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CAFRAL Working Paper Series

29 August, 2023

Anatomy of a Liquidity Shock on Non-banks

with Nirupama Kulkarni & K.M. Neelima

Abstract 

This paper investigates the anatomy of a liquidity shock in the non-banking sector in India in September 2018 when a large state-funded company defaulted on its debt obligations. We construct a unique supervisory database of non-banking financial companies (NBFCs) matched to their borrowers and lenders, and employ a difference-in-differences methodology to exploit ex-ante differences in NBFCs' exposure to liquidity mismatches. 
While the defaulted company was quickly bailed out, we find that stressed firms experienced a significant decline in commercial paper growth, majorly attributed to mutual funds as they faced redemption pressure from investors. Firm composition of funds and ex-ante liquidity were the main mechanisms driving the impact. Balance sheet attributes such as firm size and provisioning buffers also played a role in determining the extent of the impact. `Stressed' firms could not substitute with alternate funding sources such as debentures or bank credit in the short run, and consequently cut down credit to their largest borrowers, as sectoral allocation of credit also declined. The banking sector predicated its support to non-banks based on their loan performance. While banks stepped in to support `healthy' NBFCs, they cut back credit to unhealthy ones. Such selective bank support, or ringfencing by banks during the shock episode proved effective in averting the contagion of the liquidity shock to the traditional banking sector while continuing to support healthier firms. Such an approach can strike a balance between financial stability and targeted assistance..

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