More NBFC law is not the solution.

The solution is to eliminate interconnectedness, which can only be accomplished if banks are forbidden from lending to NBFCs. The rationale was to ensure sufficient disclosures so that depositors could make “informed decisions,” similar to the approach to investor protection taken by capital market regulator SEBI.

Revised rules are still awaited, based on RBI’s Discussion Paper (DP) titled Revised Regulatory Framework for NBFCs: A Scale-Based Approach (released on January 22, 2021). One hopes that the delay is due to a rethinking of the DP’s primary takeaway: higher regulatory rigour, with larger NBFCs’ rules brought nearly on par with banks, is the best way to prevent contagion and maintain financial stability.

No! To understand why, one needs to go back in history. When RBI was entrusted with the regulation and supervision of NBFCs in 1964, it was cognizant of NBFCs’ need for more flexibility and hence opted for ‘lighter and differential regulation’. As the DP points out, today’s regulatory arbitrage in favour of NBFCs is by design rather than by default. The rationale was to ensure adequate disclosures so that depositors could take ‘informed decisions’, on the lines of capital market regulator SEBI’s approach to investor protection.

With the growth in size and importance of NBFCs, prudential regulations were introduced in 1994, though the line between banks and NBFCs remained clearly demarcated and the practice of lighter/differential regulation continued. The underlying logic was sound. Unlike NBFCs, banks are the backbone of the payments system. Banking is based on trust. Banks alone accept deposits withdrawable ‘on demand’. This means that if a significantly large number of depositors try to withdraw their deposits at the same time, banks will not be able to repay them immediately. Yet, depositors don’t worry.

If they did, there would be a run on the bank; all depositors rushing to withdraw their deposits and the bank will fail. History has shown us that if one bank fails, depositors are likely to lose faith in other banks as well. Hence the term ‘systemic failure’. Therefore, banks continue to be licensed (with promoters required to pass the ‘fit and proper test’) and are subject to a higher degree of regulation compared to NBFCs (latter are only registered, not licensed, by RBI).

This differentiated and light-touch regulatory approach to NBFCs changed in the early 1990s with increasing instances of ‘regulatory arbitrage’ coming to light. Over the years, however, RBI has, seemingly, turned a blind eye to such activities.

The concerns of RBI listed in the DP are three-fold: (a) ‘Systemic Risk’, (b) ‘Regulatory Arbitrage’ and (c) ‘Inter-connectedness’

‘Systemic Risk’ is a real danger in the banking system, not in the case of NBFCs. Unlike banks, when one NBFC fails, even if it results in a loss of faith in NBFCs, the reality is depositors cannot withdraw their deposits; NBFC deposits are not repayable on demand. Depositors will have to wait till deposits mature. It is this higher risk inherent in NBFC deposits that compels the latter to pay a higher rate of interest for the same maturity compared to banks.

Thus, unlike in the case of banks, the failure of an NBFC, even a large one, does not pose a systemic risk, as evidenced by the recent Indian experience.

As regards ‘Regulatory Arbitrage’, research has shown this was the main cause of the 2007-08 financial crisis in the US. Assets ‘originated’ by US banks that follow the ‘Originate to Distribute’ model, migrated through asset-backed commercial paper (ABCP) to Money Market Mutual Funds etc with disastrous consequences, since the underlying assets were of questionable quality.

In contrast, banks in India still follow the traditional ‘Originate-to-Hold’ model. Hence, the US experience cannot be extended in toto to the Indian situation. Regulatory arbitrage in India has manifested itself in the form of banks’ lending to NBFCs, which, in turn, lend to sectors banks cannot or would not lend either because of restrictions on banks or because they are too risky.

The DP points out more than 50% of the funds raised by NBFCs are presently sourced from banks. In effect, assets of NBFCs have migrated to the balance sheets of banks. Banks do not have any control over origination; nor do they know the quality of assets held by these NBFCs. Any deterioration in asset quality directly affects banks’ balance sheets. Contagion is direct and swift, with no recourse and banks can do nothing about it.

It is this inter-connectedness that is the root cause of our present ills as it has the potential of significantly affecting the health of banks and hence, the stability of the financial sector. The DP’s answer is to increase prudential regulations. Unfortunately, as recent bank failures have shown us, increasing the severity of prudential regulations has not prevented failures.

More regulations will only make compliance more complicated without eliminating the root cause. Just as the Basel Norms did not prevent the global financial crisis, more regulations alone will not make the system foolproof.
The remedy is to eliminate inter-connectedness, which can be achieved only if banks are not allowed to lend to NBFCs.


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