IMF raises concerns on NBFCs’ over-exposure

Context: A recent report by the International Monetary Fund (IMF) titled “India Financial System Stability Assessment” highlighted that stress in the Non-Banking Finance Companies (NBFCs) may pose risk in the financial system due to their overexposure to the power and infrastructure sector.

Relevance of the Topic: Prelims: NBFCs Mains: NBFCs- Risks and Way forward

Findings of the IMF Report

• NBFCs Over-Exposure:
  • NBFCs (particularly infrastructure financing companies) have an excessive concentration of loans in the power sector, which has been historically plagued by structural inefficiencies.
  • In FY24, 63% of power sector loans were from the three largest Infrastructure Financing Companies. This increased from 55% in 2019-20. 
• Dependence on Market Instruments and Bank Borrowings:
  • In Q2 FY24, 56% of power sectors’ lending was financed by market instruments and only the rest by bank borrowings.
  • Since FY19, the dependence on bank borrowings for financing their lending has increased, raising systemic risk. 
  • State-owned NBFCs like IREDA are at a higher risk.
• Limited Regulatory Support compared to Banks:
  • Unlike banks, NBFCs cannot accept demand deposits and their funds are not insured.
  • They lack direct access to RBI’s liquidity facilities, making them more vulnerable to financial shocks.
• Cascading Effect:
  • NBFC distress could have cascading effects across the financial system due to their deep inter-linkages with banks, mutual funds, and corporate bond markets.
• Spillover Effect on Banks and Financial Markets:
  • Any financial distress in NBFCs could amplify stress across the banking system, leading to liquidity crises in mutual funds and bond markets.
  • Past crises, such as IL&FS and DHFL collapses, demonstrated how NBFC failures impact the broader economy.
• Regulatory gaps for State-owned NBFCs:
  • State-owned NBFCs dominate the sector, with three government-backed Infrastructure Financing Companies (IFCs) holding one-third of total NBFC assets.
  • Unlike private NBFCs, state-owned entities are not subjected to large exposure limits, raising regulatory concerns.
• Regarding status of Public Sector Banks:
  • In the event of a stagflation, public sector banks (PSBs) may have difficulties maintaining a capital adequacy ratio (CAR) of 9%.
    • CAR is the ratio of capital to risk-weighted assets, used to measure the bank’s ability to absorb losses. 
    • RBI mandates a 12% CAR for PSBs and 9% CAR for Scheduled commercial banks.
  • Though the likelihood of stagflation had receded in 2024, geopolitical risks and monetary policy miscalibration of major central banks could result in an increase in interest rates, which could slow economic growth.
  • PSBs are relatively more vulnerable because they have lower initial CARs and are more sensitive to credit risk.

Read More: Non-Banking Financial Company (NBFC) Sector 

IMF Recommendations

• PSBs should strengthen their capital base, including by retaining their earnings instead of paying dividends to the government. This can ensure they support economic recovery in a potential future downturn. 
• Regulatory parity: State-owned NBFCs should have the same regulatory burden as private sector NBFCs to create a level playing field.
• Reducing over-reliance on Market instruments: NBFCs should diversify funding sources to reduce dependence on market instruments and bank borrowings.
• Strengthening liquidity regulations: NBFCs, particularly those with significant infrastructure exposure, should comply with stricter liquidity norms to avoid asset-liability mismatches.
• Enhanced Data sharing and Risk monitoring: Regular monitoring of NBFCs’ lending patterns and improved risk management frameworks are needed to prevent financial disruptions.
• Prioritising financial stability over developmental motives: The government should balance financial stability with the developmental role of banks and NBFCs.