RBI Deputy Governor M Rajeshwar Rao delivers new curve ball to NBFCs

Reserve Bank of India (RBI) Deputy Governor M Rajeshwar Rao’s call for aligning the regulatory framework for non-banking financial companies (NBFC) with the “principle of proportionality” and scaling down their “network externalities within the financial system” throws a curve ball to the sector.
 

Talking about incentives to convert into banks and scaling down on network externalities could mean several things.

It could either be reducing the acceptance of public deposits and substituting them with external commercial borrowing (ECB).

Or it could be cutting down their connections with sections of the financial system so that any possible contagion arising out of the failure of one big NBFC does not bring down the whole system, experts say.
 

This is not a new demand by the central bank. The regulation pursued for NBFCs is what the central bank describes as “light-touch”.
 

NBFCs don’t have to maintain cash reserves and statutory liquidity ratios in the way banks do, although their capital adequacy ratio should be at least 15 per cent as against the banks’ 12 per cent.
 

NBFCs so far also did not need to maintain high-quality liquid assets the way banks have to. But from December this year, that will change. Importantly, NBFCs do not have priority-sector lending obligations. It is another matter that some NBFCs specialise in those areas.
 

But those light-touch regulations seem inadequate when one considers the size of the NBFC sector.

 

Between March 31, 2009, and March 31, 2019, the assets of NBFCs grew at a compound annual growth rate (CAGR) of 18.6 per cent, while the balance sheets of scheduled commercial banks (SCBs) grew at a CAGR of 10.7 per cent.
 

The aggregate balance sheet of NBFCs increased from 9.3 per cent to 18.6 per cent of that of banks during the corresponding period.
 

The asset size of NBFCs (including housing finance companies), as of March 31, 2020, was Rs 51.47 trillion. In terms of interconnectedness, at the end of 2019-20, NBFCs have been the largest net borrowers from the financial system, of which more than half was from banks, followed by asset management companies-mutual funds (AMC-MFs), and insurance companies, the deputy governor said in his speech.
 

It is understandable that the central bank would want to regulate the sector more.
 

Officials in the NBFC sector seem to be not too concerned about the views of the central bank.
 

“The basic point that the deputy governor stressed was the principle of proportionality when it came to regulation. NBFCs which are large and have a lot of externalities obviously carry a spill-over risk in the financial system, and thus should be subject to stringent regulation, which is comparable to banks,” said Raman Aggarwal, chair (NBFCs), Council for International Economic Understanding (CIEU).
 

The interconnectedness, experts say, can be brought down in many ways. It could be reducing deposit taking, giving away raising ECBs, or raising ECBs instead of deposits. Experts also say many large NBFCs would have no problem getting regulated at par with banks, and still not want to convert into banks.
 

“Some regulations for NBFCs are much stricter than those for banks,” said the head of one NBFC.
 

Besides, as a result of the RBI’s strengthening of banking licence rules, industrial houses cannot apply for them. Many large NBFCs are run by industrial houses.
 

According to Anil Gupta, vice-president and sector head of ICRA, the primary concern seems to be the liability side of the NBFCs because of their sizable dependence on banks. The RBI wants to reduce the interconnectedness of the NBFCs, especially of the larger ones, with the banking system. “If NBFCs can build their own liability base or reduce their size, it reduces the interconnectedness. This can happen if larger NBFCs convert into banks or shrink their balance sheet, hence the liability towards the bank goes down and so does the interconnectedness,” said Gupta.
 

Some NBFCs have become too big and may not want to shrink their balance sheet. They target growing their assets under management 15-20 per cent each year. This can pose rollover risks or liquidity risks.
 

“The transition of large NBFC to a bank has its own set of challenges because deposits built up can require huge investments in the branch network and could have long gestation periods,” Gupta said.
 

Some interconnectedness can be reduced by the central bank itself.   “Any regulator can use technology tools to track in real-time if any promoters of financial institutions are borrowing from domestic markets and probably even have a limit for such borrowings,” said Srinath Sridharan, markets commentator.