Regulating the Non-banking Finance Company Sector

nbfc

The latest rules from the RBI introduce a tighter regulatory regime for India’s NBFC sector, which has so far enjoyed a favourable policy ecosystem. Even though the new changes are well-timed, many fear they may sound trouble for the distressed but economically important sector.   

On January 22, Friday, an armed gang pulled off a heist at a Muthoot Finance office in Krishnagiri, Tamil Nadu. The team stole nearly 25 kg of gold (valued at about Rs 7.5 crore) and nearly a lakh in cash. Within a day, they were nabbed in Telangana. According to police, such lending outlets have become a pet target for burglars and robbers of late. Muthoot Finance is an NBFC, aka non-banking finance company. Ironically, the NBFC sector has been making news in the recent past for robberies of a different kind — looting depositors’ hard-earned money.

Interestingly, Muthoot Finance is arguably the first NBFC from India, having started operations in 1888. 

Today, India has around 10,000 NBFCs registered with the country’s central bank, the RBI, which, curiously, has been trying to regulate the lenders for myriad reasons. In simple terms, an NBFC is a less sophisticated bank. In the language of the banking regulator, a non-banking financial institution or NBFI is “engaged in varied financial activities”… which are incorporated under the Companies Act, 1956. 

Mainly, there are two kinds of NBFCs: those who take public deposits and those who do not. An NBFC usually offers loans and advances. It also does the acquisition of shares, stocks, bonds, debentures, securities issued by governments. In fact, many NBFCs do much more. They engage in activities such as leasing, buy and sell, insurance, chit business and such. 

Too big to fail?

For regulators, NBFCs seem an enigma. Their workings continue to be a puzzle to the authorities and watchdogs, especially the RBI and market regulator SEBI, which have been trying to regulate the finance companies with moderate success. Even though banks in India face stringent rules with regards to their functioning, NBFCs, despite that they are also engaged in similar activities, have been treated with kids gloves for the very fact that their operations, size, reach and influence on the economy have remained suitably minimal.

But that has changed over time. The sector is valued at Rs 30.9 lakh crore (2018-19) and they help immensely towards furthering the great cause of financial inclusion. Most banks in India now have NBFCs as their top borrowers. Considering that the NBFCs are known for their risk appetite and no-frills lending pattern, they court danger, which often translates into larger problems, as was seen in the IL&FS scandal in September 2018.  

For starters, the Infrastructure Leasing and Financial Services Ltd, popularly known as IL&FS, was an NBFC. It was set up over three decades ago. The company funded construction projects across the country. Its portfolio included the much-hyped Chenani-Nashri tunnel, which was called India’s longest road tunnel, Delhi-Noida Toll Bridge, Baleshwar-Kharagpur Expressway, and Gujarat International Finance Tech-City (GIFT).

IL&FS went bust in 2018, defaulting on their payments to investors and depositors, creating a giant ripple effect in the Indian economy.  IL&FS obligations were huge: the company and its subsidiaries owed investors nearly a lakh crore (Rs 99,354 crore, to be precise). 

Falling like ninepins 

Another big NBFC that went down recently was Dewan Housing Finance Corporation Limited (DHFL). The bankrupt mortgage finance company now owes its creditors some Rs 85,000 core. Just last week, its creditors came together to beat out a resolution plan for DHFL. 

The events, described by many sector watchers as a watershed moment of the wrong kind in the history of India’s non-bank lending sector, helped expose the larger maladies dogging the sector, such as cash shortage, high capital costs and a booming pile of toxic loans. The events in fact helped cement the oft-cited moniker of shadow banking firmly on the NBFC sector, calling for stricter regulations before it becomes too big to fail. 

The IL&FS explosion introduced a liquidity crisis in India’s financial services market. Evidently, this and many similar busts and bad loan moments in India’s NBFC sector prompted the government to formulate a set of fresh rules that could help prevent and preempt a potential systemic crisis an NBFC meltdown could introduce to the country. 

RBI steps in

It is in this context that the RBI is bringing in a regulatory framework for the NBFCs that feature stronger, stricter and more wide-spread rules. Last week, the RBI introduced to the public a discussion paper on the new rules. According to the central bank, the new rules regime will have a scale-based approach. This means the companies will be classified based on their scale. 

To this end, the RBI wants to introduce four layers: the base layer (NBFC-BL), the middle layer (NBFC-ML), the upper layer (NBFC-UL) and the top layer. They are ranked based on their importance to the financial system and, hence, the economy. The current threshold for systemic importance is ₹500 crore. This might go up to ₹1,000 crore.

According to the RBI, for the NBFCs, the era of soft regulations are over. The central bank says no significant regulatory measures were taken to control the sector. It was in the late 1990s that the sector saw some meaningful regulations, following the CRB crisis in 1996-97. To jog the memory, this was a major blowout in India’s NBFC sector in which investors lost nearly Rs 1,200 crore (in August 1997, Re/$ exchange value was at Rs 35, against Rs 70-plus today).

Interestingly, the CRB scam had many similarities with the IL&FS crisis. The big-ticket NBFC had witnessed spectacular growth before the default debacle. Still, it seems few lessons were learnt. Even though the Parliament entrusted the RBI with enough regulatory powers to track and control erring NBFCs, it seems to have taken over three decades for the central bank to introduce regulatory reforms for the NBFC sector. 

A crucial sector 

A major reason behind the delay, say experts, is the fact that several NBFCs are controlled by the might of political parties, especially in states such as Maharashtra. This prevents the problems in such ‘shadow banks’ to emerge rather slowly and political pressure prevents regulatory oversight. Today, the balance sheet of NBFCs equals nearly 35 per cent of the banks’ (nearly Rs 50 lakh crore in 2020) from just about 12 per cent in 2010. That’s phenomenal growth. 

Clearly, it is important that such companies are not allowed to grow beyond capacity and endanger the economy in general and the NBFC sector in particular, say experts. At the same time, the central bank should not be allowed to micromanage a sector that has contributed immensely towards advancing financial inclusion in India’s villages. 

In states such as Kerala, the NBFC sector greatly supports microenterprises and cooperatives. The sector went through a major churn during the Covid-19 crisis. Even though the centre in May 2020, announced a Rs 30,000 crore special liquidity scheme for the sector, followed by a Rs 45,000 crore partial credit guarantee scheme, the sector is still reeling under extreme stress. Industry watchers hope the new regulations would not serve a deathblow to the distressed sector; instead, they hope they proposed rules would bring in more transparency and accountability in the NBFC space.  

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