Liquidity stress testing for NBFCs – Vinod Kothari Consultants (2024)

– Vinod Kothari

finserv@vinodkothari.com

Stress testing is a part of risk management process. Stress testing envisages those plausible, however, low frequency events, which may occur and disrupt the operations. In the context of a financial intermediary – stress may be seen either in the solvency (that is, capital is not sufficient to absorb the risks or losses), or liquidity (that is, the bank is perfectly solvent, and yet, does not have enough liquidity to discharge immediate liability).

The need for stress testing comes from para 15A (para 15 for non-systemically important NBFCs) read with Annex II of the Master Directions for NBFCs[1] which provide as follows:

“Stress testing shall form an integral part of the overall governance and liquidity risk management culture in NBFCs. An NBFC should conduct stress tests on a regular basis for a variety of short-term and protracted NBFC-specific and market-wide stress scenarios (individually and in combination). In designing liquidity stress scenarios, the nature of the NBFC’s business, activities and vulnerabilities should be taken into consideration so that the scenarios incorporate the major funding and market liquidity risks to which the NBFC is exposed.”

The corresponding regulation in case of banks is the RBI circular on Liquidity Risk Management by Banks[2] along with Basel III Framework on Liquidity Standards – Liquidity Coverage Ratio (LCR), Liquidity Risk Monitoring Tools and LCR Disclosure Standards[3] and subsequent amendments thereto.

The following is a general guidance to doing liquidity stress testing for NBFCs.

Stressing factors:

Stress testing is done for external economic factors. The important ones are real GDP, interest rates, credit spreads, equity prices, exchange rates, or other economic variables that may be relevant to the entity’s assets or liabilities.

Liability side stress

The sources of liquidity stress reside on the liability side. The following factors are relevant:

  • Extent of leverage: Clearly, entities with low leverage are less exposed to liquidity stress, as the extent of external debt in the total assets is relatively small. However, it is commonplace for financial entities to have high leverage. In that case, the following factors become relevant.
  • Contractual maturities of liabilities and run off rates: Liquidity risk is created when a liability, which is contractually payable, cannot be paid because the requisite cash inflows have suffered. Therefore, the scheduled maturities of liabilities have to be seen. The relevance of run off rates is the tendency of liabilities to get rolled over instead of coming for repayment. Hence, what matters is the run off, that is, the tendency of liabilities not to be rolled, and therefore, seek repayment. If we are referring to run off rates in situations of stress, the run off rates may go very high. However, liquidity risk may not consider a creditor seeking prepayment of the liability in question. For example, if a loan is due for repayment in year 2026, and the entity passes through a stress, except where there has been occurrence of events of default, the borrower is entitled to deny any request for prior payment of the facility.
  • Extent of revolving facilities: If there are revolving credit facilities, such as overdrafts, cash credit, or revolving/replenishing structures of securitisation, these may be sources of liquidity stress, as the facility providers or investors will refuse to replenish the same. Therefore, there may be immediate liquidity stress.
  • Liquidity needs for any downgrade triggers: Quite often, availability of credit or a facility to the entity is based on a minimum rating condition, for instance, investment grade. If the rating of the entity declines, and that becomes the basis for facility providers to recall the facilities, then there may be substantial liquidity strain.
  • Margin requirements under derivatives, loans against shares or similar requirements: If the entity has raised funding where there are dynamic margin requirements, or the entity has derivatives transactions where there may be margins based on the MTM value of the derivatives, there may be liquidity strain arising from the same.

Asset side issues

  • Delinquencies in loans and receivables: In case there are delinquencies in loans or receivables on the asset side, it could impact the liquidity position because it might create a mismatch in inflows and outflows. Especially in cases where repayment of a liability is pegged with the repayment of an asset/ receivable, a delinquency may cause asset-liability mismatch issues.
  • Illiquidity of investments or other assets: In case of investments, they could be either held till maturity or sold prior to maturity to realise cashflows. In case of a sale, in case the market for the security intended to be sold is illiquid, it could have a major impact on the liquidity position of the company. If the investment or asset cannot be sold due to its illiquidity, then there may be a big impact on the short term liquidity position.

Contingency plans

The most important issue in liquidity stress analysis is the understanding of the sources or support areas that the entity will draw upon, should any stressful liquidity situations arise.

  • Any uncalled capital or equity support.
  • Any repo financing based on existing assets: Repo financing is available in case of Govt treasuries and securities, and certain high quality assets. If the entity has such assets, in the event of a stress, it may deploy such assets to raise short term funding.
  • Restrictions on lending activities: Quite an intuitive option, wherever there are liquidity shocks, the financial institution in question should stop its financial activities, including investments, except in case of committed and non-cancellable facilities.
  • Fire sales of assets: Though this is actually a late or last option, if there are assets which may be sold in the event of a stress, that may also be a an important contingency plan for a liquidity shock.
  • Call financial facilities where the entity has a call option: As a lender/investor, if the entity has an option to seek earlier retirement or redemption of any funding facility, the entity should exercise such options too.

Combined event of solvency and liquidity shocks

While the risk of solvency and risk of a liquidity shock are not the same, however, there are strong interlinkages between the two. Liquidity risk may cause the entity to cause fire sales, etc., which may result into steep losses. Likewise, solvency risk may make lenders jittery, increase run rate, etc.

Hence, while considering the liquidity risk, the spillover impact of a solvency risk should be also be factored.

Liquidity stress testing in context of Indian NBFCs:

While the essential points concerning liquidity stress testing remain the same, some specific points that are relevant for Indian NBFCs, and may have significant impact on the liquidity risk as well as risk management, are as follows:

  1. NBFCs in India are mostly non-deposit-taking. Hence, the possibility of a run by retail liabilities does not arise.
  2. To the extent there is a dependence on cash credit and short term borrowing lines, there is a stronger liquidity risk. A liquidity risk at the provider of such lines of credit may also transmit the risk to the NBFC in question.
  3. The more the concentricity of the liabilities, the risk may be considered as the possibility of one or more of the providers not renewing their facilities.
  4. An examination of the asset side also becomes important. If there are retail pools of loans, the same may be sold in situations of stress. However, illiquid pools such as corporate exposures, intra group exposures, unlisted equities or bonds, may be very hard to liquidate.

[1] The liquidity risk management guidelines for NBFCs were introduced on November 04, 2019 vide the following RBI notification (and was subsequently consolidated in the NBFC Master Directions) –https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11719

[2] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=7680&Mode=0

[3] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=8934&Mode=0

As an expert in risk management, particularly in the context of financial intermediaries, I bring a wealth of knowledge and practical experience to the table. My insights are not just theoretical but are backed by a deep understanding of the regulatory frameworks and practical implications involved in stress testing for entities like Non-Banking Financial Companies (NBFCs). Let's delve into the concepts presented in the article:

Stress Testing in Risk Management:

  • Stress testing is a crucial component of the risk management process, aiming to identify and evaluate plausible but low-frequency events that could disrupt operations. In the financial context, stress can manifest in solvency (insufficient capital to absorb risks or losses) or liquidity (adequate solvency but insufficient liquidity for immediate liabilities).

Regulatory Framework:

  • The need for stress testing is emphasized in regulatory guidelines such as para 15A (for systemically important NBFCs) and Annex II of the Master Directions for NBFCs issued by the Reserve Bank of India (RBI). Similar regulations exist for banks, outlined in the RBI circular on Liquidity Risk Management, Basel III Framework on Liquidity Standards, and subsequent amendments.

Liquidity Stress Testing for NBFCs:

  1. Stressing Factors:

    • External economic factors like real GDP, interest rates, credit spreads, equity prices, and exchange rates are considered in stress testing.
  2. Liability Side Stress:

    • Factors such as extent of leverage, contractual maturities of liabilities, run-off rates, revolving facilities, liquidity needs for downgrade triggers, and margin requirements under derivatives are assessed.
  3. Asset Side Issues:

    • Delinquencies in loans and receivables and illiquidity of investments or other assets are identified as potential sources of liquidity risk.
  4. Contingency Plans:

    • Uncalled capital or equity support, repo financing based on existing assets, restrictions on lending activities, fire sales of assets, and calling financial facilities with a call option are suggested as contingency plans during liquidity stress.
  5. Combined Event of Solvency and Liquidity Shocks:

    • Acknowledges the interlinkages between solvency and liquidity risks, emphasizing the importance of considering the spillover impact of solvency risks when assessing liquidity risk.

Liquidity Stress Testing in the Context of Indian NBFCs:

  • Specific considerations for Indian NBFCs are highlighted, including the non-deposit-taking nature of most NBFCs, the impact of dependence on cash credit and short-term borrowing lines, and the challenges associated with liquidating illiquid pools of assets.

The article references regulatory guidelines issued by the RBI, emphasizing the importance of compliance with these guidelines in the liquidity stress testing process. The comprehensive understanding of these concepts and their practical implications demonstrates a thorough grasp of the subject matter.

Liquidity stress testing for NBFCs – Vinod Kothari Consultants (2024)
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