OPINION | Does the rise of non-bank funding represent financial disintermediation or liquidity shuffling?

Non-bank funds which had a share of 33% a few years back, now contribute about 49%, so much so that even when bank credit slowed

A constant refrain has been about the lack of private sector investment in capital formation despite a host of measures such as interest rate cuts, tax reductions and fiscal incentives. The RBI’s latest monthly bulletin has a study on funding for the commercial sector which seems to allay fears, at least on resource availability. It says the financial system, though still bank-led, has liberalised sufficiently with diverse sources of funding now, especially non-bank avenues such as equity, bonds, foreign capital, and non-bank entities.

The gist seems to be that funding is not a constraint any more. Non-bank funds which had a share of 33% a few years back, now contribute about 49%, so much so that even when bank credit slowed, as in FY25, overall funding managed to grow by 30% thanks to the new sources.

Sources of funding remain limited

The growth is undoubtedly impressive but it does not necessarily mean the financial system has disintermediated or become more diverse, as the investor base is still limited.

More than half of incremental funding in FY25 came from NBFCs, housing finance companies and other financial institutions. But we need to note that these entities continue to be largely bank-dependent.

While reckoning non-bank sources, the RBI study excludes only bank borrowings, not the other exposures such as bonds, debentures, and commercial paper. If we include these, banks’ exposure to NBFCs works out to a high 43% (March 2024). And it is surprising how the study missed out on mutual funds, who have been a key player in the funding ecosystem. They are now virtual quasi lenders with a sizeable part of their debt funds being invested in corporate bonds and NBFCs.

A lot of equity issues are about facilitating exits

Equity issuance was about 22% of funding, but not all of this translates into fund availability, because they could include equity under offer for sale (OFS), where money raised goes to exiting investors, not to the companies. Capital markets now seem to be used more for exiting rather than for raising capital.

A SEBI study of IPOs during the period April 2021-December2023 found that of the 144 IPOs which collectively raised a total of Rs 2.1 trillion, about 65% was OFS, through which pre-existing shareholders sold their shares. Another interesting feature was that almost 43% of equity was raised through the non-profitability route, i.e., by companies that did not meet IPO norms of minimum profits. Such issues mandate high allocations of 75% to qualified institutional investors, which meant mutual funds, insurance companies, pension funds, commercial banks etc. making it more of a private placement than a public issue.

 Bonds are mostly used by financial intermediaries

Corporate bond issues have been the major success story, massively outnumbering equity but mostly for the financial sector who picked up over 80% of the issuance.

Either non-financial corporates had low appetite or they were crowded out by the financial sector, because bonds formed only about 11% of their non-bank funds. For sure top-rated corporates could have raised bonds which were cheaper than bank credit.  Again, with almost all the issuance being through the private placement route, it was banks and mutual funds, among others, that majorly picked up the subscriptions.

Foreign capital can be a volatile source

Foreign capital did contribute a good bit, around 18% during FY25, and is moreover a genuine non-bank source, but it can be very volatile, especially FDI, to be counted as a stable source.

We may have more diverse instruments now but not more diverse investors. This is clear from the constant shuffling of liquidity between entities, often blurring the distinction between users and providers.

RBI’s financial stability report shows a high level of interconnectedness

The RBI’s financial stability reports itself refer to the extent of financial interconnectedness in the system. In corporate bond markets where NBFCs are the largest issuers of debt, the principal investors are mutual funds and banks.  In mutual funds, surprisingly, nearly 60% of debt funds mobilised are from corporates, who seem to be using mutual funds for treasury management. And taking into account equity funds, corporate investment in MF assets is a significant 40%. The deployment pattern of debt funds by mutual funds also shows the back-and-forth movement of money- about 33% of MF debt fund assets of Rs 18 trillion (March 2024) were in corporate bonds. This meant that corporates were not only major investors in, but also significant borrowers from mutual funds.

About 26% of MF debt funds were invested in banks/NBFCs through certificates of deposits and commercial papers. Banks who had been complaining of deposits fleeing to mutual funds, found them returning to them in other forms. For all the disintermediation taking place, the ubiquitous role of financial institutions is hard to miss. This may be inevitable given the lack of developed asset markets and low retail participation, but the financing of corporates by mutual funds seems to fall between the cracks of the banking and market regulators, especially given past crises relating to corporate debt with a few mutual funds.

At the root of the poor retail participation is the low household financial savings which limits the avenues for investments. For all the headlines around the retail IPO boom, the growth in demat accounts or SIP subscriptions, we must remember these market instruments form only about 10-11% of financial savings.

High government deficits represent a structural problem

But the bigger problem is the large and growing fiscal deficit which has in a sense, fashioned the financial system architecture- public sector banks, SLR requirements, regulations incentivising government securities over others, prudential norms and so on- all of which channelised the bulk of private savings to fund the government, rather than the private commercial sector.

About 45% of financial savings are in fixed deposits with banks/NBFCs, another 34% are in provident funds, pensions, and small savings- thus nearly 80% were in in entities that have mandates to invest substantially in government securities. Even after statutory ceilings have been significantly reduced, banks prefer holding government paper in excess of requirement for reasons of safety.

(SA Raghu is a columnist who writes on economics, banking and finance.)

Views are personal, and do not represent the stance of this publication.