Non-Banking Finance Companies’ (NBFCs) concentrated exposures, especially to the power and infrastructure sectors—the cause behind the 2016 bank distress—could trigger systemic issues through their linkages with banks, corporate bond markets, and mutual funds, cautioned the International Monetary Fund (IMF) in its latest Financial Sector Assessment Programme (FSAP) for India.

The FSAP recommended that financial stability objective should be prioritised over social and developmental goals.

IMF noted that while banks reduced their direct exposures to the large power and infrastructure companies, NBFCs— particularly large state-owned infrastructure financing companies—have significantly increased theirs.

If major NBFCs were to become distressed, the shock could spill over to banks, corporate bond markets, and mutual funds that finance NBFCs, and be amplified in the process.

The FSAP observed that Banks and NBFCs are generally resilient to severe macrofinancial solvency and liquidity shocks, but some banks, particularly public sector banks (PSBs), may need to strengthen their capital base to support lending in such situations.

Weak tails comprise a few non-systemic NBFCs and urban cooperative banks (UCBs) that report below minimum or negative capital even in the baseline.

The IMF’s FSSA for India, which is based on its Financial Sector Assessment Program (FSAP) mission that visited the country in March and June 2024 and virtually concluded in October 2024, recommended that the authorities should manage potential systemic risks from concentrated exposures.

The regulations of state-owned NBFCs should be aligned with those of the private sector, especially given that state-owned NBFCs are currently exempt from large exposure limits, per the FSAP mission. Further, data and tools for system-wide and contagion risk analysis should be enhanced, and broader macro prudential policy could be implemented.

The FSAP mission suggested that the central bank should be ready to expand crisis-time liquidity policy options to include tools more suited for systemic liquidity events among NBFIs (non-banking financial institutions) and markets.

Moreover, the authorities should also continue efforts implementing long-standing policy recommendations to align India’s financial sector policy framework in line with international standards. This includes enhancing the independence and power of regulators, particularly over state-owned institutions; implementing pillar-2 capital charges and the International Financial Reporting Standard (IFSR) for banks and risk-based supervision of insurers; improving conglomerate supervision; and establishing a comprehensive resolution regime.

Directed lending should be relaxed

Directed lending and public finance requirements should be further relaxed and, instead, the government should establish broad infrastructure to support digital lending, introduce state-of-the-art credit enhancement tools, and promote safe securitisation.

India is deemed by the IMF to have a systemically important financial sector, according to Mandatory Financial Stability Assessments under the FSAP, and the stability assessment under this FSAP is part of the bilateral surveillance under Article IV of the IMF’s Articles of Agreement.