The sector has been facing liquidity challenges as investors became risk averse after a series of defaults by IL&FS Group in September 2018.

The COVID-19 related disruptions would worsen the asset quality of non-banking financial companies (NBFCs) and further aggravate their liquidity stress, according to a report. The weakening of NBFCs' solvency will increase risks for banks that have large direct exposures to the sector, global rating agency Moody's said in a report.

The sector has been facing liquidity challenges as investors became risk averse after a series of defaults by IL&FS Group in September 2018.

"Asset quality at non-banking financial institutions (NBFIs) will significantly deteriorate as economic disruptions from the coronavirus outbreak deepen an economic slowdown that has been underway in the past few years," Moody's said in a report.

Asset quality deterioration at NBFCs on average will be more severe than at banks because the former focuses more on riskier segments, according to the report.

The Reserve Bank of India's (RBI) three-month moratorium on repayments of loans would create a significant drain on near-term liquidity at NBFCs, the report said.

Most NBFCs do not have substantial on-balance sheet liquidity because they primarily manage liquidity by matching cash inflows from loan repayments by customers with cash outflows to repay their own liabilities, it said.

Most NBFCs do not have substantial on-balance sheet liquidity because they primarily manage liquidity by matching cash inflows from loan repayments by customers with cash outflows to repay their own liabilities, it said.

"Moratoriums on loan repayments will result in substantial declines in cash inflows over the next few months,'' the rating agency said.

The extent of liquidity stress will depend on the number of customers seeking moratoriums and the degree of the economic shock, the report said.

The longer the restrictions on economic activity remain, the longer it will take for loan repayments to return to normal levels even after moratorium periods end, it said

The agency expects loan repayments to drop 50 per cent during moratorium periods.Securitization, which has been a key source of additional funding for NBFCs in the past year, will also become more difficult because collections from securitized loans will decline because of loan moratoriums, Moody's said.

"NBFCs' weakening solvency will raise risks for banks at a time when risks to systemic stability have increased because of a default by Yes Bank, which triggered deposit outflows at some smaller banks,'' the report said.
Banks, particularly public sector banks, have large direct exposures to NBFCs.

The recent government measure to effectively make a direct purchase of NBFC debt will provide some near-term relief, but it will not sufficiently address NBFCs' structural funding weakness, the report said.