Goodbye shadow banking

Bad loans in some NBFCs will definitely rise but no one should complain. They are no longer shadow banks

Early this year, the boss of a large non-banking financial company (NBFC) wanted to know why the media always describe NBFCs as shadow banks. As our conversation progressed, he got mildly irritated.

A shadow bank is into the business of lending but is not subject to any regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.

The Reserve Bank of India (RBI) probably overheard us. By the year’s end, a string of new norms is in place to strengthen the regulations for this set of lenders which has been playing a critical role in Asia’s third largest economy. Indeed, India has a bank-led financial system but the banks aren’t always excited to lend; besides, they cannot reach every borrower.  

The RBI is making efforts to restore trust in the sector, the reputation of which has got dented. Infrastructure Finance and Leasing Services Ltd and Dewan Housing Finance Corp Ltd had collapsed in 2018 but that was not the end of the nightmare. Bankruptcy proceedings have recently started against Srei Infrastructure Finance Ltd, Srei Equipment Finance Ltd and Reliance Capital Ltd. All these firms collected money from the public. Such NBFCs need to be ring-fenced as they pose systemic risk. Particularly those that are interconnected, with exposure to mutual fund and insurance businesses, should not enjoy kid glove treatment.

In January 2021, there were 9,507 NBFCs registered with the RBI. Of these, just 64 were deposit-taking NBFCs; six of them have been barred from taking fresh deposits. The non-deposit-taking NBFCs with a loan book of at least Rs 500 crore, called systemically important NBFCs, have the lion’s share in the loan assets — around 83 per cent. Collectively, they have lent around Rs 29.04 trillion till March 2021. The deposit-taking NBFCs have a loan book of Rs 4.85 trillion — a 14.5 per cent share. The remaining 2.3 per cent of the pie belongs to the small non-deposit-taking NBFCs, which outnumber the two other categories by many times.

The prompt corrective action, or PCA, framework — first introduced for banks in 2002 — will now be applicable to large NBFCs. They will be quarantined whenever their vital financial statistics drop below the prescribed threshold. The RBI has also introduced scale-based regulations and prudential norms on income recognition and asset classification, and provisioning pertaining to advances is being harmonised across all lending institutions. With these, the NBFCs are almost on a par with banks, in terms of supervision and regulations.

The PCA framework — meant for all deposit-taking NBFCs and large non-deposit takers in the middle, upper and top layers of the central bank’s scale-based regulation for the sector — comes into effect on October 1, 2022 based on their financial position on or after March 31.

The scale-based regulation divides the NBFCs into four layers in accordance with their size, activity and perceived risks. At the base layer are NBFCs with an asset size of under Rs 1,000 crore. Peer-to-peer lending platforms, account aggregators, non-operative financial holding companies and NBFCs not accessing public funds belong to this category.

The middle layer consists of all deposit-taking and non-deposit-taking NBFCs with an asset size of Rs 1,000 crore and above, the primary dealers who buy and sell government securities, core investment companies, housing finance companies and infrastructure finance companies.

In the upper layer are those NBFCs which, according to the RBI, warrant close scrutiny based on a set of parameters and scoring methodology. Ten largest NBFCs by asset are in this layer.

The top layer remains empty for now but any NBFC in the upper layer may migrate to the top layer if the RBI senses it can become a risk for the system.

The PCA framework does not cover the non-deposit-taking NBFCs with an asset size of less than Rs 1,000 crore, primary dealers, housing finance companies and the government-owned entities. The primary dealers are not in the business of lending, while housing finance companies are still supervised by the National Housing Bank even as the RBI regulates them. Technically, not many NBFCs will be affected but there is a catch as the RBI can take any action at any time, irrespective of the size of an NBFC.

There are three risk thresholds and three yardsticks to measure them. The focus is on the capital adequacy ratio, Tier-1 capital ratio and net bad loans ratio. The restrictions on an NBFC get progressively tighter as it breaches higher threshold levels. The three thresholds for bad loans are: between 6 per cent and 9 per cent; 9-12 per cent; and greater than 12 per cent.

An NBFC placed under the PCA framework for breaching the first threshold will face restrictions on dividend distribution; the promoters will be asked to infuse capital and reduce leverage. If it breaches the second threshold, it will not be allowed to open new branches; and, once the third threshold is pierced, it will be banned from making all capital expenditure except for a technological upgrade.

Rater Crisil Ltd has pointed out that most of the medium and large NBFCs rated by it should not face any challenge, either on capital adequacy or asset quality. Icra Ltd, another rating agency, finds the thresholds around total capital adequacy and Tier-I capital liberal but warns that some NBFCs could breach the net bad loan criterion (more than 6 per cent) if the asset quality does not improve. At least three large NBFCs with assets of Rs 25,000 crore or more have already breached the non-performing asset (NPA) criterion.

The uniform income recognition, asset classification and provisioning norms for lenders across segments — which are already in place — could impact the balance sheets of many NBFCs.

A loan becomes overdue if it is not paid on the due date, but many NBFCs keep it vague in the loan agreements and take advantage of this. They justify this saying the cash flow of the borrowers in certain segments they cater to is very different from that of large corporations. So, if a borrower’s due date of payment is, say, December 12, an NBFC may wait till the end of December for the repayment. A loan turns bad when the borrower does not service it for 90 days. In this case, the borrower ends up getting 109 days to pay up and avoid a defaulter’s tag (90 plus 19 days for the rest of December).

There’s a twist here, too. A bad loan can become good only when the entire overdue is settled, but many NBFCs are happy to treat them as a standard asset if the borrower clears interest overdues or partial overdues. Now the RBI wants them to do so only when the entire arrears of interest and principal are cleared by the borrower.

Bad loans in certain segments will definitely rise following the new norms but no one should complain. The NBFCs are no longer shadow banks.

The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd

His latest book: Pandemonium: The Great Indian Banking Story

To read his previous columns, please log on to www.bankerstrust.in

Twitter: @TamalBandyo