Take care of NBFCs

Tighter regulation is important, but so is the timing

Regulation of non-banking financial companies (NBFCs) is reportedly being significantly tightened soon, with the Reserve Bank of India (RBI) reviewing their reporting and financing requirements. There are more than 10,000 NBFCs, but the focus of the RBI will be on those that affect systemic stability. For some years now, NBFCs defined as “large” — with assets of more than Rs 5 billion — and that are systemically important have been subject to differing requirements. That will likely now kick up a notch, bringing their regulatory status close to that of banks. A ceiling may be placed on their financing by commercial papers — the source of the asset-liability mismatch that has recently caused tremors in the sector. In addition, the structural liquidity statements of large systemically important NBFCs will be made more rigorous.

The motives for this regulatory change are obvious. It is increasingly clear that, over the past years, as banks have exited some forms of lending, the slack has been taken up by NBFCs. This means that they are now a significant source of macroeconomic risk and thus the macro-prudential environment must be altered to reflect this new reality. The recent crisis in Infrastructure Leasing & Financial Services, or IL&FS, underlined the importance of such a change. Thus, the direction of this regulatory tightening is not to be argued with. However, the timing must be carefully calibrated, keeping in mind the needs of the broader economy. It would be unfortunate if a hasty introduction of macro-prudential norms led to precisely the sort of crisis that such norms are in fact supposed to make less likely. Some such as the former chief economic advisor, Arvind Subramanian, have argued for a full-fledged asset quality review of large NBFCs as was conducted over the past years for commercial banks. This would be a mistake at the present juncture, as it would likely increase irrational concerns rather than setting them at rest.

The important principle to keep in mind is that the market itself has been alerted to problems within the NBFC sector by the IL&FS crisis, and therefore a gradual and careful examination, transformation and unwinding of assets and liabilities is ongoing. This process should not be interfered with — either by clumsy attempts to prop up the sector or to infuse greater liquidity into it, or by too rapid changes to the existing regulatory environment. The market must be allowed to make reasonable decisions about rolling over NBFC debt. While a transformation of NBFC balance sheets — in such a way that there is more equity capital, reflecting their new role in the economy — may well be essential, it is important for systemic stability that this takes place in a gradual rather than a rushed fashion. More than the security of the financial sector is at stake. NBFCs have come to play a vital role in the economy as the third and most engaged layer of the financial system. Infrastructure and project finance, as well as micro, small and medium enterprises, has come to depend upon the healthy working of the sector. The new RBI governor and other relevant authorities should carefully consider the timing of any new measures that affect the sector’s well-being.