Picture a small garment trader in Tiruppur. He is eager to rebuild after months of lockdown. His cash flows are uneven, so his local bank turns him down. A non-banking finance company steps in and offers a quick loan. This helps him buy fabric and pay his workers. Across India, thousands of such stories play out every day.

Shadow banks have become essential to India’s financial system. They include non-banking finance companies, housing finance firms, microfinance institutions, and digital lenders. They reach customers that traditional banks often avoid. After the pandemic, their role grew even bigger as many small businesses and households needed urgent cash.

But this rising importance also means risks. If shadow banks run into trouble, the impact does not stay with them. It can spread to banks, mutual funds, and even ordinary savers. Understanding these risks is key to keeping India’s growth story safe.

Here are eight reasons why shadow banking could threaten India’s financial markets in the coming years.

Borrowing short and lending long is a hidden problem

Shadow banks often borrow money that they need to pay back soon. Then they lend that money as long-term loans.

Data from the Reserve Bank shows that over 44 percent of NBFC borrowings come due within one year. At the same time, around 62 percent of their loans are longer term. This works fine in stable times. But if markets tighten or investors pull back, shadow banks can suddenly face a cash crunch.

This is what happened with ILFS in 2018. The company could not refinance its borrowings and defaulted. The shock spread to mutual funds, banks, and insurers. Though this happened before COVID, the pandemic reminded everyone how quickly liquidity can dry up.

Bad loans are still rising

Shadow banks often lend to people and small businesses that do not have steady salaries or formal accounts. When the pandemic hit, many lost their incomes overnight.

As of late 2024, gross bad loans for large NBFCs stand at about 6.3 percent. Before COVID, this was closer to 5.5 percent. Some microfinance lenders also report stress in collections, especially in rural areas.

Unlike large banks, many shadow lenders do not have big capital reserves. If bad loans keep rising, it could threaten their ability to stay afloat.

Too much focus on one sector can hurt badly

Many shadow banks build their growth by focusing on just one type of lending. Some put most of their money into real estate. Others build large portfolios in vehicle loans or unsecured personal credit.

This can bring quick profits when times are good. But it becomes dangerous when that sector slows down. After COVID, real estate developers faced cash flow problems and delays in projects. NBFCs with heavy exposure to builders struggled with repayments. DHFL, once a large housing finance firm, failed partly because it concentrated too much on property lending.

Dependence on banks and mutual funds makes them fragile

Shadow banks cannot raise money through deposits from ordinary people. They mostly rely on borrowing from banks or selling bonds to mutual funds.

This funding model works when investors feel confident. But after COVID struck in early 2020, mutual funds sharply reduced buying NBFC bonds. Data from AMFI shows that debt mutual funds held about 19 percent of their assets in NBFC paper in March 2019. This fell to around 14 percent by the end of 2021 before slowly improving.

If there is another global shock or a rise in domestic rates, shadow banks might again struggle to raise fresh funds. The Reserve Bank has repeatedly flagged this as a structural risk.

Tighter rules help, but gaps remain

Regulators have learned from past crises. After ILFS and DHFL, the Reserve Bank introduced stricter rules. Large NBFCs now have to keep stronger capital and follow more detailed risk management norms.

But some gaps remain.

• Mid-size NBFCs do not face the same tight rules until they cross certain asset levels.
  
  
• India does not have a dedicated backstop or resolution fund for shadow banks like some global markets do.
  
  

This means if several medium-sized lenders get into trouble at once, the pressure could spread across the entire system.

Close links can spread trouble fast

Shadow banks are tied closely to banks and mutual funds. Banks lend large sums to them. Mutual funds buy large volumes of their bonds.

This means if one major NBFC fails, it does not stop there. Banks that lent money to it and funds that hold its bonds also feel the pain. When ILFS defaulted, banks had to mark down their loans. Mutual funds faced redemption pressures. Even healthy NBFCs found it hard to raise new money because investors started avoiding the entire sector.

Fast growth in digital lending brings new risks

Fintech platforms and app-based lenders have changed how personal loans work in India. Many partner with NBFCs to offer quick loans with very little paperwork.

This makes borrowing easier but also builds risks.

• Some customers take multiple small loans across different apps without realizing how much they owe.
  
  
• Certain lenders push short-term, high-interest loans that can trap people in repeat borrowing.
  
  

The Reserve Bank’s new rules on digital lending from 2023 bring more checks and fair recovery practices. But the strong pressure to grow means some players still cut corners.

Losing confidence can freeze credit

Perhaps the biggest risk is a sudden loss of trust. If investors or banks start doubting the strength of shadow banks, they might stop lending to them at all.

This would choke credit to small businesses, home buyers, and consumers just when India needs them to drive growth. Estimates suggest shadow banks now provide close to 30 percent of new retail lending. Any serious pullback could slow the wider economy.

The road ahead

The good news is that after earlier crises, regulators and many large NBFCs have strengthened their balance sheets. Capital buffers are thicker. More shadow banks now borrow through longer-term bonds rather than relying only on short-term loans.

Still, some risks remain. Many lenders continue to have large exposures to just one or two sectors. Others rely heavily on banks and mutual funds for short-term funding.

For investors and savers, it is smart to watch early warning signs such as

• a sharp rise in bad loans,
  
  
• Bond yields on NBFC debt are climbing much faster than those of public banks.
  
  
• or repeated refinancing by smaller lenders that suggests cash flow stress.
  
  

A sharper look for professionals

For market experts, the key question is whether India’s shadow banking system could face a mini liquidity squeeze if global rates rise further or domestic demand weakens.

Will mutual funds continue to buy NBFC bonds if government securities start offering better returns? Could tougher regulatory stress tests force higher provisions that slow new lending? Should India consider a dedicated facility to protect non-banking finance companies if contagion risks escalate?