Non-bank lenders have seen their source of funds suddenly dry up after a series of defaults by Infrastructure Leasing & Financial Services Ltd (IL&FS) that triggered a liquidity crisis.. Aniruddha Chowdhury/Mint
Non-bank lenders have seen their source of funds suddenly dry up after a series of defaults by Infrastructure Leasing & Financial Services Ltd (IL&FS) that triggered a liquidity crisis.. Aniruddha Chowdhury/Mint

S&P sees rising risk of contagion in India's financial sector

  • Many finance companies have lost more than half of their equity value in the past year, and credit markets are charging huge premiums on debt issued by the riskier finance companies
  • A recent contagion analysis released by the RBI suggested that the failure of any top-five HFC or NBFC could result in the default of up to two banks

Rating agency Standard and Poor’s (S&P) on Wednesday said it sees a rising risk of contagion in the Indian financial sector as many finance companies have lost more than half of their equity value in the past year, and credit markets are charging huge premiums on debt issued by the riskier finance companies.

“India's finance companies are among the country's largest borrowers. A substantial part of this funding comes from banks. The failure of any large non-banking financial company (NBFC) or housing finance company (HFC) may deliver a solvency shock to lenders," S&P Global Ratings said in a note.

Non-bank lenders have seen their source of funds suddenly dry up after a series of defaults by Infrastructure Leasing & Financial Services Ltd (IL&FS) that triggered a liquidity crisis. Banks and mutual funds reduced lending to NBFCs and HFCs, creating a cash crunch and forcing the shadow lenders to sell assets and cut back on new loans. The Reserve Bank of India (RBI) has also put caps on withdrawals by depositors after fraud in Punjab and Maharashtra Co-operative (PMC) Bank came into the fore.

A recent contagion analysis released by the RBI suggested that the failure of any top-five HFC or NBFC could result in the default of up to two banks. “That could have dramatically negative effects for credit growth and the economy," S&P said.

The rating agency said this contagion runs the risk of spreading to real estate companies. “Finance companies are the largest lenders to this segment and any failure among such institutions could jeopardize credit flows to developers. The real estate companies are already grappling with weak demand, low sales, and high leverage. We saw this kind of contagion in Mexico after the global financial crisis. The default of Mexican non-bank mortgage lenders sent some large home builders into default as well," it added.

S&P said it believes that the government and the RBI may support systematically important institutions such as banks rather than NBFCs unless it risks the stability of the financial sector. “The RBI is monitoring the top-50 finance companies closely based on the size of their balance sheet, the scale of their operations, as well as governance practices and credit behavior. The RBI has categorically stated that it is not standing by as lender of last resort to the finance companies," it added.

Companies with perceived governance challenges will also be at risk, the rating agency said. “Even when credit is available, the higher borrowing costs will likely hurt the profitability and growth of finance companies," it added.

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