Failure of large HFCs similar to bank collapse, says RBI report

India’s financial system remains stable due to the improved resilience of the banking sector, but from a contagion risk perspective, if a large housing finance company (HFC) fails, it would impact as much as the failure of a large bank, the Reserve Bank of India (RBI) said in a report on Thursday.

The bi-annual financial stability report noted that the recent pressure faced by non-banking financial companies (NBFCs) had brought in greater discipline to the sector. The report also pointed out stress in the retail lending segment and suggested exercising caution.

The HFC and NBFC sector is going through a tough time. RBI Governor Shaktikanta Das has said in the past that the central bank is keeping close vigilance on some large players, but it has not extended any credit line as of now.

ALSO READ: Asset quality in banking sector may improve in 2020, show RBI stress tests

“Recent developments in the NBFC sector have brought the sector under greater market discipline as the better-performing companies continued to raise funds while those with ALM (asset liability mismatch) and/or asset quality concerns were subjected to higher borrowing costs,” the report said.

The contagion risk caused by NBFCs is also now much less than what it was in September or March 2018.

“The failure of an HFC with the maximum capacity to cause solvency losses to the banking system will lead to a loss of 5.8 per cent of the total tier 1 capital of the banking system and the failure of one bank. The failure of an NBFC with the maximum capacity to cause solvency losses to the banking system will lead to a loss of 2.7 per cent of the total tier 1 capital and the failure of one bank,” it warned.

ALSO READ: Consumer loans may be the next big headache for NBFCs: RBI report

In September, the failure would have shaved off 8.6 per cent of the tier 1 capital of the banking system.

Under the same hypothetical situation, if a bank with the maximum capacity to cause contagion losses fails, it will lead to a “solvency loss of 5.5 per cent of the total tier 1 capital of the banking system, a liquidity loss of 3 per cent of total liquid assets and the failure of two banks”.

This underscores “the need for greater surveillance over large HFCs/NBFCs”, the report said.

On a standalone basis, though, banks have improved their resilience. The provision coverage ratio of banks rose sharply to 60.6 per cent in March 2019 from 52.4 per cent in September 2018 and 48.3 per cent in March 2018.

In a baseline scenario, the FSR expects the banking sector’s gross NPA ratio to decline from 9.3 per cent in March 2019 to 9.0 per cent in March 2020.

ALSO READ: More steps in the offing for timely fraud detection in banks: RBI

The number of banks having gross NPA ratio of more than 20 per cent came down in March 2019, compared to September 2018. This implied a broader improvement in asset quality. While banks’ asset quality improved, balance sheet liquidity, which is proportion of liquid assets and stable liabilities, as also profitability need improvement, the FSR said.

Among other issues, the FSR pointed out that states are now borrowing more from the market, and these bonds are now getting lapped up by investors.

ALSO READ: Fixed maturity plans of mutual funds face risk of concentration: RBI report

“Traditional captive investors in government securities, especially banks, have changed their strategies to focus on state development loans, which have the advantage of higher yields and these are increasingly finding their way into their HTM portfolios even as more liquid central government securities are moving elsewhere,” it said. Even mutual funds are now buying state development loans, “prioritising yield pick-up over liquidity.”

Mutual funds are the biggest lender to the system, but they have reduced their investment in commercial papers and debt of NBFCs and HFCs. Consequently, these NBFCs and HFCs are relying more on long-term bank loans for their funding, which could be unsustainable, the report said.