Indian financial sector is facing rising risk of contagion and failure of any large finance company will adversely impact economic growth, S&P Global Ratings said in a report on Wednesday.
According to the report, a bank failure could disrupt interbank market, payments, hurt credit availability and adversely affect economic growth.
"India's finance companies are among the country's largest borrowers. A substantial part of this funding comes from banks. The failure of any large non-banking financial company or housing finance company may deliver a solvency shock to lenders," said S&P Global Ratings credit analyst Geeta Chugh.
Moreover, the failure of a large finance company may have other consequences, such as draining the credit available to the sector.
"This contagion runs the risk of spreading to real estate companies too. Finance companies are the largest lenders to this segment and any failure among such institutions could jeopardize credit flows to developers," the report said.
Given the seriousness of such risks, S&P expects the government to support systemically important institutions that get into trouble. The support is more likely to be available to banks rather than any finance company, it said.
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According to S&P, India's funding conditions remain fragile after the default of IL&FS, with a tight refinancing market and choppy equity markets, collectively making it difficult for institutions to raise capital.
"A bank failure in the current market could exacerbate risks. It may be cheaper for the government to support a bank than letting a shaky credit system undermine the economy," it noted.
In its base case, S&P expects that the resolution of weak finance companies will be "swift and orderly", and contagion will be managed.
The global financial services major however does not expect the contagion to impact public sector banks.
"While many public sector banks are weak, people draw comfort from their state ownership and the repeated demonstrations of government support for the institutions--for example through regular capital infusions," it said.
The report cited past cases of weak bank failures such as Global Trust Bank, Nedungadi Bank, United Western Bank, Bank of Rajasthan and Sangli Bank where there was "swift action that nipped contagion in the bud".
"In the currently fragile financial markets, government support and swift action are essential to maintaining system stability," the report 'Indian Financial Sector Braces For Fat Contagion Tail Risk' noted.