Too close for comfort: Why banks and NBFCs will be hard to pull apart
What does rising interconnectedness between banks and NBFCs mean for India?
Did you know that globally, banks are the largest recipients of funds from non-banking financial institutions (NBFIs)?
According to the Financial Stability Board’s Global Monitoring Report on Non-Bank Financial Intermediation, in 2021, banks drew a significant portion of their funding from NBFIs in various countries. For instance, in South Africa, NBFI funding accounted for more than 30% of total bank assets. Similarly, in Luxembourg and Chile, banks’ use of funding from NBFIs was over 20% of their total assets. The corresponding number for Australia, Brazil, Korea, Switzerland and Argentina was over 10%!
The FSB’s data also points out that interconnectedness between banks and other financial institutions, viewed from this lens, has been steadily falling since 2013. (This change is slow, and the report shows that banks’ overall use of funding has not changed significantly across these international jurisdictions.)
However, latest RBI data shows something of interest – India seems to be bucking both these global trends.
In India, banks are net lenders to NBFIs.
The interconnectedness between them has been increasing.
At this point, I would like to make a critical distinction. The FSB report defines NBFIs to include non-bank lending institutions, insurance companies, pension funds, and other financial intermediaries.
But when we speak of interconnectedness in India’s context, we refer primarily to banks’ interconnectedness with Other Financial Institutions (OFIs), such as non-banking financial companies (NBFCs) and Housing Finance Companies (HFCs).
Financial institutions like NBFCs and HFCs account for nearly 89% of banks’ exposure in India. They are also the largest borrowers from India’s financial ecosystem.
(Source: RBI)
This interconnectedness between banks and NBFCs in India is mainly direct. At the end of March 2023, 88% of banks’ exposure to NBFCs was primarily through direct lending. The remainder could be attributed to indirect exposure through commercial papers and debentures issued by NBFCs.
(Source: RBI)
What does this increased exposure of banks to NBFCs entail for the banking system and the overall economy?
Let’s review.
The pros
Improved exposure to overlooked sectors
In India, household savings are the largest source of funding. Banks have access to this huge, cheap funding source, allowing them to distribute credit at competitive rates compared to NBFCs.
Moreover, banks cannot lend to specific segments such as the informal economy and MSMEs, due to strict regulatory oversight. Other segments are also unattractive to banks because of lower credit risk appetite, high operating costs, or lack of documentation that begets an inability to underwrite.
As a result, NBFCs are forced to serve segments where they can compete with banks’ low cost of credit. They also cover ground lost by banks and cater to underserved niche segments inaccessible to banks due to regulatory and operational reasons.
By sourcing funds from banks, NBFCs can tap into their access to cheap deposits and extend credit to loan-starved segments. This has also given rise to a more formalised framework for co-lending. This mechanism has been a resounding success, and may explain the growing interconnectedness between banks and NBFCs in India, even though it continues to decline in other countries.
The shock-resistant core-periphery model
Such interconnectedness facilitates better credit flow in the economy and lays the foundation for a more resilient banking system. It creates a core-periphery model, which allows the banking system to withstand shocks.
Banks’ risk-taking impacts the core-periphery structure, and vice versa. In times of crises, this model gives banks insurance against high-risk investments because government bailouts are often designed for systemically important banks.
Banks tend to use these funds to pay interbank claimholders higher rates of return than what they would earn on their own assets, which insures claimholders against losses from these important banks. This means that systemically important banks can maintain their value through liabilities even during crises because the government guarantees them.
The cons
While creating such a firewall between core and peripheral financial institutions can help the system better tide over crises, there might be more to the issue than meets the eye.
In a recent paper, Joseph Stiglitz and Levent Altinoglu explain that the interconnectedness and high risk-taking reinforce each other, creating an adverse feedback loop.
Arrow 1 – Risky banks become systemically important
Government-backed surety allows important banks to continue enjoying investments even in times of crises. They become larger and interconnected, even though their portfolios are highly risky.
Arrow 2 – Risk-taking by peripheral banks
The insurance of an important bank’s liabilities leads to peripheral financial institutions concentrating their resources on risky assets backed by bailout funds, even when such funds offer no direct benefit to these less-important financial entities.
Arrow 3 – Peripheral banks’ desire for insurance against crisis risk
Financial institutions on the periphery have a desire to be insured against risk. So, they end up investing in systemically important banks to benefit from the insurance provided to them by governments in times of crises.
As a result, the concentration of government bailout resources in only systemically essential banks leaves financial institutions on the periphery vulnerable.
Conclusion
Apprehensions around growing interconnectedness between banks and NBFCs are being voiced. A few months ago, RBI governor Shaktikanta Das flagged the “contagion risks” that might arise from such arrangements -
"Given the increasing importance of NBFCs ,the increasing interconnectivity between banks and non-banks merits close attention. NBFCs are large net borrowers of funds with exposure from banks being the highest.”
However, overly cautious measures to curb the spread of potential contagion is a precarious proposition. It would strike at the heart of collaboration and partnership between financial institutions that have, with a bit of help from financial technology, come to define the financial landscape of the country.
Quarantining systemically important banks and peripheral institutions from one another is a rather utopian submission. Allowing them to fall like dominoes is the recipe for a crisis.
Financial institutions have never been as interconnected as they are today, and engage in economic activities that involve varying degrees of risk. The only solution is to maintain healthy porosity between them by employing a framework at the intersection of finance, policy and technology.
Cheers,
Rajat