Cap NBFCs' bank borrowings for financial stability: RBI study

A cap on borrowing by non-banking financial companies (NBFCs) from banks may strengthen the financial system. According to a study by the Reserve Bank of India (RBI), non-deposit taking NBFCs would lead to more systemic risks, owing to their reliance on banks for funding needs.

“As a policy, when NBFCs are discouraged from raising public deposits, these become non-deposit taking, while increasingly substituting public deposits with borrowings from the banking system,” the working paper said. Hence, there seems to be scope to fix a separate ceiling for ND (non-deposit taking) NBFCs to borrow from the banking system, the study added.

Non-banking financial companies heavily depend on banks for meeting their funding needs, as many of these are not allowed to raise deposits. However, by borrowing through banks, these indirectly use public deposits, on a much larger scale than by raising deposits on their own.

The study also said due to high inter-connectedness, the vulnerability of the financial system may increase due to high inter-dependability. “There is a possibility that chains of inter-connectedness can make the system more vulnerable to shocks in any market, or at any single larger institution,” the RBI working paper said.

While both banks and NBFCs would be impacted if either of these sectors are hit, the impact on NBFCs would be much greater. “Even at the slightest symptom of a crisis or a crisis-like situation, NBFCs can face pressure of withdrawal from banks, similar to the one encountered from mutual funds immediately after the Lehman Brothers episode,” the study said.

Also, with tighter capital adequacy norms, banks may lend less or may completely stop lending to the sector in extreme cases.

“Banks may either become too reluctant to lend to NBFCs or in an extreme case, these may completely refrain from lending to NBFCs, which would further precipitate the situation. Any strain in the normal chain would compel NBFCs to turn to the money market with higher costs to wade over the tight liquidity conditions, thus disturbing the money market as well,” the paper said.

Apart from suggesting a cap on the borrowing limit of ND-NBFCs from banks, the working paper also suggested NBFCs should diversify their sources of funds.

“NBFCs’ future growth depends, to a large extent, on the success these achieve in diversification of sources of funds,” it said.