It seems that the world can never be far away from a financial crisis. Even as it projects a world economic growth of 3.8 per cent, the IMF warns of increased financial instabilities and elevated risks. The US is a good example — its GDP is growing at 2-3 per cent, unemployment numbers are at their lowest at around 4 per cent and inflation is refusing to rise beyond 2 per cent — yet its economic managers constantly worry about a recession waiting to be triggered by the next financial crash.

Financialisation — the increased role of financial motives and markets — is believed to be behind these risks, a theme echoed by many central banks also. The global flow of capital has also exported financialisation to developing economies, with yield seeking capital flows distorting exchange and money markets in other countries.

The financial instability risks in India emanate from its banks and other actors in the financial system. For some years now, the RBI has been tracking systemic risk through its Financial Stability Reports but the focus has been on banks, since they constitute over 75 per cent of the system.

Banks are also the single largest supplier and user of funds but their net exposure is low as they borrow and lend largely among themselves or to players in the same category (such as NBFCs).

Stress tests

The RBI’s standard stress test has been to evaluate the solvency of banks (measured by their capital adequacy) against varying NPA levels.

In its latest report, the RBI seems to have realised the shortcoming of this method, because as it itself says, on this count, at least five banks should have folded up during 2018. That they did not is testimony of the implicit state guarantee built in bank deposits which facilitates a constant flow, unhindered by considerations of asset quality or the health of banks.

But it is the two non-bank segments — NBFCs and mutual funds (MFs) — that are making news from a risk perspective. NBFCs and housing finance companies (HFCs) are the largest borrowers of funds after banks, but they are highly dependent on MFs and banks who subscribe to their commercial paper (CPs) and bonds. The liquidity crunch that NBFCs are facing is attributed to the IL&FS default last year, which is unfortunate, because it was more a case of infrastructure financing going wrong, but the NBFC label stuck because IL&FS was (mis) categorised as one.

Nevertheless, the issue was the break in the recycling of short-term borrowings through CPs that triggered the default. A large NPA portfolio has the same effect on a bank, but it is able to sweep the liquidity problem under the carpet because there are no restrictions on deposits. But market instruments are different — they are rated, revalued and come with covenants that make their automatic recycling both difficult and expensive.

Yet the RBI puts NBFCs through the same solvency test as banks (NPAs and capital adequacy) and reckons that only a small percentage of NBFCs will be unable to meet solvency in the event of NPAs shooting up. In fact the sector has a healthy CRAR in excess of 20 per cent. This is hardly a comfort when we consider that liquidity is a source of risk.

Finally, mutual funds have also jumped into the risk radar recently. Though not under the RBI’s purview, they find a mention in the RBI report because they are the largest suppliers of funds (next to banks), investing mostly in NBFCs, corporates and even banks.

In fact, their exposure to the financial sector, under both their equity and debt schemes, is significant which makes them susceptible to financial sector risk. But it is the nature of their participation that raises questions — they are expected to be investors through the secondary market and not lenders to companies against collateral.

In fact, mutual funds generally look to make capital gains rather than interest income from debt investments, even as some of the debt schemes are pitched to investors as near equivalents of bank FDs. Thus while interest rate risk reduction may be achieved by holding on till maturity, the fund investor could face significant credit risk because of the nature of the lending — promoter funding rather than project financing.

This would also be clear from the fact that fund houses were stuck with the loans despite holding rated, collateralised and supposedly marketable instruments. While SEBI seeks to protect investors and RBI oversight aims to rein in lenders to reduce systemic risk, this one seems to have slipped through the cracks.

The writer is an independent consultant

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