India’s Non-banks Emerge from the Shadows

By Cindy Li and Sean Creehan

Discussion of shadow banking in Asia is often dominated by developments in China. By one measure of its sheer size, China accounts for 60 percent of shadow banking assets in Asia. But the Financial Stability Board’s February 2019 Global Monitoring Report on Non-Bank Financial Intermediation—a new annual exercise that replaced the Global Shadow Banking Monitoring Report—has shed new light on the noteworthy growth in other emerging Asian economies, like India. India’s non-banking financial companies (NBFCs) in particular were found to be among the fastest growing in the world. Meanwhile, the bankruptcy of a large Indian NBFC in 2018 has put the sector under media scrutiny. Despite increasing risks to growth, India’s NBFC sector is still on track to expand at a rapid pace in coming years, in part because it plays an important role in the financial system.

Who are India’s NBFCs?

While India’s NBFCs are often loosely referred to as shadow lenders, that catch-all term does not capture the sector’s diversity. NBFCs in fact encompass a wide range of non-bank financial institutions that employ a range of business models: asset-based finance, direct investment, and traditional lending, to name a few. Not all NBFCs need a license from the Reserve Bank of India (RBI), and many are not subject to the central bank’s supervision. As one example, Housing Finance Companies, non-banks that specialize in real estate sector loans are not included in RBI statistics measuring the industry.

This market is highly fragmented with a total of more than 10,000 non-bank lenders at yearend 2018. As of March 2019, 265 NBFCs were designated as systemically important by RBI as their assets exceed the 5 billion rupee ($72 million) threshold. Systemically important non-bank lenders constitute 84.8 per cent of the NBFC sector’s total assets, while the vast majority of NBFCs are small lenders.

Rapid Growth of a Systemically Important Industry

As an industry, NBFCs are systemically important players in India’s financial system. In the twelve months ending in March2018, they provided 19.2 percent of total lending in India, up from 15.2 percent three years ago. The industry had a combined balance sheet of more than $370 billion in assets as of September 2018.

NBFCs’ loan book grew rapidly in recent years as commercial bank lending slowed significantly due to bad loan workouts. As of 2018, Indian banks have an estimated $190 billion of bad loans that are mostly concentrated in public sector banks. With the system-wide nonperforming loan ratio highly elevated, at 10.8 percent as of end-2018, commercial banks are under tremendous pressure unload bad loans, which weigh on earnings and create pressure for recapitalization in lieu of new lending. As of end-2018, 11 out of 25 public-sector banks were placed under prompt corrective actions (an RBI framework for banks with weak financial conditions); they are prohibited from expanding loan books until they have restored capital to a satisfactory level.

With bank credit shrinking, NBFCs stepped up to provide credit, with a particular focus on several sectors that have consequently become increasingly dependent on non-bank financing. As of fiscal year 2018, infrastructure, commercial real estate, and residential housing made up more than 70 percent of NBFCs’ loan portfolio according to one estimate. NBFCs also play an important role in extending credit to so-called priority sectors that are part of the Indian government’s directed lending policy, which mandates that 40 percent of all bank lending goes to sectors like agriculture, renewable energy, and small- and medium-sized enterprises. Banks that have difficulty meeting these targets—sometimes due to a mismatch between their competitive advantages and priority sector demands—may buy securitized loans to priority sectors issued by NBFCs to meet the quota. For example, India’s largest public sector bank, State Bank of India, formed an alliance with NBFCs to extend credits to priority sectors, a business model that the RBI has promoted since last year. While such partnerships may help meet the government’s overall directed lending targets, they increase the interconnectedness between the banking system and NBFCs, creating new vulnerabilities.

The High Profile Bankruptcy of the IL&FS

This rapid growth of India’s NBFC industry and its attendant vulnerabilities was highlighted by the high profile collapse of the Infrastructure Leading & Financial Services Limited (IL&FS) last year. The incident incurred an estimated $12.8 billion in investor losses and raised concerns on NBFCs’ financial soundness.

IL&FS was a large and complex NBFC with more than 250 subsidiaries whose business lines include investment management, financial services, and transportation operators. The company was known for several high profile projects such as the financing of India’s Chenani-Nashri Tunnel, the longest in the country. Two of IL&FS’s subsidiaries reported having trouble repaying loans and commercial paper in 2018, the Indian government stepped in to take control of the company in order to prevent contagion to the rest of the financial markets.

The incident bears the hallmark of a shadow banking crisis: IL&FS is a large, complex financial services group with opaque structure and operations, and it is not subject to the same level of prudential regulation as banks. By investing short-term funding sources in long-term infrastructure projects, IL&FS incurred what financial regulators might call a significant and risky maturity mismatch. Despite its vast size, IL&FS also lacked traditional banking backstops, most notably government-issued deposit insurance. The firm’s heavy use of leverage—with a debt-to-equity ratio of 16.8x, as of March 2018—amplified potential risks for its investors.

IL&FS relied on loans and commercial paper as sources of funds, and its failure has shaken investors’ confidence as they worry about the potential for serial defaults. NBFCs as a group subsequently saw their market value plunge even though IL&FS was the only one among them that actually defaulted. A number of mutual funds and banks that hold IL&FS debt—roughly $13 billion in total—faced significant market losses as agencies slashed ratings for companies that were part of the IL&FS Group.

In order to restore confidence and to alleviate the ongoing liquidity crunch in the NBFC sector, the RBI stepped in to facilitate bank lending. Meanwhile, the number of NBFCs has declined sharply over the past several quarters as the RBI proactively revoked licenses for small NBFCs who failed to meet RBI’s minimum net owned fund requirement.

Attached at the Hip, Ailing Banks Fill in Funding for NBFCs

Despite facing their own substantial asset quality issues, India’s banks have returned to fill a funding void caused by the downturn in market sentiment for NBFCs, which led to outflows in debt mutual funds, among other typical NBFC funding sources. According to Credit Suisse, as of the end of 2018, bank lending to NBFCs was up 55 percent year-over-year, accounting for roughly one-fifth of all new loans, and now 7 percent of total Indian banking sector loans. For some public sector banks, already ailing from exposure to other troubled sectors, lending to NBFCs is as high as 10-15 percent of banks’ total loan books.

Which Borrowers Have been Hurt the Most?

In real estate and construction, non-banks have provided essential funding, in excess of 55 percent of NBFCs’ portfolio, as of FY2018, for commercial and residential real estate combined. According to one estimate from Indian real estate analytics firm Liases Foras, the country’s largest 90 developers have $6 billion in annual debt service, but in aggregate have an interest coverage ratios of roughly 50 percent. With a decline in NBFC funding, these developers may find it difficult to restructure their debt, leading to financial distress. For both borrowers looking to purchase a home and recent buyers whose loans are based on base rates set by specific NBFCs, the liquidity crunch is raising the cost of housing substantially.1

As implied by the headline-grabbing troubles of IL&FS, an infrastructure-focused firm, NBFCs play a crucial role in infrastructure financing as well, representing roughly 25-30 percent of outstanding NBFC loans, according to varying estimates. Infrastructure borrowers have been at the center of longstanding asset quality problems, but India has huge infrastructure needs that have historically been supported in part by the NBFCs. Even the recovery of failed infrastructure projects relies on asset reconstruction companies, a type of NBFC. Indeed, the RBI was sufficiently concerned about the impact of an NBFC liquidity crunch on infrastructure that, in late 2018, it relaxed rules on mandated hedging of external commercial borrowings (i.e. foreign borrowing) by infrastructure companies and NBFCs that finance them.

For India’s small business owners, particularly women who represent the majority of Indian entrepreneurs, the liquidity crunch is limiting the availability of microfinance, with new microfinance loans down 15 percent quarter-over-quarter, as of December 2018.

Reassessing the Role of Non-banks in India’s Economy

The IL&FS incident not only revealed the vulnerabilities posed by India’s shadow banks to the broader economy, but also exposed the fragility of India’s financial system as its banks recover from a severe downturn in asset quality. A number of market sectors have become highly dependent on non-bank financing, in part because of demand unmet by banks still struggling to repair their balance sheets. In that sense, the recent NBFC liquidity crunch should be considered within the broader context of the country’s financial development.

The downturn among NBFCs provides an opportunity to reconsider the role they play in the financial system. At a minimum, observers can agree that investing short-term funding sources, such as commercial paper, in long-term assets like real estate and infrastructure is one historical recipe for financial crises, suggesting a need for effective prudential oversight of non-banks and their historical funding sources (e.g. mutual funds).

For lending to priority sectors like agriculture, NBFC loan securitization in theory enables banks to fund sectors they might not otherwise be able to directly bank, or at least not at the scale to meet their hefty quotas. As the world has seen in previous crises, loan securitization can encourage an overextension of credit, particularly when there is a complex connection between originators and eventual funders.

Going forward, Indian regulators will continue to face the challenge of evaluating the critical role that NBFCs currently play in the economic system. NBFCs have proven themselves to be an important source of credit to the economy as banks retreat from lending amid prudential regulation concerns. But the prominent role of NBFCs will also underscore risks inherent in non-bank lending activity, with attendant challenges for the country’s policymakers in safeguarding the stability of India’s broader financial sector.


1. As of April 2019, home loans in India made by banks must be set according to market benchmarks based on RBI regulations. NBFC-issued home loans may be based on a prime rate determined by the individual NBFC, which is therefore subject to the banks’ internal liquidity constraints.


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