Surgical actions needed to salvage the NBFIs

Non-banking financial institutions (NBFIs) have been on the radar screen of various stakeholders, analysts and observers ever since the People's Leasing and Financial Services Ltd (PLFSL) went bankrupt and faced liquidation. The failure of PLFSL triggered a crisis of confidence.  This was subsequently worsened by the unveiling of the story on the scam-hit International Leasing and Financial Services Ltd. (ILFSL).  

To say that the NBFI sector is stressed is surely an understatement.  According to Bangladesh Bank (BB), as of end-September 2019, 13.3 percent of NBFI funds constituted their capital, 52.8 percent were from deposits, 22 percent borrowed from the call money market and the rest were other liabilities. Of their total funds, 74.7 percent were invested in loans and leases while cash liquidity constituted 13.1 percent.  The rest were in investments (4.4 percent), other assets (6.3 percent) and fixed assets (1.5 percent).  Their aggregate Non-Performing Loan (NPLs) increased from 8.1 percent of total loans at end-March 2017 to 10.4 percent at end-September 2019.  The actual NPLs are likely to be significantly higher than shown on papers. Their return on assets was only 0.48 percent and return on equity 3.9 percent.

BB conducts stress tests on these financial institutions based on four risk factors:  credit, interest rate, equity price and liquidity. At end-September 2019, out of 33 NBFIs, 4, 19, and 10 were positioned in Green, Yellow, and Red zones respectively.  Simply stated, only 4 are healthy, 19 are vulnerable and 10 need serious attention. Most clients of the vulnerable NBFIs are having difficulties cashing their deposits and profits at maturity.  These companies misused the funds obtained from their clients. They borrowed money from different banks and the call money markets. There has been a maturity mismatch in the NBFI sector as they take deposit for a maximum period of two years but give out loans for 10 to 20 years in general. 

The private sector credit disbursement by NBFIs dropped to an all-time low (since FY02) of 4.1 percent in FY19. The major reason for the sharp fall in credit growth is the public distrust in the NBFIs as the sector along with the banks had witnessed a series of scams and irregularities in recent years.  Distrust in the NBFIs intensified following their failure to pay individual depositors as well as the banks and the subsequent BB moves to liquidate the Bangladesh Industrial Finance Company Limited and PLFSL. 

BB raised the limit on NBFI borrowing from the inter-bank call money market from 30 to 40 percent of their equities with effect from September 1, 2019.  Sensing their malpractices and to meet their own liquidity shortage, banks started withdrawing their investments from the NBFIs. BB instructed banks not to withdraw their deposits from the NBFIs.

None of these made a difference.  NBFIs have now become a boil in the body of the financial system.  Measures are needed before the boil reaches toxic levels. A conventional bailout package from BB cannot be the most appropriate response. In some cases, such as the ILFSL, as stated by Khondokar Ibrahim Khaled, a guru on all financial system related matters and beyond, "there has been no management crisis…. The crisis stemmed from money embezzlement….. The depositors' fund will have to be returned in order to protect the NBFI. And the Anti-Corruption Commission will have to play a major role in recovering the money." 

The Bangladesh Leasing and Financing Companies Association has proposed four measures: (i) a Tk 10,000 crore special refinancing scheme at the BB to provide 5 years term loans at rates equivalent to the 6 months Treasury bill rate; (ii) extension of emergency liquidity support against the cash and statutory reserve requirements except those struggling due to poor corporate governance; (iii) instruct banks not to withdraw funds from NBFIs for next two years and fix the interest rate on these deposits at no more than 7 percent; and (iv) merge the 4-5 insolvent NBFIs and convert the bank and non-bank funds placed with them into equity in proportion to their exposure. Except the last, the other proposals sound like paracetamol treatments. It is reassuring to see both the Finance Minister and the BB have been circumspect in responding to these proposals.  

The Indian government seemed to have learned rather late in the game, simply pumping in liquidity is no cure. The non-banking finance industry continues to need a bailout package for survival. The government introduced a series of steps to turn the sector around in November 2019. It issued fresh rules under the Insolvency and Bankruptcy Code (IBC) to help out distressed institutions battling a liquidity crunch. Financial services providers, or classes of such entities, are covered by a special window under the bankruptcy code. The decision to provide support will be made after talks with the concerned regulators based on a resolution plan under IBC. 

An administrator appointed by the bankruptcy tribunal will stitch together a turnaround plan. The administrator will be nominated by the regulator, such as the Reserve Bank of India (RBI) in the case of non-bank lenders and housing financiers. The registration or the license of the financial services provider will not be suspended or cancelled during the bankruptcy resolution process. In case a turnaround of the financial institution is not possible, the tribunal will listen to the views of the regulator before deciding to liquidate it. A court-monitored procedure for resolving their distress will enable new investors to back a turnaround plan by offering them legal protection from any risk associated with investing in a bankrupt firm.

Bangladesh needs a framework for resolution of the troubled NBFIs. Non-bank financing provides a range of benefits by opening an alternative avenue for credit supply and increasing the availability of higher-yielding investment products to households. However, these benefits have come at the cost of increased financial stability and transaction risks. While the risks vary across the different types of non-bank financing, some involve excessive risk, with limited prudential safeguards and transparency. Non-bank financing in Bangladesh has facilitated higher leverage (both within and outside the financial sector), significant liquidity and maturity mismatches, lending to risky borrowers and a web of interconnections feeding back to the banking system. 

Going back to Khondokar Ibrahim Khaled, the problem is deeper than just banking or management deficiencies.  There exists a predatory financial ecosystem involving predators and preys.  This ecosystem accomplishes the function of marauding the weaker elements, such as small investors, who blindly trust their institutions, while inevitably creating financial crisis and generating systemic risk.

Many economies have managed the financial stability risks stemming from an increase in non-banking activity with varying degrees of success. Mitigating these risks requires designing regulations that cannot be easily circumvented while addressing the risks. 

The importance of adequate legal protection, clear institutional mandates and accountability to ensure sufficient independence and resources for oversight agencies to act effectively can hardly be overemphasized. Prioritization of financial stability at the agency and cross-sectoral levels will be crucial to ensure that risks outside the regulatory perimeter are mitigated and monitored. Strengthening the legal framework for NBFI resolution would improve incentives and reduce the potential risks to public resources that could arise from the failure of financial institutions.  

The author is an economist.