The slowdown that began among India's non-banking financial companies (NBFCs) is spreading. Sectors that had come to depend on credit from NBFCs are posting awful numbers. Insurance is slowing and real estate is troubled. The automobile sector -- which contributes half of India's manufacturing output -- is shrinking as stressed NBFCs prioritise survival above lending growth.

Naturally, Prime Minister Narendra Modi’s government is worried. But it, and the Reserve Bank of India (RBI), should avoid any attempt to succour the NBFC sector with liquidity. Giving NBFCs the false appearance of health would only increase, not decrease the chances of a systemic crisis.

RBI Governor, Shaktikanta Das, warned that the central bank sees some signs of fragility, particularly in NBFC that are exposed to the housing sector. The question is what to do about it. On the one hand, Das sought to reassure investors that the RBI would prevent another large NBFC from collapsing. (The current crisis was set off when highly connected Infrastructure Leasing & Financial Services Ltd defaulted last year). On the other hand, he said, if NBFCs have undertaken certain governance practice and certain ways of function and they have to a price for it, they will have to pay a price for it.

If those two statements do not quite seem to go together, that is because Indian policy-makers and businesses are split over the right course of action. Many executives and some ruling-party politicians concerned about growth, would like to see the sector bailed out. Anil Ambani, a tycoon with a large stake in financial services, has said that NBFCs are in intensive care and, in the ICU, if you want to save the patient, what is needed is not Paracetamol but full life support.

But many regulators correctly doubt that is the best strategy. NBFCs have come to occupy a space in the Indian economy for which they were not built. Some of them gorged on money raised from the public -- from state-owned banks or debt mutual funds -- to lend to long-tenure projects, some of them in politically exposed sectors such as real estate or infrastructure. NBFCs filled this niche by default: The government is short of money, there is no real corporate debt market in India, and the traditional banking system was burdened with bad loans.

Policy-makers have responded cautiously thus far. The Centre has set aside a large amount of money to recapitalise state-run banks, which many hope will mean they start lending again to liquidity-starved NBFCs. (In some sense, that is making a virtue out of a necessity: Basel requirements and their own bad-loans crisis meant banks needed the capital anyway.) To encourage state-owned banks to help clean up the NBFCs balance sheets, the government has also announced that it will partially guarantee their purchase of securitised pools of NBFC assets.

On the other hand, the restrictions on that guarantee are stringent enough for some analysts to declare its too weak. Fitch points out that that struggling NBFCs may still have to fend for themselves.

The only solution

Lets be clear: If the sector has to survive and be useful, some of the NBFCs will have to die. The regulators and politicians are generally terrified of anything shutting down, whether its a bank or an airline or a real estate company. But, in this case, they will have to stand by as it happens -- and, in some cases, administer the lethal injection themselves.

What is important is to ensure those failures do not bring down the entire financial sector. There is a reason to believe that is possible. In China, for example, smaller banks and NBFCs fueled growth for years. As in India, the markets generally believed that regulators would never let them collapse. But the Chinese authorities takeover of Baoshang Bank Co in May this year shows that such systemic inconsistencies have a sell-by date.

This new granularity in how lenders are treated is exactly what India needs as well. Indian investors should not be led to believe that the government or the RBI stands as a backstop behind sectors indulging in risky lending; that would mean that finance is not doing its job of correctly measuring and pricing risk. A few quarters of pain in sectors that depend upon shadow financing is a small price to pay to produce a sector that winds up doing its job efficiently and sustainably.

(Mihir Sharma is a Bloomberg Opinion columnist)