NBFCs' contagion concerns

Reserve Bank of India's decision to increase risk weights on unsecured consumer loans and bank funding has dealt a double blow to non-banking financial companies

Non-banking financial companies (NBFCs) have recently been in the news for the wrong reasons. The Centre for Advanced Financial Research and Learning (Cafral) released a report highlighting a growing risk in bank financing for NBFCs and potential dangers in the digital lending landscape.

Subsequently, the Reserve Bank of India (RBI) decided to increase the risk weights on unsecured consumer loans from banks, NBFCs and credit card providers, as well as on bank loans to NBFCs. The RBI’s decision was prompted by a surge in consumer credit growth, a significant portion of which is unsecured, and increased bank lending to NBFCs. The compound annual growth rate (CAGR) of retail loans during the last two years has been about 25 per cent, almost double the growth rate in gross lending, with a quarter of these loans being unsecured. According to the Cafral report, NBFC borrowings from banks and financial institutions increased from 29.68 per cent of their total borrowings in 2019 to 35.46 per cent in 2022. At present, this proportion has reportedly reached about 41 per cent.

The close interconnectedness between banks and NBFCs is obvious from the fact that the share prices of both banks and NBFCs slumped due to the RBI’s recent move. Of course, the NBFCs are worse off compared to banks as a result of this decision.

NBFCs have been adversely affected both on their borrowing as well as lending sides. This is a case of double whammy for them. The increased cost of borrowing from the banks is likely to force NBFCs to rely more on market borrowings, thereby raising the bond yields and increasing their overall borrowing costs. Not only this, an increase in risk weight on capital for unsecured loans will further raise NBFCs’ lending rates for such loans.

NBFCs have been around for decades in India, playing an increasingly critical role in credit intermediation. According to the Cafral report, NBFC credit increased from 8.6 per cent of gross domestic product (GDP) in 2013 to 12.3 per cent in 2022. Importantly, they provide the last-mile delivery of financial services to the small-scale and retail sectors that remain underserved by the banking sector. In fact, many banks have themselves floated NBFCs through separately capitalised subsidiaries.

Globally, banks and NBFCs compete in fixed deposit mobilisation and in lending. However, in India over a period of time, their relationship has evolved into a complimentary one.

For their funding, apart from bank borrowings, NBFCs in India tap into the bond market, meeting short-term needs through commercial papers.  Deposit-taking NBFCs were discouraged through prudential norms and regulations, leading to the number of deposit-taking NBFCs decreasing from 784 in 2002 to 49 by 2022. For many years, the RBI has not allowed new NBFCs to raise resources through deposit-taking.

Debt funds and banks are the principal investors in the bonds issued by NBFCs. In a way, NBFCs and mutual funds are the most active and dominant players in the bond market. The strong interconnectedness between NBFCs and mutual funds was demonstrated in 2018 when one of the large NBFCs defaulted in its bond repayment, leading to a serious crisis in the bond market affecting debt mutual funds.

On the fund deployment side, one of the developments has been a massive increase in the retail loan portfolio of NBFCs. This portfolio grew by 223.2 per cent during the period 2013-2022.

One of the key advantages of NBFCs is their flexibility in their lending practices. Compared to banks, NBFCs have made better use of fintech and digital lending platforms. The co-lending model, adopted for joint lending by banks and NBFCs, envisages a win-win solution, combining the lower cost of banks’ funds with greater outreach and operational flexibility of NBFCs. The recent RBI directive will particularly affect digital loans offered by fintech firms, as unsecured credit forms a substantial proportion of their lending business.

It is difficult to find fault with the RBI’s move. No one can argue against the need to maintain the quality of assets of both banks and NBFCs, ensuring financial stability. In fact, following the 2018 crisis, the RBI has implemented a number of measures to strengthen regulatory oversight of NBFCs. Of course, considering the dynamic nature of the market and the increasing use of technology in operations, the regulator needs to be flexible in its approach.

While the regulation of NBFC is a wide subject and there are many aspects, the following paragraphs raise some issues that warrant the attention of the central bank and the government.

The interconnectedness of NBFCs with banks and capital markets poses a serious contagion and financial stability concern. The proportion of their borrowings from banks should be reduced, and reliance on the bond market should be increased. However, this is easier said than done, as the bond market is not accessible to lower-rated NBFCs. A larger issue is the need to deepen the bond market in India, wherein much needs to be done. The market should have more participants, ensuring ample liquidity across different bond ratings. Restricting bank funding to NBFCs without deepening the bond market could particularly impact smaller NBFCs.

The increased borrowing costs of NBFCs would even impact their lending rates for desired sectors like micro, small and medium enterprises, housing and education. This may not be desirable considering the limitations in banks’ outreach for disbursing such loans.

A closer look is required at the operation of NBFCs that are subsidiaries of banks. A bank and an NBFC owned by it, with both in the same line of business, raise regulatory arbitrage concerns. The dealings between the two must be at arm’s length, related party transactions need closer scrutiny. The question is: How do banks treat their own NBFCs compared to other NBFCs? This is crucial for ensuring a level playing field for all NBFCs, whether owned by banks or not.

The regulator should clearly spell out its stance on the issue of NBFCs raising funds through deposits. In case the policy is a strict “no”, and likely to remain so in future, there should be a sunset clause for this activity by the existing deposit-taking NBFCs. In other words, the regulator should prescribe a cut-off date beyond which they can no longer accept deposits. This is essential to level the playing field for all NBFCs and provide clarity on the matter.

The writers are, respectively, distinguished fellow at ORF and former chairman of Sebi, and professor at NISM