India’s central bank has called for greater scrutiny of the shadow banking sector and warned that the failure of a major non-banking lender could have as much impact on the markets as a big bank.

In its biannual financial stability report, the Reserve Bank of India said that while banks are showing improvement in tackling bad loans, liquidity stress in the shadow banking sector was a concern.

The report, however, noted that interest payment defaults by Infrastructure Leasing & Financial Services Ltd (IL&FS) and its group entities, and the ensuing stress they created, helped bring greater market discipline among shadow bankers.

Following the IL&FS crisis in September last year, the source of funds to non-bank lenders suddenly dried up and it triggered a liquidity crisis.

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Banks and mutual funds, the main lenders to non-banking financial companies and housing finance companies, scaled down their exposure to these companies. This created a cash crunch and forced shadow lenders to sell assets and cut back on new loans.

Problems at IL&FS came to light in September after several group companies defaulted on repayments due to severe liquidity problems. Later, the government appointed a new board of directors, led by noted banker Uday Kotak, which is now working on ways to revive the ailing group. IL&FS group has an accumulated debt burden of more than 900 billion rupees – close to US$13 billion.

On June 4 a non-bank home-loan lender Dewan Housing Finance Ltd delayed interest rate payments, which hit the net asset values of debt funds. Many mutual funds had lent to the company in the form of debt securities.

The shadow banker had reportedly missed interest payments of 9.6 billion rupees ($139 million). Valuation norms require a write-down in the value of assets in cases involving such payment delays.

In January Dewan faced a claim that it had lent money to ‘shell companies’, allegedly linked to DHFL promoters, which was later used to buy assets abroad. Following this allegation, the group was hit by a series of downgrades from rating agencies and on May 21 the company stopped accepting and renewing fixed deposits.

In order to ease liquidity, DHFL and its holding company Wadhawan Global Capital sold stakes in many of their subsidiaries.

The central bank has noted that the consolidated balance sheet size of the non-banking-financial-company sector grew by 20.6% to 28.8 trillion rupees ($417 billion) during 2018-19, from 24.5 trillion rupees ($354 billion) during 2017-18. The sector’s gross bad loans as a proportion of total loans increased from 5.8% in 2017-18 to 6.6% in 2018-19.