banking ecosystem.

These linkages ensure that the overall financial services system functions effectively but they also show how vulnerable the system is to contagion risks. Let me elaborate.

A default by an NBFC on repaying debt to a bank may impact the credit rating of the debt product issued by the entity, which mutual funds may have subscribed.

Given mutual fund investments are subject to rating category adherences, a reduction in rating may trigger a sell-off on the debt product, further exacerbating the problem for the NBFC.

We saw this play out in the 2018 NBFC crisis.

It is during such times that the market panics amplifies and the regulators need to step in as lenders of the last resort, a facility available only to scheduled commercial banks and not to NBFCs.

It is something the NBFC industry has been asking for a long time from the Reserve Bank of India. We also do understand that the RBI does not want complacency to set in within the NBFC ecosystem on account of such an option being available to them.

The suggestion is not for the same to be a blanket option available to all NBFCs but to lay out certain conditions and circumstances under which such a support would be available.

The RBI, for instance, could evaluate making a special liquidity window available for so-called Top Layer and Upper Layer NBFCs, which have significant borrowings exposure to fixed income schemes of mutual funds and banks.

This would ensure that financial stability risk is effectively managed. It would also help develop significant market confidence.

Another option would be to develop emergency lines of credit from financial institutions such as SIDBI, NABARD or NHB, which would specially be made for NBFCs during periods of stress, with special approval from the RBI.

A special emergency fund can be created and the NBFC ecosystem asked to contribute periodically in the form of insurance.

These are just ideas and are only being suggested to look at innovative and meaningful ways to support the NBFC ecosystem.

The regulator could consider setting up a working committee, with industry professionals contributing to the thought process.

With the kind of growth that the country is looking for, it is important to focus on the strength and resilience of the financial services ecosystem and a thought in this direction would be meaningful and relevant in the long run.

This article first appeared in MoneyControl on 20 January 2025