Filling regulatory gaps for NBFCs

Written by Amal Agarwal

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

Confidence in various regulatory structures was swirling in his head in the wake of the 2008 crisis. Investment banks such as Lehman Brothers have invested in the housing market and financed these investments through the interbank market, while insurance giants such as AIG have created complex financial derivatives to invest in the housing sector. Once prices fall in the housing market, investment banks and insurance firms begin to make huge losses. These losses soon spread to the banking system because NBFCs are connected to the overall system in a complex maze of interconnection. The global financial system was linked to the US financial system, which paralyzed the entire global financial system and the world economy.

The global financial crisis has given the NBFC a new name — Shadow Bank, which is said to operate like a bank but is not strictly regulated under the shadow. The crisis has led to much discussion surrounding shadow-banking and what can be done to bridge the regulatory gap between banks and non-banks. The term was seen as insulting, as if they were only conducting shady financial activities, which was not the case. Accordingly, in 2017, the Financial Stability Board, an international body that monitors and recommends the global financial system, recommended changing the name from shadow banks to non-bank financial institutions.

Against this global backdrop, let us analyze the NBFC situation in India. Although India did not face the NBFC crisis in 2008, we did face a crisis a decade later, in 2018. The failure of the IL&FS group put other NBFCs in the spotlight. Other NBFCs struggled to get funding from their main source bank. The RBI does not directly fund the NBFCs and thus opens a special window through the banks to support the NBFCs. Even before 2018, NBFCs have a long history of failures and the RBI is trying to control them. In the post-independence period, the RBI did not pay much attention to the NBFCs as their share in the overall financial activity was negligible. Consequently, there was no provision in the Banking Regulation Act (1949) to regulate NBFCs. The RBI’s thinking began to change in the 1960s with certain NBFC failures and frauds. In 1963, the RBI Act was amended to allow regulators to inspect and monitor NBFCs. Since then, there have been multiple committees to study the NBFC sector. Committees have suggested reforms that primarily revolve around strengthening the capital base of NBFCs, higher prudent rules and more. The RBI has worked on the advice, but gaps remain due to the nature of the NBFC sector. One of the main reasons for these gaps is that there are multiple types of NBFCs that have grown over the years and are regulated by multiple types of regulators.

In 2021, the RBI solved this problem by classifying all its regulated NBFCs into four levels based on size: base layer, middle layer, upper layer and top layer. This scale-based regulation allows the RBI to initiate regulation based on size rather than the type of NBFC (in the former case). The RBI has recently passed a number of regulations seeking to strengthen regulatory and compliance requirements in the middle (NBFC-ML) and upper levels (NBFC-UL) of the NBFC.

First, it asks NBFC-UL to maintain a capital equity ratio of 9%, as for banks. Second, it applies a large exposure framework to NBFC-UL, which reduces debt to one or more interconnected adversaries. Third, the RBI has issued guidelines restricting loans and advances to directors and their relatives. It advises NBFCs to follow loan valuation policies carefully when lending to the real estate sector. Fourth, the central bank has introduced Legal Entity Identifiers (LEIs), where individual borrowers of a certain large amount are coded. LEIs were first applied to commercial banks and have now expanded to NBFC-UL and cooperatives. Fifth, the RBI has asked the NBFC to appoint a Chief Compliance Officer, similar to a commercial bank. The above reforms are welcomed as they bring NBFC control closer to commercial banks. The RBI has also applied these rules to NBFCs in the middle and upper tier, leaving the base layer to develop and continue to innovate.

The author is an Assistant Professor of Economics at Ahmedabad University