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

Non-banking finance companies (NBFCs) are known for targeting niche loan segments and building business models around them. Stock market investors love this approach, and as a sector, NBFCs often enjoy a higher valuation — stock price to book value — than traditional banks.

While there is a risk on the asset or loan side of the balance sheet due to the concentration of portfolios, such as gold loans, infrastructure-focused loans, or microloans, there is an equal risk on the liabilities or funding side of the book. 

This risk became evident in early March 2023 when as many as four mid-sized US banks, including Silicon Valley Bank (SVB) and Signature Bank, failed as many depositors withdrew their funds in quick succession. These banks had parked their funds in long-term maturities to earn higher interest rates, which led to a crisis emerging from solely from the liabilities side.

The RBI is now concerned about the buildup of risk on the liabilities side, especially in the NBFC sector, which constitutes more than one-fifth of the banking sector. The past failures of large NBFCs like IL&FS, SREI Infra, and Dewan Housing show that risks can emerge from anywhere (assets or liabilities) and threaten financial stability of the entire system. There is also a cost of bailing out these large institutions. 

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 Rs 16.58 lakh crore and gross receivables of Rs 1.61 lakh crore as of the end of March 2024. "A breakup of their gross payables reveals that the bulk of funds were sourced from SCBs, followed by AMC-MFs and insurance companies," states the report.

The choice of instruments in the funding mix of NBFCs shows continued reliance on long-term funds. The NBFCs funding mix includes long-term loans provided by banks and alternative investment funds (AIFs), and long-term debt by  insurance companies and mutual funds (AMC-MFs), as well as commercial paper (CPs), which is mostly subscribed to by banks and mutual funds.

The banks' share in the funding mix of NBFCs has jumped from 47.5 per cent in December 2018 to 55.1 per cent in March 2024. Similarly, the long-term funds provided by banks and AIFs have increased from 40.7 per cent to 45.9 per cent in the same period.

Since NBFCs and housing finance companies (HFCs) are among the largest borrowers of funds from the financial system, with a substantial part of funding from banks, the failure of any NBFC or HFC could act as a solvency shock to their lenders and spread through contagion.

"By end-March 2024, the hypothetical failure of the NBFC with the maximum capacity to cause solvency losses to the banking system would have knocked off 2.29 per cent (2.72 per cent in September 2023) of the latter’s total Tier 1 capital, but it would not lead to the failure of any bank," states the RBI.

"Similarly, the hypothetical failure of the HFC with the maximum capacity to cause solvency losses to the banking system would have knocked off 3.87 per cent (4.34 per cent in September 2023) of the latter’s total Tier 1 capital, but without the failure of any bank," states the RBI.