The Covid-19 pandemic has heightened the systemic risk arising from the activities of non-bank financial intermediaries (NBFI), previously known as shadow banking, and such risks are likely to rise further in 2021, experts warn.

The financial stability of and systemic risks in non-bank lending have “rocketed up the priority list” since the market crash in March and its fallout, said Ashley Alder, chief executive of Hong Kong's Securities and Futures Commission (SFC). He is also vice chairman of the board of the International Organization of Securities Commissions (Iosco) and chairman of its Asia Pacific regional committee.

“That is the subject of a huge amount of work and thought at the moment,” he said during a webinar on December 2 organised by the Official Monetary and Financial Institutional Forum (Omfif). Ensuring stability of the sector remains at the top of the priority list for Iosco next year, Alder added.

Ashley Alder,
Hong Kong's SFC

NBFIs provide additional sources of financing for households and corporates, and they contribute to systemic risks through links with the global banking system. While NBFIs include insurers and pension funds, the concerns mainly lie with risk from so-called 'other financial intermediaries' (OFIs). Investment funds and money market funds are the largest OFI sub-sectors that provide credit to banks, according to the Financial Security Board (FSB).

There has been a sustained build-up of corporate debt over some years, intermediated through non-bank markets, largely using the different types of bond markets, Alder said. “There are questions around the fragility of corporate balance sheets" in respect of structural vulnerabilities within intermediaries in relation to the underlying asset classes or markets.

Generally, the credit quality of NBFIs will deteriorate in 2021, but the degree of deterioration will differ partly depending on jurisdictions, Rowena Chang, associate director at Fitch Ratings, told AsianInvestor.

The three jurisdictions in the region where the rating agency sees pressure in respect of non-performing assets among NBFIs are China, Indonesia and India, said Jonathan Lee, head of non-banks in Asia Pacific at Fitch.

INDIA FALLOUT

He singled out India as a market where conditions will remain challenging for non-bank lenders, notably those in construction finance, even as the economy recovers from the pandemic-driven contraction.

Problems in India’s $370 billion shadow banking sector started to show as early as June 2018, when Infrastructure Leasing & Financial Services (IL&FS), an unlisted infrastructure lending giant with more than 150 subsidiaries, defaulted on the repayment of commercial paper and inter-corporate deposits worth about $60 million. By September 2018, the company had collapsed. The pandemic made matters worse.

In April this year, Franklin Templeton Mutual Funds said that it will wind up six Indian yield-oriented, managed credit funds, citing “severe market dislocation and illiquidity” caused by the Covid-19 pandemic.

“This decision has been taken in order to protect value for investors via a managed sale of the portfolio,” the asset manager had said in a statement. The action is limited to funds with material direct exposure to the higher-yielding, lower-rated credit securities in India that “have been most impacted by the ongoing liquidity crisis in the market”, it said.

This month, India’s Supreme Court reportedly allowed the fund house to convene a meeting that will enable it to seek unitholders’ approval to wind down the fund schemes.

Jonathan Lee, Fitch

In China and Indonesia, the situation is less severe. Regarding Indonesia, “we expect lingering pressure on asset quality due to the sector’s exposure to higher-risk borrowers, Fitch Ratings director Katie Chen said.

"Pre-emptive provisioning in 2020 should provide some buffer for sector profitability”, she added, but risks may arise from a re-imposition of social distancing rules as the virus continues to spread.

In China, Fitch Ratings expects a mild increase in the sector’s non-performing assets. This is not, however, likely to exceed the levels during the pandemic when the sector faced its most severe asset-quality pressure. Overall credit costs should be balanced by strong collections and recoveries from underlying leased assets, according to Lee.

PANDEMIC PRESSURE

Regardless of the lending conditions in any jurisdiction, Alder noted that the prospect of fiscal measures winding down after the pandemic could put further strain on corporate cash flows, which meant the potential for defaults will increase if companies could not service their debt.

Still, Alder said that the regulation of NBFI activities should be conducted with caution. One factor to consider is “what level of resilience is appropriate", he said.

“You do not want to get to a situation where you've effectively suppressed what they do, which then leads to an impediment to the way in which they support the real economy, and particularly now because companies are under stress, and we need to ensure that investment continues and productivity is supported,” he added.

The level of “macro-prudential approach” is also complicated by the increasing interconnections between banks and non-banks. In the context of money market funds, Alder said the question was “do we approach them from a resilience perspective on the assumption that they are cash equivalents, or do we look at it the other way around, that they are more investment funds?”

“At the moment, they just seem to be in a grey area, which they have been for some time, and you have to have clarity around this to make good policy choices,” he said.