RBI warns on growing bank-NBFC linkage, pushes for greater governance

NBFC-banks interlinkages pose financial stability risks

The share of non-bank financial companies in total bank credit is less than 10 percent. Add other instruments such as commercial papers and bonds of NBFCs that banks subscribe to, and the total exposure remains below 10 percent. NBFCs reported a stellar 67 percent jump in net profit in FY23 and a healthy 34 percent growth for April-September of FY24.

Why is then the Reserve Bank of India worried about financial stability and the interconnectedness between banks and non-banks?

Indeed, the regulator’s unease comes through clearly in the latest report on the trend and progress of banking in India. The RBI has urged non-banks to diversify their sources of funding away from banks. As such, the recent measures such as increase in risk weights on bank loans to NBFCs shows the central bank’s worry.

One reason is that India has been an outlier in this regard relative to the global trend. “First, banks remain globally net borrowers from NBFIs. Second, the interconnectedness between them has continued to fall. The opposite holds true for India,” the RBI said. Further, this interlinkage has been growing in recent years.

Secondly, one only has to recall the NBFC crisis five years ago triggered by the collapse of IL&FS which eventually caused damage to even banks. At that time, the damage was manageable owing to limited exposure of banks. This is not the case today.

Then there are instances of mispricing of risk by banks noticed by the regulator. A more serious offence flagged by the RBI has been that of evergreening of loans through the alternative investment funds (AIF) route, measures to mitigate this have also been announced. The evergreening through AIFs was more prevalent among NBFCs than banks.

It is understandable why the RBI wants lenders to tighten their governance standards in the interest of financial stability. The risks of a contagion effect from NBFCs onto bank balance sheets is higher today than before.  The hike in risk weights on bank loans to NBFCs announced in November should encourage better pricing of risks by banks. That means NBFCs will need to pay higher interest rates which could push them towards the friendlier bond market (the spread over government bond yields is still lower than pre-pandemic levels).

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NBFCs have piled on more risk on their balance sheets. In FY23, unsecured loans grew by 28 percent and their share in total NBFC credit rose to 30 percent. NBFCs are big lenders to micro, small and medium enterprises (MSME) and this segment grew by a staggering 42 percent in FY23 for NBFCs. While the overall gross bad loan pile has come down for NBFCs but delinquencies in loans to medium industries remained elevated at a massive 19 percent. NBFCs also saw their restructured loans increase to 3.7 percent of their book in FY23 from 2.4 percent in FY22.

The upshot is that even as bank lending to NBFCs grew at a fast clip, the risk on NBFC balance sheets also increased. The regulator is bound to recognize this as early signs of vulnerability. As such, the RBI has introduced the scale-based regulation (SBR) for NBFCs that categorises lenders into four groups based on their size. “With the implementation of SBR, there is a need for further enhancing governance and internal audit standards of NBFCs,” the RBI said in its report.

The RBI wants all regulated lenders to fortify their governance framework and risk management. On its part, the central bank is readying several measures including harmonizing regulation to strengthen governance.

Unlike elsewhere globally, India’s NBFCs offer the critical last mile link to unbanked areas and segments that banks perceive as economically unviable or risky. NBFCs have been lending more in rural and semi-urban centres and towards segments such as microfinance, farming, small businesses and unsecured loans. A stable and strong NBFC sector will ensure the credit aspirations of unbanked areas are met without the risk of accidents in the future.