Do NBFCs Propagate Real Shocks?

In this paper, we try to explain the role of Non-bank Financial Intermediation (NBFI) to percolate and propel a real shock to the rest of the economy through the bank-NBFI interactions. We propose a simple theoretical model which identifies the channels and distinguishes between idiosyncratic, structural and sectoral shocks, cleanly. In our model, the non-deposit taking Non-bank Financial companies (NBFCs) which are the provider of risky, small and fragmented loans, are financed by borrowing from commercial banks. This link connects the NBFCs with the commercial banks and, in turn, with the rest of the economy. A higher realization of the failed firms (idiosyncratic shock) in the NBFC financed sector and a rise in the sector-wide productivity risk (sectoral risk) increase the interest rate charged by the banks and unemployment rate but reduces the real wages and per capita capital formation of the economy. However, when the average number of failed firms increases (structural shock), the reverse happens.