Anatomy of a Liquidity Shock on Non-banks

with Nirupama Kulkarni & K.M. Neelima

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Abstract 

This paper investigates the anatomy of a liquidity shock in the non-banking sector in India in September 2018 using a unique supervisory database of non-banking financial companies (NBFCs) matched to their borrowers and lenders. Using a difference-in-differences methodology, we exploit ex-ante differences in NBFCs’ exposure to liquidity mismatches as identification. 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 size and provisioning requirements were the main mechanisms driving the impact of the shock for the stressed firms who could not substitute with alternate funding sources such as debentures or bank credit in the short run. Consequently, these firms cut down credit to their largest borrowers, and 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.