Non-banking financial services under significant funding pressure as investors shy away
The government and central bank may want to improve credit flow to shadow banks, but Fitch Ratings is of the view that risks in India’s banking sector may increase as a result of the central bank’s recent steps. The Reserve Bank of India (RBI) has taken several steps to encourage banks to lend to non-banking financial companies (NBFCs) and retail borrowers. In a bid to combat sluggish demand, the government and the central bank have taken several measures to help keep credit flowing to the real economy. Averting a significant slowdown would help borrowers and, therefore, the stability of the financial system, but the measures could push up banking-sector risk if they lead banks to accept higher credit risk than they previously had appetite for, Fitch Ratings said in a note on Wednesday.
India’s 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. India’s overarching approach across the financial system is aimed at achieving a more inclusive financial system in which bank savings can support lending to parts of the economy that are beyond the bank’ distribution network or risk appetite. However, it increases the potential of risks in the non-banking financial services sector spilling over to banks, exacerbated by the limited capacity of India’s capital markets to provide extra funding to NBFIs.
The central bank announced three main steps in August to encourage banks to lend more. The first one was to increase the single-exposure limit to 20% of Tier 1 capital (from 15%). Second, priority lending status was given for loans to NBFCs that on-lend to finance agriculture, small businesses and homebuyers. And finally, a reduction in the risk weight for consumer loans (except credit cards) to 100% (from 125%). This follows several other initiatives in recent months to boost lending, including harmonising risk weights on NBFC exposure, allowing banks to raise additional liquidity by selling excess government securities, and a partial credit guarantee from the government on banks’ asset purchases from NBFCs.
The non-banking financial services sector, historically an important provider of consumer loans in India, is under significant funding pressure as investors shy away following the default of Infrastructure Leasing & Financial Services in 2018 and Dewan Housing this year. NBFC disbursements have declined steeply as a result, with knock-on effects to other sectors, particularly consumption. Reduced availability of financing has contributed to the slowdown in India’s auto sector, with vehicle sales in July falling 31% year-on-year, according to the Society of Indian Automobile Manufacturers.
Most banks will be reluctant to lend to weaker NBFIs as they are focused on conserving their limited capital while grappling with legacy bad loans and a new wave of deteriorating asset quality. The reduction in the risk weight for consumer loans will give a small boost to banks’ regulatory capital ratios. 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 increase in the single-exposure limit is likely to have a more significant effect on lending as it will allow some banks to lend significantly more to NBFCs. Large NBFCs, whose bank funding previously came from a handful of large banks, will be able to get additional funding from these and other banks as a result of the higher limit.