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The RBI wasn’t giving us false warnings when it woke up to systemic risks associated with reckless uncollateralised retail lending by banks and NBFCs. Following the initial regulatory tightening starting in November 2023 it was predictable that the intensity would increase.
Now, there have been actions against specific finance companies involved in rigging up prices of IPOs and debt instruments using the lending route. Recently, even SEBI has initiated tighter surveillance on MFs regarding their exposures, specially regarding small- and mid-caps (SMID).
The central bank has also tightened the screws on fintech companies leveraging digital lending and payments aggregator space using co-branded credit card business. These measures have triggered a fall in the equity markets.
It would be naive to consider these episodes as isolated; a sharper decline in financial asset prices can cause capital erosion thereby triggering a chain reaction. Compared to the 2017-18 SMID meltdown, the current situation looks more vulnerable. Unlike the previous episode, which was dominated by investment through mutual funds, the current exuberance is pivoted on greater direct retail participation catalysed by the digitisation boom.
NBFCs face a double whammy as RBI increased risk weights for both bank exposures on NBFCs and separately on retail lending of NBFCs as well. The latest actions are a fallout of company-specific surveillance.
Earlier, RBI had also warned about the over-reliance of NBFCs on borrowing from banks and over-exposure of banks in the NBFC sector. NBFCs form the biggest chunk of services sector lending of banks; it is de facto retail lending. As the risks come to the fore, more actions may follow, impacting the BFSI space.
These regulatory actions may impact bank lending to NBFCs, resulting in higher credit costs.
Bank factor
Will banks be insulated? The view that banks will benefit from the RBI actions by gaining market share from NBFCs is a simplistic one. The RBI is concerned about reckless uncollateralized lending, including that by banks. Will that be reflected in the next Financial Stability Report?
What happens to the NBFC portfolio will have a spillover effect on banks as well. Lending to NBFCs typically serves as a via media to earn higher yield without taking the underwriting risk, even as NBFCs are growing their uncollateralized retail portfolio.
In addition, the rising defaults as a result of credit tightening would also have a spillover effect on banks if defaulters have borrowed from both NBFCs and banks. In fact, a recent CAFRAL study shows that interconnection between banks and NBFCs has been growing significantly. This heightening interconnection has been due to the various support mechanisms allowed by RBI, including the LTRO and TLTRO instruments, in the post-Covid era allowing banks to buy asset portfolios of the NBFCs.
CD ratio
Separately, RBI is also working towards reducing the elevated credit deposit (CD) ratio of the banking sector, accentuated due to lagging deposit growth and exuberant retail lending. Our estimates show that the systemic CD ratio has risen closer to 80 per cent or a 30-year peak (adjusted for the recent HDFC merger); bank-specific data shows that for most large banks the CD ratios have risen by 700-800 bps over the past 24 months.
Including credit, investments in government bonds, and cash, the overall allocation has risen close to 115 per cent, which is also a peak (ex HDFC merger). Hence, it is quite unlikely that banks can further increase their credit-deposit ratio by gaining market share from NBFCs even as they reduce lending to NBFCs. On the contrary, they may also see their exuberant retail lending slowing, due to rising default risk and the tightening measures initiated by the RBI.
The widening web of regulatory tightening by the RBI and SEBI forebodes that the next financial stability report of the RBI would be far more nuanced than the usual “all is well” grandstanding.
As the readjustment process unfolds, sectors dependent on leveraged spending may slow down. India’s private final consumption expenditure has been growing modestly at 3.0-3.5 per cent, much lower than the estimated real GDP growth of over 8 per cent and despite the exuberant retail lending. Consumption demand might start aligning with a lower growth path determined by by household real income situation.
Sinha is Co Head of Equities & Head of Research - Strategy & Economics, Systematix Group
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