WHAT IS ALM MISMATCH AND HOW IT HAS CREATED LIQUIDITY CRUNCH FOR

NBFCs
The business model of Non-Banking Financial Companies (“NBFCs”) is sourcing and deployment of its
fund. They make profit from interest rate margin, i.e. difference between interest rate paid by them and
interest rate charged by them. Apart from interest rate margin, liquidity is one of the most important criteria
to examine viability of NBFCs. Asset liability management is an important determinant of liquidity of
NBFCs.
WHAT IS ASSET LIABILITY MISMATCH?
The maturity of liability and asset of a FI generally differs. The sources of funds for NBFCs generally have
short to medium- term maturities, i.e. they need to be paid back to the investors/ lenders in 3-5 years, and
its assets (loans and advances) usually have larger maturity period. NBFCs usually provide loans for a longer
period to borrowers, for instance home loans can have a tenure of up to 20 years. Providing long term
loans from short term funds leads to what is known as an asset liability mismatch. To put it in simple
terms, mismatch occurs when the tenure of maturing loans (which are on the assets side of the balance
sheet of a NBFC) do not match the tenure of the sources of funds on the liabilities side.
For example, if large part of the funds with a NBFC has a maturity of two-three years, and the NBFC lends
that money to an infrastructure company for say 20 years, there could be a payment crisis as the money is
locked with the borrower.
CONSEQUENCES OF ALM MISMATCH
ALM mismatch creates various risks which needs to be managed by the NBFCs, two of the most prominent
consequences are emergence of interest rate and liquidity related risks. For instance, if as much as 90 percent
of the assets of a NBFC are maturing in 10 to 15 years but about 50 percent of its liabilities are maturing in
one or two years, the NBFC will face a severe crunch in terms of matching its outflows with its inflows in
the short and medium term. If a bank tries to fund its long-term loans from short-term funds, it is setting
itself up for serious problems in its profitability and margins. Thus, ALM creates risks for NBFCs that need
to be managed.
Interest rate risk: ALM mismatch creates interest rate risk as the sources of funds available to NBFCs are
of shorter maturity, they need to be rolled over and thus, are repriced faster than loans and every time the
source of fund is rolled over and if interest rate has gone up, the NBFCs will have to pay a higher rate on
them. But, their assets, i.e. loans cannot be repriced that easily. Because of this faster adjusting of NBFCs
liabilities and sources of funds to interest rate ALM affects net spread which NBFCs earn.
Liquidity related risks: ALM mismatch may lead to serious liquidity issues. NBFCs need to pay off their
liabilities when they become due, but they cannot recall their loans. They will have to find a new source of
funding or they will not be able to service their depositors. In acute situations they may have to pay
exorbitant interest to raise new funds. And in such situations if they are not able to arrange any new funding,
it may lead to NBFCs defaulting on their commitments and in worse situations this may lead to winding
up of the NBFCs.
ALM & INDIA’s LIQUIDITY CRUNCH
In last 8-10 months, the country's financial system has been grappling with multiple woes in the wake of
the turmoil at diversified IL&FS group as well as debt defaults by some other large entities including DHFL.
ICRA, in March 2018 had released a warning on the buildup of risk in the retail focused NBFCs. It had
said the sector would require Rs 3.8-4 trillion of fresh debt capital in FY19 to grow at 20 per cent in the
current financial year while facing twin challenges in the form of narrowing options and increased
borrowing cost for adequate debt raising. ICRA further stated that “Based on the asset liability mismatch
(ALM) analysis of large retail-NBFCs, we note that the pricing related pressure is expected to be higher in
the second half of FY19, as debt redemptions are expected to happen at a faster pace than their advance
maturities and as incremental growth is expected to be more robust in the second half”.
The result of IL&FS default was that both public and private sector banks have stopped lending to NBFCs
and decreased their exposure to this sector. Banks, since April 2018, have reduced their exposure to NBFC
sector by 4.6% this when coupled with rising interest rate resulted in credit crunch - drying up of sources
for raising of funds and increased pressure on margin for NBFCs.
DHFL has been facing liquidity problems since September 2018 when defaults by the IL&FS Group
triggered a credit crisis. Credit crisis in market made it difficult for DHFL to raise new funds. DHFL’s
commercial papers were also downgraded by rating agencies which made it extremely difficult for DHFL
to raise funds by issue of commercial papers. These ALM issues lead to severe liquidity crunch which
resulted in default by DHFL.
RBI’s DRAFT ALM FRAMWORK FOR NBFCs
RBI in its ‘Trend & Progress Report’ released on June 11, 2019 admitted that debt default by a large NBFC
(IL&FS) in mid-2018 has highlighted the vulnerability and need for strengthening regulatory vigil on the
sector in general and on the asset liability management (ALM) framework in particular. Accordingly, RBI
has released draft circular regarding ALM framework for NBFC’s.
In its draft guidelines, RBI has proposed to introduce a Liquidity Coverage Ratio (LCR), which is the
proportion of high liquid assets set aside to meet short term obligations for all NBFCs with an asset size of
more than ₹5000 crore. Starting April 2020, NBFCs will have to maintain a minimum of 60% of LCR as
high liquid assets which will be increased in a calibrated manner to 100% by April 2024. The regulator has
also proposed to revise the ALM of NBFCs to ensure that the difference between inflows and outflows
during the first 7 days is not more than 10% of the total outflows. Similarly, over the next 8-14 days and
15-30 days, the cash flow mismatch should be only 10-20% of the cumulative outflows. This is to ensure
that NBFCs’ reliance on external debt to repay its maturing debt is reduced, given the current market
conditions where funding from banks and mutual funds has become scarce.
RBI has also asked NBFCs to adopt liquidity risk monitoring tools to capture any possible liquidity stress.
This will include concentration of funding by counterparty/ instrument/ currency, availability of
unencumbered assets that can be used as collateral for raising funds, certain early warning market-based
indicators, such as, price-to-book ratio, coupon on debts raised, breaches and regulatory penalties for
breaches in regulatory liquidity requirement. The guidelines have also proposed to introduce a stock
approach to liquidity—as opposed to a cash flow approach—to ensure asset adequacy to repay debt. For
instance, the liquidity ratios being proposed are short-term liability to total assets; short-term liability to
long-term assets; commercial papers to total assets; non-convertible debentures(NCDs, with original
maturity less than one year) to total assets; short-term liabilities to total liabilities; long-term assets to total
assets; etc.
CONCLUSION
NBFC sector plays an extremely important role in context of Indian Economy. NBFCs have excelled in
delivering credit to the last mile, including retail and micro, medium and small-scale sectors. However,
NBFCs’ ability to perform their role effectively and efficiently requires them to be financially resilient, well-
regulated and properly governed so that they retain the confidence of all their stakeholders including their
lenders and borrowers. The current crisis underpins the importance of sound ALM framework and policies.
For NBFCs, liquidity is as important as profitability, if not more.