Strengthening regulation

Growth of NBFCS needs better supervision by RBI

Non-banking financial companies (NBFCS) play an important role in the Indian financial system. They complement the banking system in credit intermediation, which is also reflected in the sector’s growth. The size of the NBFC sector has gone up from about 12 per cent of banking assets in 2010 to about a quarter. While the expansion has helped the economy, light-touch regulation in the sector can increase systemic risk. Some NBFCS have considerably large balance sheets. In this context, to strengthen the regulatory framework of the sector, the Reserve Bank of India (RBI) published a discussion paper last week.

The proposals are in the right direction. In 2006, for instance, the RBI introduced differential regulation and classified part of the sector as systemically important. Capital adequacy and exposure norms were applied to this segment. Regulatory requirements were again revised in 2014 for different categories of NBFCS. Over the past five years, NBFCS have not only grown significantly but have also become the largest net borrower of funds from the financial system. This has increased concern about higher systemic risk. The collapse of Infrastructure Leasing and Financial Services Ltd, for example, resulted in material stress in the system, which affected both large and small NBFCS. A repeat should be avoided. The RBI has now proposed scale-based regulation and envisages four layers, which can be seen as a pyramid.

The bottom or base layer would include non-systemically important firms, requiring the least regulatory intervention. The threshold for systemic importance is proposed to be raised to ~1,000 crore. If the limit is raised, over 9,200 of the 9,425 NBFCS that do not take deposits would fall in this category. The proposed regulatory changes will not affect these companies much, though the requirement for net-owned funds would be increased to ~20 crore from ~2 crore. The middle layer will include systemically important non-deposit-taking and deposit-taking NBFCS. Tighter exposure and governance norms would apply to this category. Firms in this layer will, for instance, need to appoint a chief compliance officer. The upper level will have a small set of NBFCS with tighter and bank-like regulation to contain risks. Companies in this category will be determined by factors such as interconnectedness, complexity, leverage, and the nature of activities. This layer would have 25-30 entities, including the top 10. NBFCS in the upper layer would also be subject to the mandatory listing requirement. The top layer will remain empty and the regulator will put entities that need special attention in this category. The regulatory engagement would be much higher at this level.

Essentially, the RBI is looking to strengthen the structures of capital, governance, and supervision to contain risk in the system. But most NBFCS will still be able to grow with limited regulatory intervention. Overall, the proposal should be positive for the sector. Better regulation will increase market confidence. Reduction in regulatory arbitrage might also prompt large NBFCS to become banks. At the same time, the RBI needs to improve its supervision capabilities. Failures of both banks and NBFCS in recent years have not necessarily been because of weaker regulation; better oversight would have contained the damage.