In search of binding ties: Lack of SRO will continue to haunt shadow banks

Legacy shadow banks continue to do business without a self-regulatory body. This is far from ideal

“The nature of our business models is diverse in terms of size, focus and customer segmentation and it’s very hard for us to be on a common platform”, says Vimal Bhandari, executive vice-chairman and chief executive officer (CEO) of Arka Fincap, a five-year-old non-banking financial company (NBFC). And this has become a hurdle for legacy NBFCs to set up a self-regulatory organisation (SRO). 
 

The Finance Industry Development Council set up in 2004 was meant to be an SRO, but it cannot lay claim to represent the entire industry. “It’s not that efforts have not been made in the past to set up an SRO, but they have never got off the ground”, offers Bhandari.
 

Data from the Reserve Bank of India’s (RBI’s) Report on Trend and Progress of Banking in India 2021-22 (T&P FY22) shows that at the systemic level, NBFCs accounted for 20.3 per cent of outstanding credit and 1.3 per cent of GDP. The sector has gone through major shifts after the blowouts at Infrastructure Leasing & Financial Services, and Dewan Housing Finance Corporation (now part of Piramal Capital and Housing Finance), and it has led to near-regulatory alignment with banks.
 

Just as errant banks can be placed under the Prompt Corrective Action framework, an NBFC is to be quarantined if it were to get into trouble. There is also a four-tiered scale-based supervisory structure in place — a base, middle, upper, and top layer, with norms becoming stricter as an entity moves up the ladder (the upper layer has been left empty for now, and an NBFC is to be parked there if it were to pose a higher systemic risk).
 

The T&P FY22 analysis of supervisory data shows that NBFCs in the middle and upper layers accounted for almost 95 per cent of total assets “and may pose systemic risks”. And it has meant a progressively more stringent regulatory regime for NBFCs in these two buckets. Even as all this plays out, some NBFCs nurse hopes of securing a banking licence.
 

Pulling in different directions
 

Yet with so much at stake, NBFCs still cannot come together to set up an SRO. Compare this with two other categories of shadow banks of relatively younger vintage — micro-finance institutions (MFIs) and fintech firms. MFIs have two SROs — Microfinance Institutions Network, and Sa-Dhan; in the case of fintechs, the Fintech Association for Consumer Empowerment has approached the RBI to become one, while the grapevine has it that the Digital Lenders’ Association of India may follow suit.

The multiplicity of NBFC categories has meant lack of coherence. At times there are several NBFCs even within the same business group — a core investment company, a housing finance company, and another for car finance. The RBI has also not sought to evolve an SRO for NBFCs, as the Securities and Exchange Board of India has done by way of the Association of Mutual Funds in India. But legacy NBFCs are not unique; it is nobody’s case that other parts of the financial world are homogenous.
 

And as they struggle to set up an SRO, their woes continue to mount.
 

As things stand, the regulatory traffic is one-way, with NBFCs at the receiving end — the result of the want of a coordinated voice. One example is the categorisation of non-performing assets (NPAs) — it is the same for a small-ticket retail loan of Rs 10,000 and a large corporate loan of Rs 100 crore. Another is that the Ind-As expected loss provisioning (ECL) for NBFCs is not applicable to banks, which has led to arbitrage in their favour.
 

While the banking regulator did float a discussion paper on an ECL-based approach for banks in January 2022, it will be some time before it is operationalised. This is said to have created problems for NBFCs’ small borrowers, by negatively impacting their credit scores and ability to raise funds down the line.
 

Then there is that perpetual peeve — the lack of a conversion road map for large NBFCs, with no prescription as to how they are to transition from being dependent on wholesale liabilities to being driven by retail deposits, like banks. Add the fact that even in the case of deposit-taking NBFCs, while the regulatory and supervisory framework has come to mirror that for banks, they cannot avail themselves of cover from the Deposit Insurance and Credit Guarantee Corporation.
 

“Due to the lack of an SRO, there’s really no voice to take up issues like, say, the lack of tax cuts on the provisioning we make on NPAs (as there is for banks),” says Y S Chakravarti, managing director and CEO of Shriram Finance. He believes that the RBI “should proactively push for an SRO”.
 

Gunit Chadha, founder and managing director of APAC Financial (and former CEO of Deutsche Bank for the Asia Pacific, who has been on the managing committee of the Indian Banks Association, or IBA, for a decade), has a different take: “I don’t think different asset sizes or varied business models of NBFCs should be an issue when we are talking of the need for an SRO.”
 

He explains that in the e-commerce space, Nykaa and Lenskart, for example, both have an online as well as a physical presence. And it does not matter if an entity had started as a branch-led NBFC, or a fintech, because eventually, most will converge into a “phygital omni-channel business model” — NBFCs will go digital and paperless, while fintechs will have to handle physical collections, even if they outsource them.
 

Again, “if state-run, private and foreign banks can work effectively through the IBA as an SRO, which has withstood the test of time, why should it be any different for NBFCs”, which will only enhance governance and regulatory comfort towards NBFCs? “The time has come to more actively debate this”, says Chadha.

A sense of déjà vu
 

The year 1997 witnessed a crisis when, in October that year, Crisil in one fell swoop downgraded the debt plans of 14 NBFCs, some of them marquee names of the time — Anagram Finance, Alpic Finance, 20th Century Finance, Ashok Leyland Finance, and Cholamandalam Investment & Finance. 
 

That move came in the aftermath of a potential game-changer that occurred in June that year: Chain Roop Bhansali’s CRB Capital had swung an in-principle banking licence from Mint Road, but went bust. The RBI not only cancelled CRB Capital’s licence, but also revoked the in-principle nod it had given to Cox & Kings to set up a bank. The crisis was a wake-up call for NBFCs to set up an SRO, but it was wasted.
 

Yet another window opened up on August 29, 2011, when the report of a working group on NBFCs headed by Usha Thorat, a former deputy governor of the RBI, was made public. NBFCs were to treat bad loans like banks — if they were not serviced for 90 days (not 180 days, unlike earlier), they would be declared duds. Tier-1 capital and the risk-weights on loans to bourses, realty and commodities was upped. Entities that wanted to be in these businesses would have to set aside more capital; and ditto on loans for commercial vehicles, construction equipment, and home-loans.
 

And in case a loan turned sticky, NBFCs got no recourse under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (Sarfaesi Act, 2002) for its recovery (a position that holds to date). The same year, NBFCs made an attempt under the late Y M Deosthalee, then chairman of L&T Finance, to set up a ‘Forum for NBFCs’, which could have morphed into a SRO. But legacy NBFCs missed that bus as well.
 

The lack of a SRO will continue to haunt shadow banks.