NBFCs – Unravelling the Indian Shadow Banks

[By Himani Singh]

The author is an Advocate enrolled at Bar Council of Maharashtra and Goa

Introduction

‘Non-banking Financial Companies’ (NBFCs) are financial institutions registered under the Companies Act, 1956(now Companies Act, 2013) and may engage in businesses such as loans and advances, acquisition of marketable securities, leasing, hire-purchase, insurance etc. To operate as an NBFC, the company must also have a valid registration under Section 45-IA of the Reserve Bank of India Act, 1934. Based on the type of business carried out, NBFCs can be classified into: deposit taking, non-deposit taking, non-deposit taking but with acquired securities in their group/holding/subsidiary company(ies). On the basis of their asset size, NBFCs can be classified into: systemically important (asset size above Rs. 500 Crore) and non-systemically important NBFCs.

NBFCs or the Shadow Banks in India

The gamut of NBFCs in India is exquisitely flavored – from housing finance and corporate lending to the more exotic infrastructure finance, promoter finance and core investment companies; and several distinct shades in between. The most attractive fragment of NBFCs that distinguishes them from traditional banks and attracts borrowers from around the world is the peer-to-peer lending segment. Just as NBFCs differ on their business, risk and leverage profiles, there are also multiple regulations and regulators governing them. But essentially, NBFCs are institutions that occupy the interstices in financial intermediation unfulfilled by banks; much like the shadow banks in United States and United Kingdom.

The shadow banking system is made up of a multitude of banking and financial operators linked to each other by financial intermediation chains of varying lengths and degrees of complexity – from hedge funds, asset managers and pension funds to insurers, money market funds, real estate funds and many others.[i] The shadow banks perform the financial intermediation function in the same way as the traditional banking system. The main distinguishing characteristics of the shadow banking system are looser supervision and greater fragmentation between operators at each link in the intermediation chain.[ii]

NBFCs were tagged as ‘shadow banks’ in India by Paul McCulley, the famous American economist, given their easy money lending nature and a separate regulatory framework governing them, distinct from the laws and regulations that govern banks. The shadow banking sector contributed significantly to the economic downturn and eventual financial crisis of the global economy in 2007-08. The crisis occurred since the shadow banks were largely unregulated. The minimal regulation resulted in negligible notice and left everyone blindsided even when shadow banks progressed towards a crisis.

In India, the IL&FS fiasco and DSP offloading on DHFL[iii] sparked a similar fear like that of 2007-08 crisis and stressed on the fact that NBFCs were subject to lighter regulation in comparison to their traditional counterparts i.e. Banks.

Regulation of NBFCs – Progress so Far

For past few years, the Indian banking sector is facing multiplying systemic risks and there is a lack of supervision in the functioning of financial institutions especially the NBFCs. The disruptive challenges arising from technological advances and overarching impact of globalization add to the trouble. The Reserve Bank of India (RBI) has brought multiple reforms to regulate the NBFCs since the 1990s and the process is still underway.

Between 1995 – 1998, the Reserve Bank of India (RBI) came up with several regulations such as exposure limits for lending by NBFCs, prudential regulations for their governance and also restricted raising deposits from public to an extent. Further, NBFCs were categorized based on their business model into deposit taking, non-deposit taking and core investment companies; along with specific directions regulating each category.

In 2000, audit requirements for NBFCs were introduced and certain exemptions were also granted to NBFCs for charitable purposes (companies registered under Section 8 of the Companies Act, 2013 ( Section 25 of 1956 )), potential Nidhi Companies as well as government companies, from applicability of core RBI Act provisions. In 2001, the concept of asset management was brought in.

In 2004, several associations formed a self-regulatory group called ‘Finance Industry Development Council’. In 2006, RBI devised a method to regulate NBFCs functioning on a large scale and identified systemically important and non-systemically important NBFCs wherein NBFCs with asset size above Rs. 100 crore were recognized as systemically important. Nearly 10 years later, in 2016, RBI increased the threshold of systemically important NBFCs to asset size of Rs. 500 Crores and also released master directions to govern each class of NBFC.

In the interim, in 2008, the government had also set up a ‘Stressed Asset Stabilisation Fund Trust’ to address the liquidity freeze caused by global financial crisis. The Trust Fund was set up to purchase short term loans from eligible NBFCs, thereby increasing the liquidity.

Next Steps

As of 2018, there are approximately 12,000 NBFCs registered with RBI and they continue to operate on uneven grounds. The government has brought in several reforms in the financial framework governing NBFCs in the past. However, in comparison to traditional banks, the issue of regulation of NBFCs is only obliquely addressed and therefore, there is a need for further reforms in the array of NBFCs in India.

It is important to re-visit the already registered NBFCs and check for qualification requirements. The license for any NBFC that does not meet the minimum eligibility criteria should be cancelled immediately. Further, it is pertinent to increase the threshold for minimum capital, especially for micro-finance institutions and asset reconstruction companies.

The regulations should not be limited to asset size but also be inclusive of streamlining the liabilities of NBFCs. NBFCs with large assets sizes, especially the systemically important NBFCs should be exposed to standard statutory liquidity ratio and liquidity coverage ratios, set for NBFCs, amongst other things.

The prudential norms concerning income recognition, asset classification and provisioning must be applicable to and tightened for all NBFCs to address the systemic risk plaguing the sector for long. The fair practices code and corporate governance norms of NBFCs should also be strengthened. Additionally, a uniform mode of risk management and settlement process should also be implemented across all NBFCs.

NBFCs are governed by multiple regulators and that leads to unnecessary sectoral gaps. Therefore, it is the need of the hour to monitor the functioning of all the NBFCs by one central regulator established in the format of an ‘Ombudsman’ which shall be helpful in achieving transparency and lucidity in their regulation.

Alternatively, a head regulatory agency consisting of a member of every regulatory agency governing a certain type of NBFC, modeled on Financial Stability Oversight Commission of United States, could help streamline the issue of multiple regulators. Given the increasing cross-jurisdictional impact on the design philosophy of financial legislation in India, it is smart to adopt the mechanisms adopted by US and UK in re-aligning the shadow banks post the 2007-08 crisis.

Conclusion

Overall, NBFCs should be recognized as an important element of the financial sector and close monitoring of their functional mechanisms and regulation, should be given as much importance as traditional banks. If we intend to avoid brewing another fiasco like the 2007-08 financial crisis in our country, or the more relatable IL&FS fiasco, the government must take prompt action and articulate steps to supplement steady growth of NBFCs/ shadow banks in India.

[i] Richard Portes, Shining a Light on Shadow Banking, London Business School (Jan. 17, 2019), at: https://www.london.edu/lbsr/shining-a-light-on-shadow-banking

[ii] Rédigé par DG Trésor, The Shadow Banking System in the United States: Recent Developments and Economic Role, Ministry of Economics and Finance – France (May 23, 2019) at: https://www.tresor.economie.gouv.fr/Articles/2013/05/29/tresor-economics-no-113-the-shadow-banking-system-in-the-united-states-recent-developments-and-economic-role

[iii] Amit Mudgill, NBFC crisis: What went wrong & can it blow up in your face?, The Economic Times (Sep. 26, 2018), at: https://economictimes.indiatimes.com/markets/stocks/news/nbfc-crisis-what-went-wrong-can-it-blow-up-in-your-face/articleshow/65947978.cms

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