Stock prices in the US and India are near record highs. Bond yields are still at the highest levels in several decades in the US. Either equity prices or the bond yields have to fall. In India, valuations are anything but cheap. Yet, money is pouring into Indian equities from Indian and foreign institutional investors. There is a liquidity-led rally even at such high-interest rates.
You may want to treat this as a note of caution if you are a trader. If you are a new investor, you must focus on appropriate asset allocation. The financial services sector leads India’s boom. Last week, we wrote about the opportunity for you in the non-banking financial companies or the NBFC sector. Financial market regulations are a constant evolutionary process. In a clampdown on retail loans, the Reserve Bank of India bumped up capital adequacy requirements for banks and non-banking finance companies last week. While the big picture for the financial services sector does not change, in the short term, the profitability of banks could come under pressure as they would have to keep a portion of the deposits aside. That would curb their ability to lend and earn an interest income.
Reserve Bank of India governor Shaktikanta Das warned about exuberance in lending. He is worried about a contagion effect due to the lending practices followed by banks and non-banks. In a speech last week, he said that the RBI observed banks and other companies indulging in high-cost short-term borrowing from depositors. In comparison, there was no change in the tenure of retail or corporate loans. That could be a potential risk for an asset-liability mismatch. The other issue flagged was the non-banking finance companies being the largest borrowers in the financial system. Banks subscribe to commercial paper and other debt instruments issued by NBFCs. Such concentrated borrowing is a risk to the financial system, according to Mr Das. He also flagged another risk to the financial system from increased collaboration between banks, NBFCs and FinTech companies. Their ability to use analytics-based lending methods could need increased monitoring to minimise risks to the financial system.
These are all legitimate concerns that could cause trouble if things go downhill in financial markets. For now, these are not causing any problems as capital adequacy in the financial system in India is adequate to take care of the potential risks. However, any exuberance in lending to retail and corporate consumers could lead to a volatile situation in the future.
Capital requirements for banks are not just an India-specific requirement. There is an increased coordination between central banks worldwide—regulatory requirements for additional capital push large global banks to create innovative financing methods. Banks in the US are setting up programs to issue credit-linked notes in the market. According to a report by Reuters, a global newswire, the US Federal Reserve has already taken note of such transactions and warned of action if they exceed limits.
You may want to identify the right banks and non-banking finance companies with a solid capital base for your portfolio. You can either do that research yourself or use technology for the purpose.
References:
https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1396
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