Understanding The Government’s Decision To Scrap Debenture Redemption Reserves For NBFCs
What about the interests of retail investors?
The government’s decision to do away with a Debenture Redemption Reserve for Non-Banking Finance Companies and Housing Finance Companies could ease the pressure on these lenders in the near term, said experts that BloombergQuint spoke to. Over the longer term, though, policymakers would need to ensure that interests of retail investors are not compromised, some of these experts said.
A debenture redemption reserve is meant to protect the interests of retail bond holders in the event of a company going through financial stress. It was introduced in company law for the first time in 2000. In 2002, the then government said that for NBFCs registered with the Reserve Bank of India, the reserve had to be at least 50 percent of the value of debentures issued via public issuance. A 2013 revision to the Companies Act brought this down to 25 percent of the value of publicly issued debentures.
On August 16, the Ministry of Corporate Affairs said that NBFCs registered with the RBI and HFCs registered with the National Housing Bank would no longer be required to maintain a debenture redemption reserve. The decision was originally announced by Union Finance Minister Nirmala Sitharaman in her maiden budget speech in July.
According to data available on PRIME Database, in the financial year ended March 31, funds worth Rs 36,788 crore were raised through public debt issuances, as compared with Rs 5,167 crore a year ago. While the data includes all types of companies, NBFCs and HFCs have increasingly tapped this route to raise money after the collapse of Infrastructure Leasing and Financial Services Ltd. in September 2018.
Relief For NBFCs?
According to Sanjay Agarwal, senior director at Care Ratings, an NBFC or a HFC is fundamentally different from manufacturing companies in the way it uses funds. While manufacturing companies borrow money from the market or banks and repay them using the profit they earn after selling their product, an NBFC or HFC depends on the interest and principal repayments from their borrowers to be able to ensure repayments. “Since the reserve is created by taking out funds from the company’s profits and their repayments are not from profits, a DRR would not make much sense for NBFCs or HFCs,” he said.
Former RBI Deputy Governor R Gandhi explained that the provision had been introduced at a time when non-financial firms were luring retail investors with high returns. This created a situation where some undeserving companies also received considerable funds and then eventually failed to repay their dues, Gandhi said.
He believes the situation is different now.
Most of the debentures issued by HFCs and NBFCs are not being bought by retail investors but by qualified institutional investors. Since these institutional investors have their risk assessment mechanism in place and they are able to extract the right kind of risk-reward, they do not need the kind of protection meant for common retail investors.R Gandhi, Former Deputy Governor, RBI
Long Term Risk?
Not all are in favour of doing away with such reserves.
"It appears that to achieve stability for the non-banking financial institutions in the shorter term, some key protections are being removed. It is likely to be negative for debt investors in the medium to long term,” said Saswata Guha, director- financial institutions at Fitch Ratings India. “Our expectation would be that the stronger NBFCs will continue to exercise prudence and set aside reserves to protect their debt investors."
A former RBI deputy governor, speaking on conditions of anonymity, said that it would be prudent to maintain a reserve and added that the government’s decision is intended to ease the burden on NBFCs in the short term. It would have been better if some stricter liquidity management norms had been introduced for NBFCs before giving them this breather, this person said.
He added that monitoring of liquidity for NBFCs needs to get aligned with the rules applicable on banks. The banking system’s liquidity position is monitored by the RBI on an overnight basis, while for NBFCs it is monitored over a 1-7 day period. Monitoring the NBFC sector’s liquidity on an overnight basis would help improve the quality of their liquidity management, the former deputy governor added.
The RBI is in the midst of formulating final guidelines for liquidity coverage ratio for the NBFC sector. In May, the banking regulator released a set of draft guidelines for the same. The draft guidelines propose a 60 percent minimum liquidity coverage ratio by April 2020, which would then be raised gradually to 100 percent by April 2024. While the regulator has received responses and inputs from stakeholders, it is yet to release the final guidelines.
PS: This story has been amended as the rules released by the Ministry of Corporate Affairs say that a separate provision to set aside a minimum 15 percent of the amount of debentures coming due over the next year remains applicable. As such, the removal of the debenture redemption reserve may not impact liquidity directly.