India Finance Report on NBFCs

Source: The post is based on the article “India Finance Report: A warning against repeating past mistakes” published in “Indian Express” on 10th November 2023.

Syllabus: GS3- Indian economy- mobilisation of resources (banking sector)

News: The article covers a CAFRAL report on India’s NBFCs, noting their improved capital and asset quality. It also expresses worry about increased bank funding for NBFCs, emphasizing potential systemic risks. This underscores the need for regulatory action due to recent monetary policy shifts and the NBFC sector’s significance in India’s economy.

What are NBFCs?

A Non-Banking Financial Company (NBFC) is a registered entity under the Companies Act, 1956, specializing in activities such as lending, investing in financial securities, leasing, and insurance. It excludes primary operations related to agriculture, industry, goods trading, or property transactions. NBFCs are commonly referred to as “shadow banks” because they operate similarly to banks but have fewer regulatory restrictions.

Read more about NBFCs

What is CAFRAL?

Centre for Advanced Financial Research and Learning (CAFRAL) is an independent body established by the Reserve Bank of India. It conducts research and provides insights into India’s financial sector, including non-bank financial companies (NBFCs). The CAFRAL report on India’s NBFC sector reveals noteworthy trends:

1. Stronger Capital Position:The report indicates a significant rise in the Capital to Risk-Weighted Assets Ratio (CRAR), soaring from 22.9% in 2019-2020 to 27.6% in 2022-23. This shows improved financial stability.
2. Enhanced Asset Quality:Both gross and net non-performing asset (NPA) ratios have consistently decreased, indicating healthier loan portfolios.
3. Economic Importance:The NBFC sector’s vital role in supporting India’s economy, particularly MSMEs, is emphasized. It served as a crucial support system post-2008 Global Financial Crisis, providing credit when banks struggled with NPAs.

What concerns does the CAFRAL report raise?

1. Rising Bank Financing for NBFCs: The report is concerned about the increasing reliance of NBFCs on bank financing. This means that NBFCs are borrowing more from traditional banks to fund their operations. The concern here is that if these NBFCs face financial stress or defaults, it could potentially impact the stability of the banking sector as well, leading to a broader financial crisis.
2. Systemic Contagion Risk:The report emphasizes the need for preventive measures to address the risk of systemic contagion. This means that problems in one NBFC could spread to other financial institutions or even the broader economy. For example, if one NBFC faces a crisis, it might trigger a chain reaction of financial problems across the sector, affecting the real economy and people’s livelihoods.
3. Monetary Policy Shocks:The report recognizes the recent shifts in monetary policy, from loose to tight, in response to rising inflation. These abrupt policy changes can catch businesses off-guard and impact the sector.

Terminology used

Capital to Risk-Weighted Assets Ratio (CRAR): It represents a bank’s capital in relation to its risk. In essence, it measures a bank’s capital against its risk-weighted assets and present liabilities. This ratio plays a crucial role in safeguarding depositors and enhancing the effectiveness and stability of global financial systems.

NPA: A non-performing asset (NPA) is a loan or advance where the borrower has not made the principal or interest payment for a duration of 90 days or more.

Question to practice

The increased reliance of NBFCs on bank financing has the potential to destabilize India’s financial sectors? Discuss