The recent debt default by Infrastructure Leasing and Financial Services (IL&FS), a conglomerate engaged in financing and developing infrastructure projects, has demonstrated the financial risks posed by India’s non-banking financial companies (NBFCs).

The crisis has already created a credit crunch, affecting sectors such as real estate that have been dependent on NBFC funding for growth. A 17 October report by Credit Suisse suggests that the exposure of NBFCs to real-estate developers could be as high as 2 trillion. The real estate stock index has declined 26% since the IL&FS crisis erupted even as the benchmark index declined by 12% over the same period.

The importance of NBFCs in disbursing credit to the overall commercial sector has risen in recent years, as banks have struggled to increase lending amid the overhang of non-performing assets (NPAs). Thus, the share of NBFCs in total credit extended has increased from around 9.4% in March 2009 to more than 17% by March 2018, data from the Reserve Bank of India’s (RBI’s) latest financial stability report suggests.

Lending by such NBFCs is often deemed as “shadow banking" globally. In its recently released Global Financial Stability Report, the International Monetary Fund warned of systemic risks associated with such shadow banking practices which might spill over to banks.

Such warnings are especially relevant for India as the size of its shadow banking sector appears to be on the higher side, when compared to many other large economies, as per the estimates by Basel, Switzerland-based Financial Stability Board (FSB).

In India’s case, shadow banking primarily consists of NBFCs and housing finance companies (HFCs). A 2017 report by the RBI said that 99.7% of shadow banking in India involves making long-term loans against short-term funding, primarily carried out by NBFCs and housing finance companies. Besides them, collective investment vehicles such as money market funds, fixed income funds, mixed funds, real estate funds are also deemed to be part of shadow banking.

The term “shadow banking" does not necessarily denote undesirable activities. In fact, shadow banking or market-based lending might be useful for growth of the financial sector in emerging market economies. For example, NBFCs in India perform many important roles, like providing credit to inaccessible areas or to niche sectors and small industries.

However, problems arise when such NBFCs become too big, invest in assets of dubious quality and are interconnected with other financial institutions, as demonstrated in the case of IL&FS. Additionally, NBFCs, owing to the nature of their business, are also more prone to risks from business cycles, excess leverage and over-reliance on wholesale funding.

Concentration risks—too much exposure to some sectors—can also be a headache. To illustrate, NBFCs kept on lending to real estate developers in recent years despite the sector being marred by incomplete projects, litigation and overall slowdown. Developer loans make up around 21% of NBFCs’ loan book, compared to 7% for private banks and 3% for public sector banks, as per the Credit Suisse report.

Worryingly, the overall non-performing asset (NPA) ratio of NBFCs has worsened in recent years and capital adequacy has been hit.

However, part of the apparent rise in NBFCs’ NPA ratio could be attributed to increasing RBI regulation and the progressive harmonization of the NPA norms vis-à-vis banks. RBI supervises systemically important NBFCs (with asset size of 500 crore and above) and NBFCs which accept deposits from public. In fact, officials have often stressed that Indian NBFCs are different from shadow banks in other countries, where there is much less regulation.

Nevertheless, the recent IL&FS episode, the related lapse on the part of ratings agencies, and the looming threat of a liquidity squeeze across the NBFC sector have raised concerns of spillover, with exposure of banks and mutual funds to NBFCs rising in recent years. As of now, this does not seem alarming per se, as total exposure is roughly equal to only 3% of banks’ aggregate deposits.

However, as history has it, including with the US subprime mortgage crisis, a growing shadow banking sector could mean trouble for the financial system. Given that the Indian banking sector is the weakest in G-20 after Russia in terms of capital adequacy, India can ill afford to allow risks to accumulate in other parts of the financial system.