Indian Mutual Funds (MFs) have taken a stance contrarian to domestic banks with respect to lending to Non Banking Financial Companies (NBFCs). While MFs are consistently trimming their exposure to NBFCs, the astounding growth in banks’ exposure to NBFCs has become a bee in the bonnet for regulator the Reserve Bank of India (RBI).

NBFCs are the largest net borrowers of funds from the financial system. NBFCs owed close to 57% to banks in FY23 followed by 17.3% to MFs (18.4% in FY22) and 18% to insurance companies. And the share of MFs and insurance companies has been largely declining for several quarters.

As per a Report by CareEdge, between February 2018 and August 2023, absolute lending to NBFCs by Indian mutual funds declined from ₹2.31 lakh crore to ₹1.77 lakh crore, a reduction of 23.5%. During the same period, absolute bank lending to NBFCs rose from ₹3.9 lakh crore to ₹13.83 lakh crore, a massive jump of 254.6%.

Although banks’ exposure to NBFCs currently is ₹14.2 lakh crore, a massive 42% of that growth took place in the last 18 months, when it was ₹10 lakh crore.      

Interestingly, MF exposure to NBFCs as a share of Debt Assets Under Management (AuM) reduced from nearly 20% in the latter part of 2018 to around 12% in 2023, while the share of banks’ advances to NBFCs as a share of aggregate advances has doubled from around 4.5% in February 2018 to over 9% in August 2023, indicating the increasing reliance of NBFCs on bank lending.

Highlighting the relative size of exposure, the report says, MFs' debt exposure to NBFCs touched 12.8% as a percentage of Banks’ advances to NBFCs in August 2023 from 13.1% in July 2023.

The report says large NBFCs focus on the capital market, while mid-sized and smaller NBFCs continue to rely on the banking system as their primary source of funding. However, given the aversion of MFs to general credit risks, their exposure to NBFCs, particularly those rated below the highest levels, is not expected to witness significant growth. Consequently, the aggregate dependence of mid-sized NBFCs on the banking sector for funding is likely to remain high while larger NBFCs will continue to move towards the capital markets, the report mentions.

The divergence in strategy by banks and mutual funds with regards to NBFCs indicate that banks are assuming risk to increase their loan books while Mutual Funds are probably weary after experiencing default by a few NBFCs like IL&FS and DHFL. Meanwhile, the ‘corporate loan book’ of banks had a stunted growth because the heavily indebted India Inc. was shying away from more loans. So banks may have focused on growing the retail loans indirectly through NBFCs, and directly through their own products like personal loans and credit card loans.

Recently, RBI has increased the risk weight on loans by banks to NBFCs by 25%, if the risk weight is below 100%. Thus, an individual NBFC’s risk weight depends on its Credit Rating. This implies that NBFCs with lower ratings that rely more on the banking ecosystem, because the Mutual Funds are averse to lending to them, will face more difficulties in availing credit from now on.

With the increase in risk weight of NBFC loans by banks a significant chunk of NBFCs in India would be impacted, which in turn would affect the end consumers as well. Whether this slows down the accelerated pace with which unsecured loans have been growing in India or fails to make a dent, needs to be seen.

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