The cheese has moved for NBFCs

WITHOUT CONTEMPT

The days of non-banking finance companies (NBFCs) doing what banks are able to do, without the corresponding regulatory rigour, are numbered.

The Reserve Bank of India (RBI) has invited public comments on a draft policy framework that will start governing NBFCs from the end of this month.

The RBI, in its wisdom, has so far taken the simplistic approach of depositor-protection as the only touchstone for regulating NBFCs. The current approach was itself adopted after a lot of public pressure, when societal realities forced Parliament to amend the RBI Act to provide for mandatory registration of all NBFCs.

Widespread defaults on public deposits, unregulated promises of unsustainable interest rates and proliferation of "pyramid schemes" (schemes where fresh deposits fund repayment of old deposits) led the RBI to stringently regulate the deposit-taking activity.

However, regulating NBFCs that did not accept public deposits did not matter much to the RBI. The commercial banking sector dominated the RBI's regulatory attention (not just because savings of public depositors were involved) but NBFCs were not such a bother so long as they did not accept public deposits.

For instance, deposit-taking NBFCs were asked to comply with the prudential norms on income recognition, accounting, provisioning and asset classification, capital adequacy requirements and disclosure requirements (all of which are similar to the regime governing banks), akin to the banking sector.

Such norms are not applicable to NBFCs that do not take public deposits. This led to banks legitimately setting up NBFCs as credit delivery vehicles, and thereby being able to do almost everything that a bank would want to do commercially, without being tied down by the fetters that regulated banks.

All they needed to do was refrain from accepting public deposits. Moreover, even for deposit-taking NBFCs, the prudential norms that are applied are far less rigorous as compared with the norms that apply to full-fledged banks.

The RBI now wants to remove the scope for regulatory arbitrage, in other words, prevent market players from moving from a regime that faces serious regulation to the one that has a relaxed regulatory regime. The central bank seems particularly keen to treat NBFCs that belong to banking groups on a par with the banks themselves.

In a candid acknowledgement of shortcomings in the legal and regulatory regime in this regard, the RBI's draft policy has made a case for a uniform scope of financial sector regulation. The RBI proposes to introduce a new concept of a "systemically important NBFC" and has invoked a International Monetary Fund's publication to make a case for supervising "bank-line financial institutions like banks."

With effect from the end of the month, the RBI proposes to put into action certain immediate steps. Every NBFC that does not accept public deposits but has an asset size of Rs. 100 crore will be considered a systemically important NBFC.

The ability of such NBFCs to borrow would be restricted to ten times the "net owned funds" (a computation similar to net worth but excluding the value of investments held). Such systemically important NBFCs would also have to maintain a capital adequacy ratio (the ratio of their capital to the risk-weighted assets) of at least 10 per cent.

Limits linked to "owned funds" are being imposed on lending and investments by systemically important NBFCs with effect from the end of this month. Such limits would be applicable not only at individual borrower or investee levels but also at the level of groups to which such borrowers and investees belong.

Making a case for activity-driven regulation instead of regulating on the basis of the form of the institution, the RBI proposes to treat NBFCs used by banks on a par with the banks they are affiliated with. The RBI is now talking about the concept of bank-owned NBFCs being treated as "banks by holding out."

In other words, if for all practical purposes, an NBFC is but a credit delivery vehicle and is used as a means to doing what the affiliated bank would want to do (from a commercial perspective), the RBI will treat the NBFC on a par with the bank.

The proposed framework will disturb the comfort zone for NBFCs that do not accept public deposits and have hitherto escaped more rigorous scrutiny.

For now, the regulatory changes entail only limiting borrowings by linking them to net-owned funds, imposing a capital adequacy ratio of 10% and placing limits linked to owned funds on exposure to single borrowers and investees and to groups of them.

However, the road map is clear. The cheese has moved.

(The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own)