RBI Financial Stability Report: Are Banks at a High Risk from NBFC Failures?

Synopsis: The RBI's Financial Stability Report highlights increased risk weights for bank funding to NBFCs to mitigate dependency risks. NBFCs pose significant risks due to their funding mix. Stress tests show potential solvency impacts but no bank failures. Regulatory vigilance is needed.

The Reserve Bank of India's (RBI) recent Financial Stability Report underscores a crucial move to mitigate risks associated with the banking sector's exposure to non-banking financial companies (NBFCs). By increasing the risk weights for bank funding to NBFCs, the RBI aims to reduce the dependency on this volatile funding mix.

NBFCs, known for their niche loan segments, often attract favorable stock market valuations compared to traditional banks. However, their concentrated portfolios, such as gold loans and infrastructure-focused loans, present significant risks on both the asset and liability sides. The failure of mid-sized US banks like Silicon Valley Bank and Signature Bank in March 2023, which was triggered by a rapid withdrawal of deposits and reliance on long-term maturities, highlighted the potential dangers from the liabilities side.

The RBI is increasingly concerned about the buildup of risks on the liabilities side of NBFCs, a sector that makes up more than one-fifth of the banking sector. Historical failures of large NBFCs such as IL&FS, SREI Infra, and Dewan Housing have shown that risks can emerge from various sources, threatening the financial stability of the entire system and incurring significant bailout costs.

As of March 2024, NBFCs are the largest net borrowers of funds from the financial system, with gross payables amounting to Rs 16.58 lakh crore and gross receivables at Rs 1.61 lakh crore. Most of these funds are sourced from scheduled commercial banks (SCBs), asset management companies (AMCs), mutual funds (MFs), and insurance companies. The funding mix indicates a continued reliance on long-term instruments, with bank funding increasing from 47.5% in December 2018 to 55.1% in March 2024.

The RBI's report highlights the potential for solvency shocks if an NBFC or housing finance company (HFC) were to fail, given their significant borrowing from banks. Stress tests indicate that the hypothetical failure of the most impactful NBFC would reduce the banking system's total Tier 1 capital by 2.29% by March 2024, while the failure of the most impactful HFC would reduce it by 3.87%. Despite these potential losses, no bank would fail as a result.

Overall, the RBI's Financial Stability Report indicates that while the banking sector is currently resilient, with improved capital ratios and reduced non-performing assets, the interconnectedness with the NBFC sector poses significant risks. The report calls for continued vigilance and prudent regulatory measures to safeguard financial stability.