Non-banking financial companies (NBFCs) need to diversify their funding sources as a risk mitigation technique, since their reliance on banks remains high despite recent reduction, according to a research from the Reserve Bank of India (RBI).

Banks not only lend directly to NBFCs, but they also subscribe to their debentures and commercial papers (CPs). "With a decline in subscription to debentures by banks, overall banks' exposure as a share of NBFCs' borrowings moderated from 43.1 per cent at end-March 2023 to 42.7 per cent at end-March 2024" , according to the report titled "Trends and Progress".

"The reduction in NBFCs' reliance on banks for funds bodes well for overall financial stability," the RBI stated in the report, adding that bank borrowings continue to be NBFCs' principal source of funding.

The rising reliance on bank funding aroused regulatory concerns, causing the RBI to boost the risk weight for banks that support NBFCs from 100% to 125 percent in November 2023. This has resulted in a moderate reliance on bank funding.

As bank lending has stalled, NBFCs are increasingly seeking to the local debt capital market for finance. While NBFCs with higher ratings have used the debt capital markets to raise funds through bonds and commercial papers, only a few have gone the international route and raised significant amounts through the overseas bond market. In addition, numerous businesses are using the securitization market to raise funds for expansion.

The research stated that money raised by NBFCs through the issuance of non-convertible debentures (NCDs) grew in 2023-24, with more than 80% of issuances being highly rated - AAA or AA. Additionally, borrowing by NBFCs via CPs grew in 2023-24, according to the report.

The report further stated that the growth of NBFCs' secured borrowings slowed in 2023-24, while unsecured borrowings increased due to market borrowings - through the issuing of financial instruments such as debentures and commercial papers. Across tiers, the NBFC-middle layer mobilises more unsecured money, owing to the presence of government NBFCs.

The RBI has warned the NBFC sector against pursuing 'expansion at any cost', stating that it would be counterproductive, and that a strong risk management framework should be established. The central bank has also urged that shadow banks increase their initiatives to resolve consumer grievances, follow fair policies, and avoid using usurious interest rates in order to remain relevant in a rapidly changing financial sector.

In October, the RBI prohibited four NBFCs, including two microfinance institutions (MFIs), from sanctioning and disbursing loans because they charged exorbitant interest rates to borrowers. The action was based on serious supervisory concerns about these companies' pricing policies, namely their weighted average lending rate (WALR) and the interest margin charged over their cost of funds, which were determined to be exorbitant and not in accordance with the requirements.

The RBI also stated in the report that NBFCs should be aware of the evolving concentration risk and climate-related financial risks connected with credit to specific sectors, in addition to being vigilant against cybersecurity threats.

Meanwhile, the survey found that key financial performance measures for NBFCs, such as return on assets (RoA) and return on equity (RoE), improved in 2023-24 across all layers and classifications.

Overall, the NBFC sector improved asset quality and capital adequacy in 2023-24. As of H1FY25, the NBFC sector's gross and net NPA ratios have fallen to 3.4% and 1.1%, respectively. Furthermore, during 2023-24, the NBFC sector's balance sheet rose by double digits (16.3 percent versus 17.2 percent the previous year). On the asset side, growth in loans and advances accelerated to 18.5% in 2023-24, up from 17.4% in 2022-23, owing to upper-layer NBFCs. Credit growth in the NBFC-middle tier was somewhat subdued due to the decrease of unsecured loans.