Scale-based regulatory framework for NBFCs optimal approach: RBI Deputy Guv

"Developments around harsh recovery practices, breach of data privacy of digital lenders has dented the credibility of the whole system," Rao said

While differential regulation in the shadow banking sector is justified till the time the scale of operations of finance companies is low, as and when they attain size and complexity that poses a risk to the financial system as a whole, it becomes very important to increase regulatory oversight over the sector, said Reserve Bank of India’s (RBI) Deputy Governor M Rajeshwar Rao.

“...it is in this background that we have conceptualised the scale-based regulatory framework aligning it with the changing risk profile of NBFCs while addressing systemic risk issue,” he said, speaking at a Confederation of Indian Industries event on the NBFC sector.

In January this year, the RBI proposed segregating larger entities and exposing them to a stricter set of “bank-like” rules, aimed at protecting financial stability while ensuring that smaller NBFCs continue to enjoy light-touch regulations and grow with ease.

In a discussion paper released on its website, the central bank had suggested a four-tier pyramid structure for the sector -- base layer, middle layer, upper layer, and a possible top layer.

The base layer will consist of non--deposit-taking non-systemically important NBFCs, which will continue to enjoy light-touch regulation, but with enhanced transparency by way of greater disclosures and improved governance standards.

Under the proposed structure, the middle layer will comprise deposit-taking NBFCs and systemically important non-deposit-taking NBFCs, where the RBI is looking to plug the arbitrage between banks and NBFCs.

The top 25-30 systemically significant NBFCs will make up the upper layer on the discretion of the RBI and will be subjected to “to enhanced regulatory rigour”.

Lastly, the RBI may, if it feels necessary, put a systemically important NBFC in the upper layer, which, ideally, would remain empty, if the central bank is of the opinion that the entity is contributing significantly to systemic risk.

Rao said, “A scale-based regulatory framework, proportionate to the systemic significance of NBFCs, may be an optimal approach where the level of regulation and supervision will be a function of the size, activity, and riskiness of NBFCs”.

He also said that while some arbitrages that the finance companies enjoy may get lost, the scale-based approach would not tamper with the operational flexibility that these finance companies enjoy in conducting their business.

India’s shadow banking sector has 9,651 NBFCs across 12 different categories and as of March 31, 2021, the NBFC sector, including housing finance companies, had assets worth more than Rs 54 trillion, equivalent to about 25 per cent of the asset size of the banking sector. The sector has grown at almost 18 per cent compounded annual growth rate (CAGR) over the last five years.

Cautioning on the pace of growth of NBFCs, Rao said, “..one needs to understand whether it is a demand-side pull or supply-side push which is contributing to the growth of NBFC sector”.

“Conventional wisdom tells us that growth consequential to demand-side pull factors translates into increased efficiency and better services to the customers.

Supply-driven growth could, on the other hand, arise out of entry by entrepreneurs who would like to enter financial services industries but are unable to meet the scale and stringent norms meant for banks,” he added.

In the past few years, the sector has seen a number of large NBFCs fail, which caused a liquidity crisis in the sector, resulting in many smaller NBFCs not getting adequate funds.

“The reputation of non-banking financial sector has been dented in recent times by failure of certain entities due to idiosyncratic factors. The challenge, therefore, is to restore trust in the sector by ensuring that few entities or activities do not generate vulnerabilities that go undetected and create shocks and give rise to systemic risk through their interlinkages with the financial system," Rao said.

“....failure of any large NBFC or HFC may translate into a risk to its lenders with the potential to create a contagion. Failure of any large and deeply interconnected NBFC can also cause disruption to the operations of the small and mid-sized NBFCs through domino effect by limiting their ability to raise funds. Liquidity stress in the sector triggered by failure of a large core investment company (CIC) broke the myth that NBFCs do not pose any systemic risk to the financial system," Rao said.

Digital lending companies

Referring to the digital lending companies, which grew their businesses exponentially during the Coronavirus (Covid-19) pandemic by providing credit to people, who needed it desperately to tide over financial distress, Rao said that while the benefits accruing from digital financial services were not a point of debate, the business conduct issues, and governance standards adopted by such digital lenders had shaken the trust reposed in digital means of finance in India.

He said the RBI received numerous complaints and is still receiving complaints around their harsh recovery practices, breach of data privacy, increasing fraudulent transactions, cybercrime, excessive interest rates, and harassment. The RBI has formed a committee that is looking into the whole digital lending business and is set to come out with regulations.

“Unfortunately, such developments spurred by purely commercial considerations have dented the credibility of the whole system which flourishes and thrives on trust. We should not compromise on the ethos of the finance for mercurial or ephemeral gains. These gains would anyway accrue to the Institutions over the long term if and when it is built on an edifice of trust and mutual benefit,” Rao said.

Further, he emphasised the fact that  RBI has been at the forefront of creating an environment for growth of digital technology, but innovation should not be at the cost of prudence and should not be designed to cut corners around regulatory, prudential, and disclosure requirements.