Measures to contain the spread of the coronavirus will increase strains among traditional banks, but the shadow banking sector – still reeling from a large-scale default 18 months ago – is likely to fare even worse. Shadow banks have tended to lend to marginalised households and firms, who are among the most vulnerable economically to the halt in activity. A surge in NPLs seems highly likely. And the riskier practices of shadow banks have caused funding to dry up. The spread of NBFC bond yields over government bond yields has surged over the past month, and remained high despite the RBI unveiling several liquidity-inducing measures last week. We suspect that, if needed, policymakers will provide support to the NBFCs that are deemed systemically important. But many smaller shadow banks are likely to struggle and potentially be allowed to fail, while those that survive will turn more risk averse. A damaged shadow banking sector – which last year accounted for 15% of new lending – is another reason to think that the economic recovery will be severely hampered after the virus has been brought under control.
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