Rajeshwar Rao: No more a shadow (of a) bank
Remarks by Mr Rajeshwar Rao, Deputy Governor of the Reserve Bank of India, at the
NBFC Summit 2024, organised by Confederation of Indian Industry, Mumbai, 9
February 2024.
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Ladies and Gentlemen!
It's a pleasure to be here at CII NBFC Summit 2024. At the outset, let me thank Mr.
Abhimanyu Munjal, Chairman, CII National Committee on Non-Banking Finance
Companies (NBFCs) for extending the invitation to me for delivering this inaugural talk
at the 6th edition of the NBFC summit organised by CII.
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I recall that it was at this forum, in earlier speech at CII NBFC Summit held in October
2021, I had dwelt upon the introduction of Scale Based Regulatory (SBR) approach in
the NBFC Sector. Much water has flown under the bridge since then. SBR framework
has since been rolled out for the NBFC sector and NBFCs have seamlessly transitioned
to the revised regulations. While I had previously discussed the detailed contours of the
SBR framework, today I propose to discuss the broad regulatory approaches behind
NBFC regulations, including SBR framework and then focus on few specific issues
pertaining to NBFC sector.
Role of NBFCs in the Financial Sector
In December 2023, Financial Stability Board (FSB) released its annual publication
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'Global Monitoring Report on Non-Bank Financial Intermediation '. It has noted that
globally, the size of the non-bank financial intermediation (NBFI) sector has decreased
by 3 per cent in 2022, which is the first notable decrease since 2009. However,
Economic Function 2 (EF2) entities i.e., entities undertaking lending activities, which are
akin to NBFCs in India, have exhibited a growth of around 10 per cent which is the
highest among all five economic categories of the NBFI sector monitored by the FSB.
The report also notes that India accounts for third largest share of EF2 assets after the
United States and the UK. At individual country level, India has the highest contribution
coming from lending entities in its total financial assets of NBFI sector.
This report also mentions that over a five-year period between 2017 and 2022, the
share of total financial assets held by the NBFI sector in half of the emerging market
economies has come down. India is, however, amongst very few countries which have
shown a growth in the share of total financial assets held by NBFIs. In essence, the
data indicates that NBFC Sector in India remains a critical cog in the wheels of
economic growth. As of March 2023, NBFCs credit to GDP ratio stood at 12.6 per cent
and the sector has grown to become 18.7 per cent of banking sector assets as on
March 2023 as compared to 13 per cent ten years ago (March 2013).
A very notable feature of Indian NBFI sector is the predominance of lending companies.
While globally, collective investment vehicles such as Money Market Funds (MMFs),
fixed income funds, mixed funds, credit hedge funds, real estate funds, etc. contribute
to around 74 per cent of the NBFI sector assets, the Indian case is quite different. This
feature, combined with the fact that NBFCs have assumed certain significance and
criticality over last few years, makes it imperative that the regulations of the NBFC
sector keep pace with the changing landscape and move from a light touch regulatory
approach to a more calibrated and nuanced approach to address the growing
interlinkages and emerging risks in order to safeguard financial stability.
It may perhaps be worthwhile to first take stock of the state of the affairs in the NBFC
sector. The SBR framework for NBFCs was issued on October 22, 2021 and it became
effective from October 1, 2022. Usually, the impact of such a reform can only be
assessed in medium to long term. However, the initial assessment suggests that the
NBFC sector has become stronger and resilient post introduction of the SBR
framework. Our interaction with industry also suggests that the framework has achieved
the intended effect of proportionate regulatory burden on the entities based on the
parameters of size, complexity and interconnectedness, among others.
As on September 30, 2023, NBFCs in the base, middle and upper layers constituted 6
per cent, 71 per cent and 23per cent of the total assets of NBFCs, respectively. The
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latest edition of the Financial Stability Report (FSR) notes that aggregate lending by
NBFCs rose by 20.8 per cent (y-o-y) in September 2023 from 10.8 per cent a year ago,
primarily led by personal loans and loans to industry. The GNPA ratio of NBFCs
continued on its downward trajectory with improvement across sectors with overall
GNPA ratio in September 2023 being 4.6 per cent vs. 5.9 per cent in Sep 2022 and
NNPA ratio was 1.5 per cent vs. 3.2 per cent in Sep 2022. Capital adequacy of NBFCs
has also improved to 27.6 per cent from 27.4 per cent during this period. The
profitability of NBFCs has also improved as evident from increase in RoA to 2.9 per
cent from 2.5 per cent.
In terms of the outlook, stress tests conducted by the Reserve Bank shows that the
overall sector will be able to withstand future shocks. For credit risk, under the baseline
scenario, the one-year ahead GNPA ratio of the sector is estimated to be 3.8 per cent
and CRAR at 22.0 per cent while under a medium shock, the CRAR may drop by
around 70 bps relative to the baseline and in the event of severe shock, the capital
adequacy ratio of the sector may decline by 101 bps relative to the baseline, to 21.0 per
cent. Similarly, for liquidity risk, the stress test results indicate that the number of
NBFCs which would face negative cumulative mismatch in liquidity over the next one
year in the baseline, medium and high-risk scenarios stood at 6 (representing 1.3 per
cent of asset size of the sample), 17 (10.4 per cent) and 34 (15.0 per cent), respectively.
Overall the NBFC sector remains healthy, stable and resilient to future shocks.
However, the FSR also notes that during the last four years, the compound annual
growth rate (CAGR) for personal loans (nearly 33 per cent) has far exceeded that for
overall credit growth (nearly 15 per cent) for the NBFC sector. Our recent increase in
risk weights of select retail loan categories may have to be seen in this context.
Regulatory approaches for NBFC sector
Coming to the regulatory approach for the NBFC sector -
While framing the regulations for the financial sector, Reserve Bank has always been
conscious of the fact that the degree of regulation of a financial entity should be
commensurate with the perception of risks posed by the entity and the scale of its
operations on the financial system. Our regulatory approach towards NBFC sector has
been guided by a combination of activity-based and entity-based regulations to
safeguard financial stability and protect customers. We have tried to leverage the
strengths of both these approaches to achieve a more comprehensive and flexible
regulatory framework. We find this hybrid approach particularly valuable for an
everevolving NBFC Sector, where innovations and new business models seem to be
constantly emerging.
Entity based regulations have the advantage of providing a comprehensive view of
overall risk exposure of a specific financial institution and is better placed to address the
systemic risks arising from the interplay of various activities within a single entity to
minimise negative externalities. From regulator's perspective, entity-based regulations
are generally easier to implement and enforce, as regulations are applied uniformly to a
set of entities. However, the flip side is that entity-based regulations may be less
precise in targeting specific activities, slower to adapt to changing landscape, and, at
times, may potentially impose extra burden on low-risk activities.
On the other hand, activity-based regulations allow for more precise targeting of
potentially risky financial activities by enabling the regulators to focus on high-risk
activities regardless of the type of institution involved. Potential down-side is that such
an approach could result in a fragmented regulatory landscape, with different rules for
various activities, potentially making oversight more complex. At times, systemic risks
arising from the combination of multiple activities may remain undetected.
It has been advocated that ideally, the principle of same risk, same activity, same
regulation should apply, i.e, there should be similar regulation for entities undertaking
similar activity to avoid regulatory arbitrage. As the saying goes - if it looks like a duck,
quacks like a duck, and acts like a duck, then it probably is a duck- and should be
regulated as a duck. However, this approach needs to be calibrated suitably for
effective yet non-stifling regulations. Instead of following a narrow approach of putting in
place the same set of regulations for all financial institutions irrespective of their scale of
operations, a nuanced approach may be more suitable for achieving the desired
objectives.
We have been cognizant of the fact that the NBFCs engage in specialised activities,
each carrying its unique risks, and the flexibility inherent in the hybrid model has
enabled us to adapt swiftly to the changes in the sector without sacrificing the
overarching systemic risk management inherent in the entity-based regulations.
Keeping this balance in mind, our regulatory approach has evolved into two broad
categories - prudential regulations and conduct of business regulations. While the
prudential regulation focusses on solvency, safety and soundness of the financial
entities and overall financial system, the conduct of business regulation focusses on
how the financial entities deal with their customers and fair business practices. The
current regulatory landscape is a combination of entity and activity-based approaches
under the pillars of prudential and conduct regulations.
Let me cite some recent regulations in the NBFC sector wherein we have tried to
maintain the balance between different regulatory approaches:
The first case in point, I would like to mention is that of Peer to Peer Lending
Platforms (NBFC-P2Ps): Since NBFC-P2Ps do not undertake any credit risk on
themselves and are merely acting as a meeting place for the lenders and the
borrowers, prudential regulations for NBFC-P2Ps have been kept very light at
basic entry level requirements. On the other hand, as the lenders on NBFC-P2Ps
trust the platforms for getting to know the borrowers, and avail additional services
such as KYC authentication, credit scoring, legal formalities, recovery
assistance, etc. Therefore, conduct norms for these platforms have been kept at
par with other regulated entities in the financial sector.
Second example is that of microfinance sector. Microfinance loans are small-sized
loans and constitutes a very small share in overall credit. Therefore, probability of
financial stability concerns emanating from microfinance loans is quite low.
However, in terms of numbers, microfinance loans affect a large number of
borrowers and these borrowers belong to the vulnerable category. Therefore, it
becomes necessary that the regulatory approach for microfinance loans is
specifically targeted to protect the interests of these borrowers. With the objective
of customer protection in mind, an entity-agnostic and activity-based
comprehensive regulatory framework for microfinance loans has been put in place
for microfinance loans provided by all regulated entities.
Third example is of regulatory framework for Infrastructure Debt Fund-NBFCs
(IDF-NBFCs). Recently, we have reviewed the regulatory framework for
IDFNBFCs wherein regulatory guidelines for the activity of infrastructure financing
have been harmonised to the extent possible with other categories of NBFCs
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engaged in infrastructure financing . Accordingly, we have withdrawn the
requirement of a sponsor for the IDF-NBFCs and have aligned their regulatory
capital requirement and exposure norms with NBFC-IFCs and NBFC-ICCs in the
middle layer. The approach allows for harmonisation of the regulations applicable
to infrastructure financing NBFCs while preserving the unique low-risk character
of IDF-NBFCs.
Are Upper Layer NBFCs regulated at par with banks?
Now, coming to specific issues pertaining to NBFC sector, let me discuss two pertinent
issues-
First, there have been some reports and discussions that the regulations for NBFCs,
especially for NBFCs in the Upper Layer, have been made at par with banks. I would
like to take this opportunity to set the record straight in this matter. While it is agreed
that the regulations between banks and NBFCs have been harmonised in some areas
and regulations for certain NBFCs especially upper layer NBFCs have been
strengthened under SBR, framework significant differences continue to exist between
the regulations applicable to banks and NBFCs. I would like to highlight just a few of
them to emphasize this-
Minimum initial capital requirement for a universal bank is 1000 crore vis-à-vis 10
crore for an NBFC. Also, the scrutiny for a banking license applicant is much more
rigorous than the scrutiny for an NBFC license applicant primarily to reflect the
access of public deposits throgh a bank license. To provide a perspective, it may
perhaps be pertinent to mention here that RBI has provided certificate of
registration to 447 NBFCs over last five years whereas no universal bank license
has been given and only 2 small finance banks (SFBs) have been given licenses
during this period.
Second major difference is that banks cannot engage in any activities other than
those which are specifically provided under the Banking Regulation Act, 1949.
Whereas there is no such provision under RBI Act governing NBFCs' regulations.
Also, banks are required to deploy minimum 40% of the adjusted net bank credit
towards priority sector lending and this requirement is even higher for SFBs at
75%. NBFCs have no such requirements.
Sometimes, it is also argued that the regulatory capital requirement of NBFCs is
higher at 15% vis-à-vis 9% for banks. However, it needs to be noted that banks'
capital requirement comprises of credit, market and operational risk capital
charges whereas for NBFCs (including NBFCs in the upper layer), the capital
requirement is based only on credit risk capital charge. Even components of
regulatory capital are not as elaborately prescribed as is the case for banks.
There are almost no regulatory restrictions for operations of NBFCs. Commercial
banks on the other hand, are subjected to detailed branch authorization policy
prescribing the manner in which they can open the branches. There are no
corresponding guidelines for NBFCs (including NBFCs-UL).
In a nutshell, I would like to emphasize that the regulations for NBFCs (especially in the
upper layer) are much more calibrated and are certainly not on par with the regulations
applicable to banks.
Should NBFCs be allowed to accept deposits?
The second issue which I would like to discuss is regarding the deposit taking activity of
NBFCs.
With the perception that SBR framework has made regulations of NBFCs more
banklike, there have also been intermittent demands that NBFCs should be allowed to
accept public deposits. Having clarified the first issue, let me emphasize that it is indeed
the non-acceptance of public deposits by the NBFCs which provides the regulatory
comfort to the Reserve Bank to have lower entry barriers for NBFCs, allow them to
specialise in any specific sector of their choice and have lower exit barriers to wind up
their businesses.
Acceptance of deposit, in whatever manner and form, necessitates existence of a
macro financial safety net including deposit insurance and central bank liquidity
backstop. These safety nets come with increased regulatory rigour and intense
supervisory oversight. The NBFCs have evolved as a niche companies serving specific
economic function and it is uncharacteristic for them to demand becoming like a bank.
Considering this, Reserve Bank has not issued any certificate of registration to new
NBFCs for acceptance of public deposits since 1997. On the contrary, Reserve Bank's
approach has been to disincentivise deposit-taking activities of NBFCs as evident from
decrease in the number of deposit-taking NBFCs over last decade from 241 in March
2014 to 26 in September 2023.
Concerns and Expectations
NBFC sector has come a long way since its initial days and the regulatory framework
for the NBFC sector has aided its development of by providing the operational flexibility
and proportionate regulations. However, there are certain risks on the horizon and I
would like to use this forum to urge the NBFCs to monitor these risks in their business
models or balance sheets and initiate necessary action as and when required:
NBFCs are large net borrowers of funds from the financial system, with the
highest exposure to banks. Several NBFCs maintain borrowing relationships with
multiple banks. Banks also subscribe to their debentures and commercial papers.
Such concentrated linkages coupled with high leverage may create contagion
risks in the financial system. Concentration of funding sources for NBFCs is also
not a prudent strategy as they may face sudden drying up of such funding during
stress events. Therefore, it may be prudent for NBFCs to focus on broad-basing
their funding sources and reduce over-dependence on bank credit.
In pursuance of high growth, there seems to be tendency among the NBFCs to
get the customers on board with oversimplified underwriting processes. While the
ease and convenience for a borrower is very important, this should not come at
the cost of underwriting standards. Besides improving the ease of lending, NBFCs
should equally focus on maintaining the quality of their loan portfolio.
Of late, some of the business practices of NBFC-P2Ps do not appear to be in line
with the regulatory guidelines. A large proportion of lenders on NBFC-P2Ps are
individuals and they are not expected to be well-equipped to understand the risks
involved in providing credit. Instead of educating the lenders about the inherent
risks in the lending activity, NBFC-P2Ps have been observed to underplay the
risks through various means such as promising high/ assured returns, structuring
the transactions, providing anytime fund recall facilities, etc. Let me make it
absolutely clear that any breach of licensing conditions and regulatory guidelines
is non-acceptable.
Under the revised framework for microfinance loans, rule-based prescriptions on
pricing of loans were replaced with a principle-based framework with enhanced
disclosures and transparency requirements. It has been observed that while the
lenders were quick to pass on the increased costs to borrowers, they have been
reluctant to pass on the benefits envisaged under the new framework. Some of
the MFIs have increased their margins disproportionately in new regime. We are
not oblivious to the misuse of the freedom provided to the microfinance sector and
irresponsible practices would compel us to act.
Post March 2023 banking sector turmoil in the US and Europe, the business
models of financial entities have come under enhanced scrutiny. We have also
observed concentrated business model in some NBFCs. For example, some of
the NBFCs, have concentrated exposure to segments such as consumer loans,
vehicle loans, etc. If any of these segment faces economic stress, there can be
significant impact on the financial of those NBFCs and, in turn, on their lenders
including banks. It is in their self-interest that entities should consider these risks
and we expect that Boards are having a pulse on such issues.
Lastly, in view of the increasing reliance of NBFCs on delivering their services
through digital medium and their partnerships with Fintechs, the sector's exposure
towards technology related risks, including cybersecurity threats and operational
disruptions, as well as their reliance on third party partnerships has increased
significantly. Therefore, we expect the entities to put in place suitable risk
mitigation measures, commensurate with their business and risk profile, even if it
means going beyond the regulatory minimum requirements.
Concluding thoughts
We have recently come out with a draft omnibus framework for the Self-Regulatory
Organisations (SROs). The SROs are expected to play an important role in improving
the compliance culture as well as promote ethical business practices, customer
protection, better governance standards, sound risk management measures and
contribute positively to the orderly development of the financial sector, including NBFCs.
The NBFC sector is an important stakeholder of the Indian financial sector.
Strengthened regulation and enhanced oversight of the NBFC sector is the best
testimony of the importance of the NBFCs in not only the financial system but overall
economy. It's time that NBFC sector comes out of its own shadow as well as that of the
banking sector. I am sure that NBFCs will play a significant role in achieving the dream
of a $5 trillion economy going forward.
Thank you.
Inputs provided by Pradeep Kumar and Anuj Sharma are gratefully acknowledged.
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Chasing the Horizon (Remarks delivered by Shri M. Rajeshwar Rao, Deputy
Governor, Reserve Bank of India - October 22, 2021 - at the CII NBFC Summit on Role
of NBFCs in Achieving $5 trillion Economy) available at https://www.rbi.org.in/Scripts
/BS_SpeechesView.aspx?Id=1135
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https://www.fsb.org/2023/12/global-monitoring-report-on-non-bank-financialintermediation-2023/
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https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1254
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NBFC-Infrastructure Finance Companies (NBFC-IFCs) and NBFC-Investment and
Credit Companies (NBFC-ICCs).