Glimpse of inter-connections between Banks and NBFCs - a balance sheet view
Shadow banking system fascinated me, especially post-2008 crisis when I realised their importance in the system. NBFCs are not allowed by the central banks, to operate in the same way as the regular banks, e.g., while banks are allowed to accept deposits (like savings accounts), NBFCs are not allowed to do so. Also, unlike banks, NBFCs do not have to follow stringent guidelines that the central bank sets for the banks. There's a reason why NBFCs are called "shadow banks" - because they operate in the shadows of the scheduled banking system. Although there are some, broad-level regulations for the NBFCs mostly they remained out of the purview of central banks. This was also because NBFCs were not looked at with great concern, as their growth was in the "shadows" - at a distance from the regulatory eyes.
The central banks - the ultimate regulators, until recently didn't realise how big the NBFC system had become and how much of an integral part of the system it had become - having the potential to put a significant dent in the formal economy. Incorporating NBFCs into the financial system, therefore, complicates the way the economy works and it's understanding.
However, I didn't understand even the basics of how banking and the NBFC sectors are actually connected. In search of this answer, I decided to read the balance sheet of a bank and an NBFC, hoping to get a glimpse and to get an idea as to how the banking system and the NBFC system are interconnected. For this, therefore, I decided to explore both of their balance sheets - I read the balance sheet of ICICI (a scheduled bank) and Bajaj Finance (an NBFC).
The balance sheet of the Commercial Bank is, relatively, boring.
- Loans (60%) - Could be further classified into different parts, as shown below. We can observe that most of the advances are term loans and mostly are secured by tangible assets. Note that, banks may extend loans to NBFCs, so this may be one of the channels of interconnection.
- Investments (~22%) - mostly in compliance with RBI-prescribed instruments only - mostly in government securities and bonds/debentures (commercial paper or certificate of deposits). Note that these commercial papers may act as a linkage with NBFCs.
- Their reserve balances with the RBI (which would be utilized for inter-bank transactions) are about 4% of the total assets. This number is a good metric to question the theory of "fractional reserve banking".
On their LIABILITIES, mainly,
- Reserves and surplus (12%) - These are several different regulatory requirements like statutory reserve, special reserve, securities premium, an investment reserve account, investment fluctuation reserve, unrealised investment reserve, capital reserve, capital redemption reserve, foreign currency translation reserve, revaluation reserve, reserve fund, revenue and other reserves and balance in profit and loss account. Not that, while reserve deposits with the RBI are assets of the bank, these regulatory requirements are liabilities because they have and must be fulfilled - think in a way that the bank is liable to comply with these requirements in order to run the business.
- Deposits (75%) - could be savings deposits, demand deposits or term deposits. Deposits from other banks may link commercial banks to NBFCs as well.
- Capital, basically, is the equity that has been raised by the bank. Interestingly, equity funding seems to form a very small part of the banks' liabilities
- Borrowings - Banks borrow from different channels that include - the RBI, other commercial banks, other institutions and agencies (like Govt of India and other financial institutions), deposits, commercial paper, bonds and debentures, money-bonds and capital instruments
However, on the NBFC side,
Their ASSETS are mainly,
- Loans (85%) - could be (a) term loans (impairment loss allowance is a kind of bad debt expense or basically if debts go bad, reduce that expense from this value) (b) Out of above - further could be backed by tangible assets or be unsecured (~57%). Note that in commercial banks most loans are secured.
- Cash and cash eqv - cash in hand or other eqv liquid investments - mostly in short-term fixed deposits - potential linkage with commercial banks
- Bank balances other than cash and cash eqv consist of fixed deposits and earmarked balances with banks. The latter means the amount that is part of the bank balance but kind of not been claimed until now. So, this consists of - (a) earmarked balances against matured fixed deposits (think like FD has matured but the amount has not been taken out from the bank and still remains in that bank account where FD was made) and (b) against unclaimed dividends. This again may have linkage with scheduled banks
- Derivatives- basically, Bajaj Finance, has cross-currency interest rate swaps.
- Trade receivables - mainly has interest subsidies (~70%)
- Investments - Unlike restricted instruments with banks, NBFCs can invest in equity and mutual funds as well. Note, here, that government securities come under (a) amortised cost and (b) fair value other comprehensive income. The difference basically is that the govt securities calculated through amortised costs are with the NBFC and collect the coupon payments. However, the FVOCI calculation are for securities that have been sold and capital gain/loss has been made along with coupon payments (if any).
- Other financial assets
- Non-financial assets - further sub-divided into (a) Current and/or deferred tax liabilities (b) PPE, CWIP, Intangible related assets and (c) Other non-financial assets. Note, mainly this asset is dominated by component (b) that's mentioned
While their LIABILITIES are,
- Derivatives - Basically has interest rate swaps
Also, note here that NBFCs raise money by issuing commercial paper, the instruments that are present in banks' balance sheets - potential linkage.
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