The recent funding crunch in the economy caused by the blowouts in the NBFC sector (IL&FS, DHFL etc) over the last two years has clearly prompted the Government to look at the problems of financial fragility that the sector faces in a holistic manner.

It has now through the Economic Survey 2019-20 mooted the concept of ‘Health Score’ as a measure of health of a Non Banking Finance Company (NBFC). This diagnostic tool can be used as an early warning system to anticipate liquidity crisis, according to the Survey.

The Survey has through analysis established that the firms in the NBFC sector are susceptible to “rollover risk” when they rely too much on the short term wholesale funding market for financing their investments in the real sector.

Policy initiatives

The latest Survey has suggested a slew of policy initiatives that can be employed to arrest financial fragility in the shadow banking system. It has suggested that regulators can employ the Health Score methodology presented in this analysis to detect early warning signals of impending rollover risk problems in individual NBFCs. Downtrends in the Health Score can be used to trigger greater monitoring of an NBFC.

When faced with a dire liquidity crunch situation, as experienced recently, regulators can use the Health Score as a basis for optimally directing capital infusions to deserving NBFCs to ensure efficient allocation of scarce capital, the Survey has suggested.

Health Score can also be used to set prudential thresholds on the extent of wholesale funding that can be permitted for firms in the shadow banking system. Such a norm would be consistent with macroprudential regulations that are required to internalise the systemic risk concerns arising due to an individual NBFC’s financing strategy. These norms could be countercyclically adjusted because the seeds of a liquidity crunch are sown during the good times, the Survey has suggested.

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