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The Regulatory Dilemma With NBFCs

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The recent troubles with non-banking financial companies have generated a lot of discussions, with calls for tighter regulation. Some have demanded that the regulator create a liquidity window for NBFCs that can be used as a source of emergency funding. The Securities and Exchange Board of India has changed the rule for ratings of NBFCs and the Reserve Bank of India has changed the rules of securitisation.

There have been no ‘big ticket’ changes to NBFC regulations that have been announced so far. The current situation does provide a good opportunity to make such changes. It is useful, therefore, to take a closer look at how NBFCs have been regulated so far.

A Legacy Of Light-Touch Regulation

Historically, NBFCs have what is often called light-touch regulation. Compared with their closest peers – banks, the regulatory oversight on NBFCs was decidedly light. Underpinning this light approach was the recognition that NBFCs serve customer segments that are un-served or under-served by banks. For a wider reach of credit, the role of NBFCs has been seen as critical. At the same time, since banks were the major providers of funding for NBFCs, there was also a concern that any risks that NBFCs take, will ultimately impinge on the banking system.

Since NBFCs were taking on risks that banks did not, the funding link between them was a mechanism of transmitting these risks from NBFCs to banks.

The regulator had to resolve the dilemma of letting NBFCs grow, by serving segments that banks weren’t on the one the one hand and controlling the risks that banks could face by funding NBFCs, on the other.

A branch of Punjab National Bank. (Photographer: Sondeep Shankar/Bloomberg News)

To serve the segments that they do, NBFCs had to be freed from regulatory constraints that banks face:

  • sector concentration norms,
  • acceptable collateral,
  • credit standards and processes that rely on non-financial information,
  • use of third-party sales channels,
  • recovery processes, etc.

NBFCs have limited constraints on credit and fewer compliance obligations as compared to banks.

The clearest expression of this regulatory dilemma was seen in the Usha Thorat Committee report, which was set up under the leadership of the former deputy governor of the RBI in 2011 to review NBFC regulation.

Former RBI Deputy Governor Usha Thorat. (Photographer: Santosh Verma/Bloomberg News)

Nearly every page of this report expresses the delicate balance that the regulator has to achieve in letting the NBFC sector grow, while controlling the risks to the banking and financial system their growth may pose.

While it quite explicitly recognised the need to be easier on the credit side of regulation, the report did suggest regulatory changes that removed the perceived arbitrage between banks and NBFCs, such as having the same income and NPA recognition norms, and sought to create a stronger protective wall for contagion to spread from NBFCs to banks through higher capital requirements (15 percent of risk-weighted assets as against 9 percent for banks).

While the share of NBFCs in the overall credit was small, risks from them to the system were seen to be modest, and hence they could be allowed to grow with ‘light touch regulation’.

However, over the last few years NBFCs grew very rapidly when bank lending was the slowest it has been in many decades. As a result, the share of NBFC in the overall credit in India rose sharply to over 20 percent. The share was less than 10 percent around the time that the Thorat Committee report was written.

"Rapid growth and continued dependence on bank funding meant that the risks to the banking system from NBFC also became larger during this period."

Also Read: RBI Ready To Be Lender Of Last Resort For NBFCs, But It’s Not Needed As Of Now, Says Acharya

A Sudden Jolt

The IL&FS building in Mumbai. (Photograph: IL&FS Annual Report)

The IL&FS episode and its aftermath have resurfaced deeper issues about NBFC regulation. For one, it reaffirmed the concern of NBFC risks impacting the banking system. With very large borrowing, questions were immediately raised on the impact of IL&FS default on banks, and also on funds and even corporates that were holding debt paper issued by the company. Essentially this episode highlighted the risks that the regulator has always perceived in letting NBFCs grow on the back of bank funding. But the sudden drying up of NBFC funding post the episode, also showed the risks NBFCs face from the banking and financial system.

Regulations in the past focused entirely on the contagion that will pass from NBFCs to banks. Recent events proved that the banking system can pose risks for NBFCs.

It is as if a physician quarantined a patient with infection to ensure that is not passed on to others, only to discover that the patient is asphyxiating due to lack of oxygen. Furthermore, it became clear that if the liquidity challenge persisted, then it would turn into a solvency problem for NBFCs.

Thus with the growth in the relative share of NBFCs in credit, the risks associated with them have become larger and more complex. The risks go both ways – NBFCs pose a risk to the banking and financial system, and the system can be a risk to the NBFCs.

The original dilemma regulators faced between letting NBFCs grow, and containing the risks from them, has become even harder to resolve.

Also Read: SFIO Says Top Executives Led IL&FS To Its Ruin

The Way Forward

Future regulations must take a comprehensive view of NBFCs and not just be focused on their asset side. Progressively over the last few years, especially since the Thorat Committee recommendations, the regulations on the asset side of NBFCs and banks have been aligned.

"" - It’s now time to look at the liability side.

NBFCs have no liquidity requirements such as statutory liquidity ratio or liquidity coverage ratio, except for SLR for deposit-taking NBFCs. When a bank borrows from another, it has to maintain a 19.5 percent SLR on such a borrowing. When an NBFC borrows from a bank, it has to maintain no SLR.

On the whole, banks have to follow much more stringent asset liability management rules as compared to NBFCs. Indeed, the regulatory oversight on NBFC hitherto can be summarised as ‘much lighter on the assets, and absent on the liabilities’. This must change. Liabilities side regulations must be imposed, at least for the systemically important NBFCs.

It is important to note that there are around 200 NBFCs and housing finance companies with balance sheets of over Rs 1,000 crore. Collectively, these large NBFCs and HFCs are the ones that must be brought under liability side regulations, so that another liquidity shock would not turn any of them insolvent.

Shadow banks are common across the world and face lighter regulations as compared to banks. They also become a source of grief when financial systems are subject to a shock. NBFCs are India’s shadow banks. When they were a relatively small part of the system, we could let them grow with light regulation. This is no longer the case. Recent events should be treated as a wake-up call and result in the tightening of regulations, before they bring serious grief to us.

Harsh Vardhan is the Executive-In-Residence at the Centre of Financial Services, SP Jain Institute of Management & Research.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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