Bridging regulatory gaps for NBFCs

By Amol Agrawal

RBI has issued a flurry of press releases on non-banking finance companies (NBFCs) recently. The purpose of these regulations is to bridge the regulatory gaps between commercial banks and NBFCs/cooperatives. Traditionally, regulators have adopted a strict regulatory approach for commercial banks, but followed a light touch regulation for NBFCs. This is because banks receive deposits from general public whereas NBFCs draw their funds mainly from financial institutions primarily banks. As banks are much better-informed than the public, there is a belief that NBFCs need not be regulated as strictly as banks. Light regulation helps them innovate.

The belief of different regulatory structures was turned on its head in the wake of the 2008 crisis. The investment banks such as Lehman Brothers invested in housing markets and financed these investments from banks via the interbank market, while insurance giant such as AIG developed complex financial derivatives investing in the housing sector. Once the prices in housing markets started declining, the investment banks and insurance firm started making large losses. These losses soon spread to the banking system as NBFCs are connected to the overall system via a complex maze of interlinkages. The global financial system was also connected to the US financial system bringing the entire global financial system and global economy to a halt.

The global financial crisis earned a new name for the NBFCs—shadow banks, called so as they worked like banks but without being regulated as strictly, thus under the shadow. The crisis also led to lot of discussion around shadow-banking, and what could be done to bridge the regulatory gaps between banks and non-banks. The term was seen as derogatory, seeming to suggest that they only carried out shadowy financial activities, which was not the case. Accordingly, in 2017, the Financial Stability Board, an international body that monitors and makes recommendations on the global financial system, recommended changing the name from shadow banks to non-bank financial entities.

Given this global backdrop, let us analyse the NBFC situation in India. While India did not face an NBFC crisis in 2008, we did face a crisis a decade later, in 2018. The failure of the IL&FS group put other NBFCs under the spotlight. The other NBFCs struggled to get funds from banks, their major source of finance. RBI does not provide direct funds to NBFCs, and thus opened a special window via banks for supporting NBFCs. Even before 2018, there has been a long history of NBFC failure and RBI efforts to regulate them. Post-Independence, RBI did not pay much attention to NBFCs as their share in overall financial activity was negligible. As a result, the Banking Regulation Act (1949), did not have any clause for regulating NBFCs. RBI’s thinking began to change in 1960s with failures and frauds in certain NBFCs. In 1963, the RBI Act was amended, allowing the regulator to inspect and monitor the NBFCs. Since then, there have been multiple committees to study the NBFC sector. The committees have suggested reforms which have been mainly around strengthening capital base of the NBFCs, higher prudential norms, and so on. RBI has acted on the suggestions, but gaps have remained given the nature of the NBFC sector. One major reason for these gaps is that there are multiple types of NBFCs that have mushroomed over the years and are regulated by multiple type of regulators.

In 2021, RBI worked around this problem by classifying all its regulated NBFCs into four layers, based on size: base layer, middle layer, upper layer and top layer. This scale-based regulation allows RBI to initiate regulations based on size rather than type of NBFCs (the case earlier). RBI has recently passed multiple regulations attempting to strengthen regulatory and compliance requirements at Middle (NBFC-ML) and Upper Layers (NBFC-UL) of NBFCs.

First, it has asked NBFC-UL to maintain capital equity ratio at 9%, similar to that for banks. Second, it has applied the large exposure framework on NBFC-UL, which minimises loans to one or more interconnected counterparties. Third, RBI has issued guidelines restricting granting loans and advances to directors and their relatives. It has also advised NBFCs to follow loan appraisal policies carefully while lending to the real estate sector. Fourth, the central bank has come up with legal entity identifiers (LEIs), where codes are given to individual borrowers of a certain large amount. The LEIs were first applied to commercial banks and have been now extended to NBFC-UL and cooperatives. Fifth, RBI has asked the NBFCs to appoint a chief compliance officer, similar to that of commercial banks. The above reforms are welcome as they bring NBFC regulation closer to that of commercial banks. RBI has also applied these regulations at middle and upper layers NBFCs, leaving the base layer to continue evolving and innovating.

The author is Assistant professor, economics, Ahmedabad University