Financial Stability Report: Contagion Risk From NBFCs Falls, Says RBI

The risk of a contagion or losses to Indian banks in case a non-bank lender fails has reduced over the last six months as these entities improved their borrowing strategies.

Non-bank financial and housing finance companies are the two largest borrowers of funds in the financial system. So, a failure of any NBFC or housing finance companies can lead to a solvency shock to banks and other lenders, the Reserve Bank of India said in latest edition of Financial Stability Report.

“The solvency losses caused by these shocks can further spread due to direct linkages among the lenders or due to an information contagion,” the RBI said. But the situation today is better than six months ago when the RBI released its FSR in June.

In June, the RBI had predicted that a failure of an NBFC would lead to 2.7 percent loss in the Tier-1 capital of the banking system and a failure of a housing finance companies would lead to 5.8 percent loss in the Tier-1 capital of the banking system. Also, the central bank had said that at least one bank would fail in case a large institution, of either type, failed.

But in its latest report, the RBI lowered its projection. It now expects the failure of an NBFC and mortgage lenders to lead to a loss of 2.5 percent and 4.6 percent, respectively, of Tier-I capital of the banking system.

Shift In Borrowing Mix

Share of commercial bank funding to NBFCs increased during 2018-19 but declined marginally in the first half of the ongoing fiscal, the RBI said. Mutual fund borrowings for the sector has been declining over the last few quarters.

NBFCs obtained around 48.4 percent of funds from commercial banks, followed by 26 percent from mutual funds and 21.3 percent from insurance companies, the report said. NBFCs and housing finance companies borrowed around Rs 8.3 lakh crore and Rs 5.9 lakh crore, respectively, as of September 2019.

“The choice of instruments in the NBFC funding mix clearly shows the increasing role of long-term loans (provided by banks and alternative investment-funds) and a declining share of commercial papers and long-term debt,” the report said.

Long-term debt, long-term loans and commercial papers were the top three instruments through which non-bank lenders raised funds from the financial systems in the last six quarters, it said.

The falling reliance on commercial papers and short-term debt imply that non-bank lenders have lowered their asset-liability mismatch over the last year and a half. That reduces the risk of failure of NBFCs and housing finance companies due to solvency issues and thereby, lowering the contagion risk to the wider financial system.