Lending risks

Interconnectedness must be watched carefully

Risks in the financial system often grow when the going is good. It is thus important for financial regulators to carefully monitor such possibilities. The Reserve Bank of India (RBI), having dealt with the twin balance sheet problem over the last decade, now seems unwilling to take chances, which must be welcomed. As RBI Governor Shaktikanta Das noted last week, there is no immediate cause for worry, but banks and non-banking financial companies (NBFCs) would be well advised to take certain precautionary measures. While the asset quality and capital adequacy of these institutions have improved in recent years, the increase in credit growth, particularly in the retail sector, warrants caution. The RBI, in fact, increased risk weighting for unsecured credit earlier this month to moderate the pace of growth. The move was also endorsed by the government.

In this address, Mr Das raised several important issues, such as interconnectedness between banks and NBFCs, and their collaboration with fintechs in providing financial services. The interconnectedness between banks and NBFCs indeed needs attention. NBFCs are expanding their balance sheets with increasing dependence on banks for funds. NBFCs not only borrow directly from the banking system, but banks also subscribe to their debt issuances. As a result, according to the RBI’s latest Financial Stability Report, bank borrowing as a share of the total borrowing of NBFCs was at 41.2 per cent in March 2023, compared with 35.6 per cent in March 2020. This suggests that banks are shifting part of their lending business towards NBFCs. As a recent report by the Centre for Advanced Financial Research and Learning noted, the share of NBFCs in the retail space expanded by 1.8 times between 2015 and June 2022. Although banks may have given space to NBFCs, a potential increase in risk in the NBFC sector will directly affect the banking system.

Further, fintech firms are being used to extend credit. As Mr Das emphasised, banks and NBFCs need to be careful in relying on algorithms, and the models must be tested and retested. Fintech firms, supported by banks and NBFCs, tend to depend on the cash flow of borrowers. It is thus possible that fintechs are actually leading the way in financial inclusion by using the data generated by digital transactions to extend credit to borrowers who were out of the formal financial system. However, it has been reported that some borrowers are borrowing from multiple sources, which could create repayment issues, and need to be watched. It is thus important that this new phenomenon is properly studied and understood.

The RBI is justified in expressing concern about developments in the financial system and taking regulatory measures to control the pace of credit growth, although the actual impact remains to be seen. In the context of increasing interconnectedness between banks and NBFCs, it is worth debating if the lack of actual competition in the banking system is prompting it to simply lend to NBFCs and avoid the hard work. For the system, what this means is NBFCs’ interest margins get added to banks’ interest margins, which in any case are high, and push up the overall cost of credit in the economy. Thus, while fintech-driven lending needs to be monitored, the reasons for increasing interconnectedness between banks and NBFCs should also be probed.