Does shadow banking exist in India? -II - Views on News from Equitymaster

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Does shadow banking exist in India? -II

Jul 12, 2013

While the previous article demystified shadow banking system, in this article we will delve more on the prevalence of the shadow banking system in India and the concerns.

The aggregate size of the shadow banking system world over is around half the size of banking systems' assets. The US has the largest shadow banking system with assets of US$ 23 trillion (in 2011), followed by the euro area of US$ 22 trillion and the UK at US$ 9 trillion.

Shadow banking and India

Compared to its foreign counterparts, the size of shadow banking system is relatively smaller in India. Thanks to the conservative banking practices, shadow banks have been under constant regulatory surveillance. Moreover, many activities that contributed to the global financial crisis are either not allowed, or if allowed, have to follow regulatory limits. For instance, complex and synthetic derivative products that were responsible for the global crisis are presently not permitted in India.

Notwithstanding the regulatory forbearance, Indian banking system too remains vulnerable to shadow banking practices. In India, NBFCs epitomize the shadow banking system as they perform bank-like credit intermediation outside the purview of banking regulation. Today, NBFC is the fastest growing segment in the Indian financial sector with annual growth higher than the banking sector.

The business model of NBFCs per se tends to be risky. Weaker underwriting standards, enhanced risk taking capabilities and increased complexity of their activities expose such entities to contingencies.

Few peculiar features that make these institutions inherently risky are listed hereunder:

  1. Management of client cash pools with features that make them susceptible to runs (eg: insurance companies, hedge funds etc)
  2. Facilitation of credit creation (eg: credit insurers, financial guarantee insurers)
  3. Securitization of loans (eg: Companies that have bulk of priority sector loans sell loan pools to banks)
  4. Loan provisions that are dependent on short-term funding (eg: micro finance institutions)
Besides riskiness pertaining to business model, NBFCs are exposed to key risks emanating from regulatory gaps, arbitrage and contagion effect. NBFCs are more prone to systemic risks on account of concentration of exposure to sensitive sectors. Also, since these shadow banking entities are more dependent on bank funding, the interconnectedness risk tends to be higher. Liquidity risks, critical of all, arise due to asset-liability mismatches. This can in no time translate into solvency risks.

The 2008 global financial crisis, which resulted from the above dangers, is a case in point. While it jeopardized the global financial system, Indian financial system was no exception. NBFCs in India came under severe pressures then. The interlinkages for funding purposes between NBFCs, mutual funds and commercial banks led to liquidity crisis during the global turmoil. More than 50% of the borrowings of NBFCs institutions came from short-term instruments such as debentures (of short term nature) to lend long-term; thereby creating liquidity crunch. During the crisis, the liquidity issues were further exacerbated with many institutional investors pulling out their investments in liquid and money market funds. Also, banks turned risk-averse and restricted their lending activities. These together heightened the funding problems for NBFCs as they found raising fresh liabilities or rolling over of the maturity liabilities quite difficult. The period also raised lot of apprehensions of few NBFCs running out of business.

The crisis, therefore, evidenced the need for further strengthening the financial system. Clearly, the regulatory framework needs to be flexible enough to be reviewed time and again as per the sector requirements.

While shadow banking is an integral part of the financial system and complement commercial banks; appropriate vigilance and due-diligence can go a long way in avoiding systemic risks.

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