RBI Financial Stability Report: Are banks at a high risk from NBFC failures?

Non-banking finance companies (NBFCs) have carved a niche by targeting specific loan segments, crafting specialized business models that attract stock market investors. Consequently, NBFCs often enjoy higher valuations, measured by stock price to book value, compared to traditional banks.

However, NBFCs face significant risks on both sides of their balance sheets. On the asset side, the concentration of portfolios, such as gold loans, infrastructure loans, or microloans, poses risks. Equally concerning is the risk on the liabilities or funding side. This vulnerability was starkly highlighted in early March 2023 when four mid-sized US banks, including Silicon Valley Bank (SVB) and Signature Bank, failed due to rapid withdrawals by depositors. These banks had invested heavily in long-term maturities to earn higher interest rates, leading to a crisis that stemmed from their liabilities.

The Reserve Bank of India (RBI) is increasingly worried about the growing risk on the liabilities side, particularly in the NBFC sector, which makes up more than one-fifth of the banking sector. The past collapses of large NBFCs like IL&FS, SREI Infra, and Dewan Housing illustrate that risks can originate from both assets and liabilities, threatening the financial stability of the entire system. Additionally, bailing out these large institutions is costly.

According to the RBI's latest Financial Stability Report, NBFCs were the largest net borrowers of funds from the financial system, with gross payables of ?16.58 lakh crore and gross receivables of ?1.61 lakh crore as of the end of March 2024. The report notes that most of these funds were sourced from Scheduled Commercial Banks (SCBs), followed by Asset Management Companies-Mutual Funds (AMC-MFs) and insurance companies.

The funding mix for NBFCs reveals a continued reliance on long-term funds, including long-term loans from banks and Alternative Investment Funds (AIFs), and long-term debt from insurance companies and mutual funds. Additionally, NBFCs utilize commercial paper (CPs), primarily subscribed to by banks and mutual funds.

Given that NBFCs and Housing Finance Companies (HFCs) are among the largest borrowers of funds within the financial system, a failure of any significant NBFC or HFC could create a solvency shock for their lenders, potentially spreading through the financial system via contagion.

The RBI report highlights that, as of the end of March 2024, the hypothetical failure of the NBFC with the highest potential to cause solvency losses to the banking system would reduce the banking sector’s total Tier 1 capital by 2.29% (down from 2.72% in September 2023). However, this would not cause any bank to fail. Similarly, the hypothetical failure of the HFC with the maximum potential to impact the banking system would reduce total Tier 1 capital by 3.87% (down from 4.34% in September 2023), again without leading to the failure of any bank.

In summary, while the RBI acknowledges the significant risks posed by NBFC failures to the banking system, current assessments suggest that these notable risks are manageable without causing bank failures.

Rewritten by : FinCrif Credit Score Analytics Based Digital Personal Loan Marketplace.