Contagion risk in financial sector: Fitch says 30% of banks’ NBFC exposure could turn bad

India’s financial sector faces heightened risk of contagion, with many finance companies having lost over a half of their equity value in the past year, Standard & Poor’s (S&P) said on Wednesday, cautioning that any failure of a large shadow lender could lead to a “solvency shock” to banks.

S&P’s report follows similar warnings from Fitch Ratings, which has projected that roughly 30% of banks’ exposure to shadow lenders could turn bad under close to a worst-case scenario, putting further pressure on their capital adequacy and reversing the ongoing recovery process of non-performing loans (NPLs).

Fitch said the difficult market environment could persist in the near term and put the resilience of the non-banking financial companies (NBFCs) through a rigorous test.

India’s shadow-banking sector has been under stress since the collapse of infrastructure lender Infrastructure Leasing and Financial Services (IL&FS) in September last year. Traditionally, banks have been among the largest providers of funds to NBFCs.

However, S&P believes contagion is unlikely to affect public-sector banks (PSBs) meaningfully despite their ongoing struggle with the bad loan crisis. This is because people draw solace from the sovereign ownership of such banks and the repeated demonstrations of official support for these lenders through frequent capital infusions.

In a research report, economists at S&P said: “The failure of any large non-banking financial company (NBFC) or housing finance company (HFC) may deliver a solvency shock to lenders.” “Given the seriousness of such risks, we expect the Indian government to support systemically important institutions that get into trouble”.

“Typically, we expect the government will only intervene for large and mid-sized banks,” S&P said. “But when paranoia is high and the contagion risks are pronounced, they may extend support to smaller banks too.”

Sectors like real estate, some small- to mid-sized banks with significant exposure to stressed NBFCs and even private banks that have purchased portfolios from these finance companies could face heightened risks and challenges.

Separately, on the systemic stress in the shadow-banking sector, Fitch said: “We estimate that the scenario would leave banks with an aggregate shortfall of $10 billion to meet regulatory minimums, and $50 billion below the level that we believe would provide an adequate buffer.”

The banking system’s gross non-performing loans ratio would rise to 11.6% by FY21 from 9.3% at FY19, against the baseline expectation of a fall to 8.2%, as per Fitch. The global agency added: “We would expect the recovery process to become even more protracted in such a difficult environment, although banks would resort to writing off some of the legacy bad loans in order to manage their NPL stock.”