Rising bank financing for non-banking financial companies (NBFCs) raises concerns about systemic contagion and underscores the need for tighter preventive measures to mitigate potential systemic fallout, cautioned Centre for Advanced Financial Research and Learning (CAFRAL), an independent body set up by the Reserve Bank of India.

In its India Finance Report 2023, released by RBI Governor Shaktikanta Das on Tuesday, CAFRAL also warned of within-sector interconnectedness, with bigger NBFCs borrowing from banks and in turn lending to the smaller NBFCs, to exploit this regulatory arbitrage.

The CAFRAL cautioned that increased integration of NBFCs with the banking sector in the post-pandemic period underscores the need for close monitoring to prevent systemic fallouts.

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Systemic risks

Inter-linkages between NBFCs and the traditional banking sector pose systemic risks.

“While NBFCs experienced massive growth, this growth has not occurred in isolation. These entities heavily rely on scheduled commercial banks for funding, a requirement that has intensified over the past decade.

“Concurrently, banks have primarily extended their lending to larger NBFCs, resulting in increased cross-lending within the sector,” per the report put together by CAFRAL research team.

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It also said that a contractionary trajectory of the monetary policy leads to building up of risk in NBFCs’ portfolios led by an increase in the share of unsecured loans. “The evidence also shows risk build-up on the assets sides on the NBFC balance sheet following a contractionary monetary policy shock. On the assets side, the shrinkage is due to a fall in secured loans and advances even as unsecured ones see a marginal increase,” the report said.

The report noted that following the market correction prompted by the Infrastructure Leasing & Financial Service (IL&FS) default and a brief pause due to the Covid-19 pandemic, bank financing for NBFCs has begun to rise again.

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Bank borrowing

NBFCs borrow predominantly from the markets and from banks. Bank borrowing constituted nearly 36 per cent of total borrowings (of ₹25,84,696 crore) as of H1 of 2022-23.

Amongst the banks, public sector banks are the largest lenders, followed by private sector and foreign banks.

The report underscored that systemic risk builds up in periods of tranquil financial conditions due to increased risk-taking and tends to aggravate the effect of a shock through negative spillovers such as fire sales across firms during crisis.

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Within sector interconnectedness

The CAFRAL researchers said NBFC index and the bank NIFTY index are positively correlated, reflecting that banks are one of the most important sources of funding for the NBFCs.

“Banks, which are heavily regulated, are mostly reluctant to lend to smaller NBFCs. The bigger NBFCs, however, borrow from banks and in turn lend to the smaller NBFCs, to exploit this regulatory arbitrage.

“Due to this increasing interconnectedness, any risk that emanates in the banking sector can impact the NBFCs directly. The increasing within sector interconnectedness for the NBFCs also mean that even relatively smaller and seemingly systemically unimportant firms can have systemic implications,” they said.

Regulators will have to be cautious and create checks and balances, for this pattern may have systemic implications in the medium term, they added.