Shadow banking is a necessity

Reported by: |Updated: November 28, 2016

While banks are not able to fulfil the needs of the economy in entirety, shadow banking (essentially constituting NBFCs) has to step in. Shadow banking has an important role, asserts Vijayanand Prabhu, investment analyst at Geojit BNP Paribas:

Mohan: Can you explain the pros and cons of shadow banking? How prevalent is the system in India?

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Vijayanand Prabhu believes shadow banking institutions have a role to play in the financial inclusion effort being initiated in India

Shadow banks fulfill the important task of providing alternate funding to entities including finance, leasing and factoring companies, investment and equity funds, insurance companies, pawn shops, and underground entities who do not have access to traditional financial institutions like banks. On the downside, shadow banking activities come with the disadvantage of increased systemic risk as compared to traditional banking channels because its activities entail financial risks akin to that of conventional banks but they are not covered by the same oversight and regulation. Though it is difficult to assess by conventional metrics, the size of the shadow banking sector in the India is roughly around 20% of the country’s GDP. A sustained and unhindered growth of the economy largely depends on the existence of a well regulated and transparent Non-Banking Financial Company (NBFC) system. These small-scale players operating in the unregulated realms of the economy account for around 15% of the lending activity of scheduled commercial banks and their share in the lending space is growing rapidly. Since NBFCs largely cater to serving the capital needs of small scale sector and rural areas, the role essayed by these shadow banking segments in financial inclusion cannot be ignored.

Vijayanand Prabhu: There are expert reports suggesting shadow banks are a necessity in certain economic scenarios. China is often quoted as an example? How dominant is the system in that country?

Of course, shadow banking institutions are paramount to fulfilling the growing credit requirements of any developing country like India where half of the population still does not possess a bank account. To cater to the needs of this huge unattended folk, shadow banking has helped a lot. In China, this sector catalyzed the rapid growth of its economy in the last three decades. It has been driven to a certain extent by off-balance sheet with poorly regulated online fintech platforms leading the lending activity in recent times. China’s shadow banking sector grew 19% in H1 2016 on an annualized basis to reach RMB58 trillion, equivalent to more than 80% of GDP, according to Moody’s Investor Services.

There are also reports that Chinese regulators are cracking down on illegal entities operating in this domain. One of the measures is curbs on ‘wealth management products’. How are WMPs related to shadow banking?

Wealth Management Products (WMPs) are one of the most important products in the shadow banking categories. They are sold by banks as typically structured savings products but are not recorded in the balance sheets of banks and are thus not subject to deposit regulation. Financial repression in the Chinese economy, for example, has been the after-effect of interest rate controls on bank deposits. Owing to prevalent high inflation rates, the desire for high return investments has spawned a huge demand for products like WMPs, whose yields do not come within the gamut of deposit rate ceiling. Now, regulators are framing solutions to mend this menace and protect the lenders from future losses. But with assets worth over 26 trillion yuan under jeopardy, regulators are bewildered as to how to address this huge liability.

How do you see India as a prospective candidate for such a spread of the system? Will it, according to you, fulfil fund needs that do not conform to the traditional financing framework?

India is growing at a rapid pace and the increasing need for easy working capital for speeding development projects is likely to spawn the emergence of several smaller players in the lending space over the next decade. Even today, individuals as well as corporates whose lending requirements are not processed by private as well as public sector banks for not satisfying minimum documentation standards are serviced by these shadow lenders. Since NBFCs largely cater to serving the capital needs of small scale sector and rural areas, the role essayed by these shadow banking segments in financial inclusion cannot be ignored. The recent move by the government and RBI to add more names into the regulated list by licensing NBFCs with majority rural presence will help to encompass more SME funding under regulatory shield. Empowering more regional players will also help to strengthen the trust factor among the investors.

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Former RBI governor Raghuram Rajan Launching Sachet

Do you think shadow banks, functioning outside the regulatory framework, could be a threat to the country’s economy?

When business volumes increase, the demand for money too will go up. When supply comes down, then customers resort to accessing easy but unsafe options. Since this space is unregulated and unexposed, the world will be unaware of this monster till the penultimate day of bubble bursting off. Here the banks and formal financial institutions are exposed to risk of losses in the event of the economy failing as loans make up a huge chunk of the liabilities of NBFCs. Financing from shadow banking entities has also inflated the country’s property bubble as lending occurs on off-plan developments, wherein apartments and houses are sold at current market prices to fund future construction.

How do you think such entities can be brought within the regulatory framework? What could be the role of RBI?

Given the diverse liquidity requirements of a vibrant start-up environment and working capital needs of rural businesses, a regulated NBFC segment rather than public sector banks grappling with bad loans is the need of the hour. The introduction of a safety tool in the form of Sachet would ensure financial stability, protect investor interest and maintain lending rates within affordable limits.  This initiative by RBI will help in boosting retail participation in the bond market through the implementation of due diligence processes.

The recent initiative by SLCCs to launch Sachet could be a beginning in this regard. How would you rate the prospects of this effort?

Investors are not comfortable with equity investments because of uncertainty of returns. The risk factor is considered as a secondary case. General perception is that fixed return investments are all safe. However unreal the rates may be, seldom do investors research about the repayment capacity of the firm. ‘Sachet’, launched by ex-RBI governor RaghuramRajan, had been devised as an effective e-tool for enabling informed investment choices and mitigate transactional dilemmas. India is the second fastest growing internet economy in the world and Sachet is a unique endeavor by the central bank to e-empower investors and make banking a transparent and risk-free process. This has also been conceived as an initiative to reduce the instances of frauds rampant in various forms of banking in India and reiterating a commitment to investor protection through empowerment and education. The introduction of a safety tool in the form of Sachet would ensure financial stability, protect investor interest and maintain lending rates within affordable limits.  This initiative will help in boosting retail participation in the bond market through the implementation of due diligence processes.

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