Competition and risk interaction, and stability: size based evidence from Indian shadow banks

Purpose Considering the size heterogeneity of Indian shadow banks (SBs), this paper investigates discrete as well as combined effects of credit risk (CR), liquidity risk (LR) and competition on the stability of the Indian SBs. Design/methodology/approach The empirical study is based on secondary source data of 100 systemically important non-deposit-taking NBFCs for a period of 14 years. Competition is computed through the Lerner Index. CR, LR and stability are measured through the accounting approach. Further, the fixed effect panel regression model is employed to identify the various intrinsic and extrinsic factors that determine the stability. Robust check is employed through the GMM model. Findings The results suggest that adverse asset selection impairs asset quality and undermines stability. The interaction between credit and LRs reveals that a strong liquidity position enables NBFCs to pursue more aggressive lending strategies. Competition plays a dual role: among large firms, high dominance of few institutions is detrimental as it encourages aggressive lending and increases NPAs due to greater market power, thereby reducing stability. Conversely among medium and small firms dominance fosters prudent lending and enhances stability in medium firms as it increases profitability with pricing power. But, the risk and competition interaction reflects that when the firms with greater market dominance leverage their position to engage in exaggerated lending, extending credit to the risky asset disrupts the stability of the SBs. Practical implications The study suggests a need for integrated risk management strategies at the firm level, as the joint effect of credit and LR can reduce the stability of the firm across all groups. The varied role of competition in stability across the firm size requires group specific intervention by RBI to foster controlled competition, encouraging prudent lending. Large firms need to be more competitive and promote stricter loan-to-value ratios to curb adverse selection. The expansion of financing activities must be backed by adequate capital to enhance profitability and stability. Also, managers must balance financing expansion with liquidity buffers to address asset-liability mismatches. Originality/value The originality of this study lies in its pioneering examination of risk development's impact on the stability of Indian SBs, an underexplored area compared to advanced economies. It uniquely identifies stability-influencing factors across SBs of varying sizes, offering size-specific insights. Additionally, it advances the literature by analyzing the joint effect of credit and LR on stability and it innovatively explores the competition risk dynamics on SB stability across firm size offering fresh perspectives.