Banks have become the single largest borrowing source for non-banking financial companies (NBFCs) and the rising interconnectedness between the two sets of lenders may pose contagion risk going ahead, Reserve Bank of India (RBI) deputy governor (DG) Swaminathan J said in a panel discussion at State Bank of India’s (SBI) 2023 banking conclave on Thursday.
“The report on trends and progress banking said while the banking sector growth (credit) has been 12-12.5%, the growth in credit to services sector grew 20% and financing to NBFC sector grew 30% within services sectors, and it is not in this one year but we have seen same trend in last 2-3 years,” he said.
To be sure, currently the RBI is not witnessing any “alarming” situation as lenders’ all financial indicators are in “safe zone”, the DG said, but the regulator at the same time does want an extraordinary interconnectedness building up and later posing a contagion risk. The central bank had in November hiked risk weight on bank lending to consumer loan NBFCs by 25% to 125%.
Separately, the regulator in December said it will launch a framework for connected lending to prevent potential conflict of interest at banks and other lenders. FE reported on December 13 that the decision to revise the guidelines on connected lending may have been prompted by instances of lenders not complying with rules on loans to companies.
Swaminathan said despite RBI governor Shaktikanta Das asking NBFCs to broad-base their resources base, it has come to the regulator’s notice that certain NBFCs have a large lender group of banks to finance their requirements.
“We have also noticed that lender group consists of 20-30 lenders, at times 40 lenders, which you will be surprised to know. If you ask not so well rated NBFCs, their answer is banks do not want to give big limits,” he said.
Large NBFCs, meanwhile, say as they pre-sanctioned credit limit with a large set of banks, they will draw down funds only from the bank which offers the lowest rate. Banks, too, do not want to lose the chance to grow their loan book.
“In the process, it is becoming a loose game for everyone, because neither risk gets monitored at underwriting stage — because of large lenders group — and more importantly in post sanction monitoring, there is a complete dilution because everyone think the rest of world will take care (as there are 20-30 lenders),” he said.
Despite challenges, the RBI is unlikely to dictate NBFCs on how many banks can they have in their borrowing profile, as it would be a “prescriptive and restrictive” move, the DG said, adding that lenders must counsel among themselves on how to address the challenges.
It is imperative that their boards are free to fix suitable sectoral and sub-sectoral exposure limits and monitor them closely to avoid any sectoral concentration, adverse selection or dilution of underwriting standards.
Stressing on the need to have a robust IT infrastructure, he said it has become imperative for banks and payment system participants to ensure uninterrupted availability of various online and mobile banking channels at all times and pointed to the recent incidents of unscheduled downtimes inconveniencing several customers.
Flagging lower IT spends he said, it has also been observed that many banks have not been spending fully the budget earmarked for procurement of IT systems and IT security systems.
He also stressed on the need for banks and other ecosystem participants to have robust disaster recovery and business continuity plans in place and test them periodically.
Interest rate risk
The DG stressed that increasing net interest margin (NIMs) that banks are presently enjoying may not be sustained in the future when the interest rate cycle reverses. He said that as external benchmark linked loans will be re-priced much faster than deposits, it will result in a pressure on NIMs and eventually profitability.
“Therefore, apart from interest rate risk in the trading book, banks must be mindful of the interest rate risk in the banking book as well,” he said.
On the liabilities side, banks must manage the pricing and duration of their deposits while trying to diversify the sources and optimising the product mix of deposits. Excessive reliance on bulk deposits, he said, must be avoided as they are more sensitive to interest rate movements and perpetuate concentration risk while also eroding earnings.