Wednesday, October 16, 2024
No menu items!
BusinessIncreasing Financial Interlinkages: Another Systemic Risk Concern?

Increasing Financial Interlinkages: Another Systemic Risk Concern?

  • Vipin Malik, Chairman & Mentor, Infomerics Ratings.
  • Sankhanath Bandyopadhyay, Economist, Infomerics Ratings.

The growing presence of Non-Bank Financial Intermediaries (NBFIs) and their inter-connectedness with the banking system has become a source of potential concern. As highlighted by the RBI Financial Stability Report Dec2023, NBFIs have overtaken traditional banks in asset size with the growth of the global bond markets from around US$ 40 trillion at the start of the millennium to US$ 152 trillion by the end of 2022. With this, vulnerabilities in bond markets have also increased, driven by surge in hidden leverage among NBFIs. Such leverage build-up is increasingly dangerous as it dilutes role of primary dealers and banks in market making as well as reducing liquidity in bond market especially in government bond market.

The rising silhouette of NBFIs in bond markets poses various challenges with implications for systemic stability. For instance, in March 2020, the US treasury market was impacted by losses of hedge funds, which had taken “large and hidden positions in treasuries through derivatives.” In September 2022, the actions of pension funds engaged in the liability-driven investment (LDI) strategies led to severe decline in gilt prices in the UK. In both instances, central banks had to intervene to stabilise the markets.

Another issue is that the increasing interlinkages of Alternative Investment Funds (AIFs) with banks/ NBFCs poses growing transmission/spillovers risks. In this context, recently RBI has made regulatory provisions to prevent “regulated entities (REs)” from making investments in any scheme of AIFs with downstream investments either directly or indirectly in a debtor company of the RE along with other related regulatory measures. One of the contentious aspects with the AIFs is the “priority distribution model.”

As explained by Pavan Burugula and Sneha Shah in a note titled as “AIFs jittery over Sebi move to ban priority distribution” (15 June 2023) in an Op ed; in a priority distribution model, the AIF creates two classes of investors; senior investors hold superior rights, such as the distribution of proceeds until a hurdle rate is met, after which junior investors are paid. Similarly, in case of a loss, investors in the senior tranche take higher losses than the junior tranche investors. Priority distribution models have always been a “grey area” in Sebi regulations since they are neither expressly allowed nor prohibited. The issue started when Sebi noticed a real estate lender and a non-bank lender misusing the AIF route to evergreen loans, which were at high risk of turning into non-performing assets (NPAs).

In recent times, bank credit has undergone compositional shifts, with an increasing proportion of credit going to services and the retail sector.

Over the past two years, banks and NBFCs have seen rapid and persistent growth in retail loan (especially unsecured lending). Between September 2021 to September 2023, banks’ retail loans grew at a compound annual growth rate (CAGR) of 25.5 per cent, which exceeded the headline credit growth of 18.6 per cent.

Consequently, the share of retail lending in gross advances increased from 37.7 per cent in September 2021 to 42.2 per cent in September 2023. A concern area is the proliferation of the unsecured loans. The RBI in its latest Dec’23 FSR report has highlighted that “Although there are no imminent signs of stress in the retail credit segment, its rapid growth amidst the disinflationary monetary policy stance raises concerns in terms of procyclicality of lending and higher debt servicing costs.”

As banks and NBFCs have entered into various co-lending models with divergent underwriting practices and banks have been the major lender to NBFCs, rising interconnectedness raises risks emanating from cross-sectional dimensions. Furthermore, there are few outlier banks that have substantial SMA (1+2) ratios even as retail portfolios are witnessing rapid growth.

Accordingly, the Reserve Bank took proactive regulatory measures, such as increase in risk weights on certain segments of consumer credit by banks and NBFCs as well as bank credit to NBFCs, along with a strengthening of credit standards in respect of various sub-segments under consumer credit, to prevent build-up of risks and spillover to the wider financial system.

The decision to increase risk weights is both stability enhancing and credit positive. First, banks and NBFCs will be required to allocate higher capital for unsecured retail loans, which will improve their loss-absorbing buffers; and second, it will dampen growth exuberance among lenders and improve credit quality.

The regulatory affairs have become increasingly challenging due to the “balancing” so that genuine business should not be affected; on the other hand, unruly business and lending practices should be regulated to pre-empt adverse spillover effects in the financial system.

RELATED ARTICLES

Most Popular