Increased forced lending to NBFCs can land banks in trouble: Fitch report

The recent steps by the Reserve Bank to encourage banks to increase lending to non-banking finance companies and retail borrowers are likely to rise risks for the sector, warns a report.

Earlier this month, the central bank announced three major steps to encourage banks to lend more to liquidity starved NBFCs--an increase in the single-exposure limit to 20 percent of tier 1 capital (from 15 percent); priority lending status for credit to NBFIs for on-lending to finance agriculture, small businesses and home-buyers; and a reduction in the risk weight for consumer loans (except credit cards) to 100 percent from 125 percent.

Global rating agency Fitch said Wednesday these initiatives are designed to help keep credit flowing to the real economy amid growing signs of a slowdown.

"Averting a significant slowdown would help borrowers and therefore the stability of the financial system, but the measures could push up banks' risk if these steps lead banks to accept higher credit risk than they previously had the appetite for," the agency said.

The constant nudging of banks to lend more to NBFCs is in contrast to the global trend of authorities trying to break the linkages between banks and NBFCs, it noted and argued that it increases the potential of risks in NBFCs spilling over to banks, exacerbated by the limited capacity of the capital markets to provide extra funding to NBFCs.

The parallel banking sector has been under significant funding pressure as investors shy away following the default of IL&FS last September and the resultant troubles at Dewan Housing early this year.

NBFC disbursements have declined steeply as a result, with knock-on effects to other sectors, particularly consumption, it noted.

Reduced availability of financing has contributed to the slowdown in the auto sector, with vehicle sales in July falling 31 percent, the worst in two decade.

"Some of the pressure on NBFIs will be alleviated if banks start to direct more funding to them, but we expect most of the benefit will go only to the strongest of them," the agency said.

The reduction in the risk weight for consumer loans will give a small boost to banks' regulatory capital ratios (estimate 1.3 percentage points on average), it said.

"This will enable banks to lend slightly more for each unit of capital, which would be positive for loan growth but negative for their overall credit profile if the extra lending is riskier than average," the report said.