An ongoing debate in India is whether or not Indian non-banking fi
nancial companies (NBFCs) are “shadow banks”. This question appears
important because we have learned from the ongoing global fi nancial
crisis that shadow banking might create systemic risks which have been
defi ned “broadly as the expected losses from the risk that the failure
of a signifi - cant part of the fi nancial sector leads to a reduction
in credit availability with the potential for adversely affecting the
real
What Is Shadow Banking?
There is much confusion about what shadow banking is, although most
think of shadow banking broadly as activities that can create systemic
risks (Claessens and Ratnovsky 2013). The term shadow banking is usually
attributed to Paul McCulley who at the Jackson Hole Economic Symposium
in
2007 defined shadow banks as “the whole alphabet soup of levered up
non-bank investment conduits, vehicles, and structures”. This definition
is quite confusing and to clear the confusion, many non-intersecting –
but non-contradictory – definitions of shadow banking have been offered.
According to Acharya et al (2013), some of the key points that have emerged are:
(a) A shadow banking system conducts maturity, credit and liquidity transformation outside the traditional banking system (Pozsar
et al 2010): Thus, not only is shadow banking usually (but not always)
less regulated than the traditional banking system (Acharya and Öncü
2010), there is also no explicit access to central bank liquidity or
public sector credit guarantees (Pozsar et al 2010). (b)
A shadow banking system decomposes the process of credit intermediation into a sequence of discrete operations (Ghosh
et al 2012): Therefore, it can be a collection not only of single
financial entities acting independently, but also of (and usually is)
networks of multiple financial entities acting together: banks, formal
and informal non-bank financial institutions, and even credit rating
agencies, regulators and governments (Acharya 2012). (c)
A shadow banking system is highly leveraged. While its assets are risky and illiquid, its liabilities are prone to “bank runs” (Acharya and Öncü 2010, 2013).
Another source of confusion is the definition introduced by the
Financial Stability Board (FSB) in 2011 (FSB 2011, 2012) and adopted by
the European Commission (EC) in 2012 (EC 2012). The FSB definition:
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The ‘shadow banking system’ can broadly be described as
‘credit intermediation involving entities and activities (fully or
partially) outside the regular banking system’.
In this broad definition, not only almost “anything” outside the
regular banking system qualifies as shadow banking, but the regular
banking system is also excluded, which is a problem because even regular
banks can get involved in shadow banking activities (see, for example,
Acharya et al 2009). Later in the same document, the FSB narrowed the
definition to “a system of credit intermediation that involves entities
and activities outside the regular banking system, and raises (i)
systemic risk concerns, in particular by maturity/liquidity
transformation, leverage and flawed credit risk transfer, and/or
(ii) regulatory arbitrage concerns”. However, even this narrow
definition is vague and still excludes the regular banks.
Almost all – if not all – of the above definitions are based on the
experiences in the US and EU. Take the non-exhaustive list of entities
and activities the EC considers as shadow banking in its above-mentioned
document. Some of the listed entities are Asset-Backed Commercial Paper
(ABCPs) Conduits, Money Market Mutual Funds (MMMFs), and investment
funds that provide credit or are leveraged, whereas some of the listed
activities are securitisation and repos. With the exception of MMMFs,
hardly any of these entities or activities is, at least currently,
relevant to “shadow banking” in India.
Indian NBFCs
Adopting the FSB’s broad definition, the Reserve Bank of India (RBI) –
the regulator of the Indian NBFCs – considers the NBFCs as
quintessentially epitomising “the shadow banking system as they perform
bank like credit intermediation outside the purview of banking
regulation” in India (Sinha 2013).
As of June 2013, there were 12,225 NBFCs registered with the RBI.
While 254 of these were deposit-taking NBFCs, the remaining were
non-deposit-taking NBFCs. However, the deposits of the deposit-taking
NBFCs constituted only about 5% of their total liabilities and the ratio
of the deposits of all of the NBFCs to that of the banking sector is
much less than 1%. This ratio has been going down for more than a decade
at the encouragement of the RBI (Acharya et al 2013). Therefore, for
most purposes the deposits collected by the NBFCs are negligible.
Of the remaining non-deposit-taking NBFCs, 418 had total asset sizes
of more than Rs 1 billion as of March 2013 and are referred to as
“systemically important” by their regulator. Although all of the
registered NBFCs are subject to similar sets of regulations
(deposit-taking NBFCs are subject to additional liquidity regulations),
the deposit-taking NBFCs as well as the systemically important,
non-deposit-taking NBFCs are subject to stricter reporting requirements
(see, for example, Sherpa 2013 for the major regulatory differences
among the two NBFC categories and the banks).
Investment and Finance NBFCs
The RBI further classifies the NBFCs into categories by function. Of
all the NBFCs, the RBI considers those that carry on as their principal
business the acquisition of securities as “investment companies”, which
are invariably non-deposit-taking. Although, the RBI classifies the rest
into various subcategories (see, for example, Sinha 2013), I lump them
into a single category I call “finance companies”, because all of them
are in the business of making loans.
Of the above 418 systemically important, non-deposit-taking NBFCs,
233 are investment companies while the rest are finance companies.
However, available RBI data (Acharya et al 2013) on the systemically
important, non-deposit-taking NBFCs indicate that of these particular
NBFCs about 30% were investment companies based on total assets as of
March 2011, suggesting that the finance company NBFCs dominate the
Indian NBFC sector. Systemically important investment company assets are
about 30% of the total assets of all systemically important NBFCs.
Based on the same data I find also that while only about 30% of the
assets of investment companies are loans, the loans of finance companies
constitute about 80% of their assets. Furthermore, while only about 47%
percent of total liabilities of investment companies are borrowings,
the borrowings of finance companies constitute more than 75% of their
liabilities. When we look at the deposit-taking NBFCs, which are
invariably finance companies, we see that their bank loans constitute
more than 25% of their borrowings, whereas their total borrowings
constitute more than 65% of their liabilities. More importantly, while
less than 10% of the liabilities of systemically important investment
companies are bank loans, the bank loans of systemically important
finance companies constitute about 20% of their liabilities.
These suggest that it is essentially the finance NBFCs that are in
the credit intermediation business and linked to the banks, not the
investment companies. Therefore, if we are to call the Indian NBFCs
shadow banks in light of the definitions and observations discussed
earlier, we better distinguish between investment and finance companies.
In addition, when we look at the NBFC sector as a whole, we see from
the RBI data that the capital to total assets ratio of the entire sector
is about 23% as of March 2013 on the average. This is a highly
respectable capitalisation by global standards. This fact alone calls
into question whether it is appropriate to consider the Indian NBFCs as
shadow banks, even though unlike the banks, the NBFCs have no access to
liquidity support of the RBI. Further, in the absence of additional
information, it is not clear whether the liabilities of the NBFCs are
prone to “bank runs” or not.
To sum up, there is no definite answer to the question of whether the
Indian NBFCs are shadow banks or not, because if we adopt the FSB’s
(2011) broad definition, they are; if we adopt the definition of
Claessens and Ratnovky (2013), they most likely are; if we adopt the
definitions of Acharya and Öncü (2010, 2013), may be not, and so on.
However, there is a problem with the question that this article began with.
But, systemic risks are not always about shadow banking. “Non-shadow banking”
– and
even traditional banking – can also create systemic risks. One example
of non-shadow banks are the “shadowy banks” of the US during the Great
Depression that started in 1929. These shadowy banks were the
state-chartered commercial banks which were neither regulated by the
Federal Reserve nor were they direct recipients of Federal Reserve
assistance back then. Mitchener and Richardson (2013) – who introduced
the concept – give detailed descriptions of the systemic risks the
shadowy banks created in the 1930s.
Systemic Risks of NBFCs?
Therefore, whether or not Indian NBFCs are shadow banks need not be
the best question to ask. A better question can be whether or not Indian
NBFCs can create systemic risks. Put differently, it may be better if
we are concerned with the systemic risks the Indian NBFCs might create.
(This does not mean that other Indian financial institutions such as
commercial banks cannot create systemic risks.)
As of March 2103, the size of the NBFC sector based on total assets
was about Rs 12.5 trillion, which is about 13% of the banking sector,
whose size was about Rs 96.7 trillion by total assets. Therefore,
although it is difficult to argue that the individual failure of any of
the NBFCs poses a systemic risk because of the smallness of the
individual sizes, it is not possible to rule out that their collective
failure may pose a systemic risk to the financial system, especially in
light of the bank-finance NBFC linkages detailed in Acharya et al (2013)
and briefly described above. More importantly, because of these
linkages, shocks to the banking sector may be transmitted to the NBFC
sector also, exacerbating the possibility of a systemic risk to the
financial system.
It is this possibility of systemic risk that we should be concerned
with in our design of NBFC regulations, not with whether the Indian
NBFCs are shadow banks or not, individually or collectively.
