Monetary policy contraction shock leads to riskier NBFC lending: Report

A contractionary trajectory in the monetary policy has led to a build-up of risk in NBFCs’ portfolios due to an increase in the share of unsecured loans, according to the Centre for Advanced Financial Research and Learning (CAFRAL)’s ‘India Finance Report 2023’.

“The evidence also shows risk build-up on the assets side of the NBFC balance sheet due to a fall in secured loans and advances, even as unsecured ones have increased marginally,” the report said.

The report, released by RBI Governor Shaktikanta Das on Tuesday, is themed ‘Connecting the Last Mile’ and provides an in-depth assessment of Indian NBFCs.

Analysis of annual and quarterly time series data between FY06 and FY23 reflects increased risk-taking by NBFCs following a monetary policy contraction. During the pandemic, the central bank cut the policy repo rate to 4.0 per cent from 5.15 per cent between March and May 2020. The rate remained at that level for two years, before being increased to 6.50 per cent between May 2022 and February 2023.

Following a contractionary monetary policy action, NBFCs face higher demand for credit as bank credit supply falls. NBFCs’ ability to meet this demand hinders monetary transmission.

As banks cut down on lending, NBFCs cater to the increased demand, but mainly to risky borrowers, which leads to advances falling slower than the total shrinkage in the balance sheet, the report said, adding that monetary policy has to then take this increased systemic risk into account. In fact, loans tend to grow for the first two years, and then start shrinking from the third year onwards.

“There is evidence that the loans and advances part of the NBFC balance sheet becomes more risky, following a contractionary monetary policy shock. Unsecured loans drive the initial increase in loans and advances, and the impact on this sub-component is not negative throughout the estimation horizon. In contrast, secured loans fall considerably faster, and the estimated co-efficient is negative throughout.”

In addition, there is also a rise in risk-taking behaviour in other asset components such as capital market exposure, wherein equity share ownership tends to increase, whereas other assets fall for about four years following a policy contraction.

On the liabilities side, monetary policy shock usually leads to a sharp fall in secured borrowings and a marginal increase in unsecured borrowings, showing increased exposure to riskier finance.

“Both secured and unsecured bank borrowings fall and unsecured debentures increase. There is also a significant fall in reserves and surplus, indicating that buffers grow thinner,” the report said, adding that evidence shows that non-deposit taking NBFC balance sheets contract in the long run following monetary contraction.

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