A Dvara Research Position Paper titled “Regulatory and Supervisory Approaches for NBFCs“.
Non-Banking Finance Companies (NBFCs) play a critical role in the credit ecosystem by acting as last-mile financiers for the unbanked and underserved segments of the Indian economy. The NBFC sector is also significantly large, contributing over 20% of the credit to the real sector. As of March 2020, the total assets of the NBFC sector amounted to Rs. 33.89 lakh cr. Further, over the last six years, excluding 2020, the NBFCs’ assets have grown at a higher pace than that of Scheduled Commercial Banks (SCBs). This is testimony to their growing importance to the economy. Thus, their continued growth and orderly development are crucial to ensure both financial inclusion and systemic stability.
Identifying the Role of NBFCs
At the heart of the current regulatory approach for NBFCs, is a view that they are competitors to banks rather than complements. This is, in our view, a flawed approach that creates a false equivalence between NBFCs and banks. It needs to be recognised that NBFCs are specialised intermediaries with a deep understanding of the real sector risks pertaining to the niche sectors that they serve. In contrast, banks have to service all sectors of the economy and thus have limited abilities to specialise. More importantly, NBFCs are not money creators, unlike banks. To that extent, NBFCs cannot be seen as posing the same level of risk as a bank or be considered as credit intermediaries similar to banks. This false equivalence has led to a scenario where NBFCs are subject to prudential regulations, which are, in some cases, more stringent than those in place for banks and disproportionate to the risks posed by them. Even among NBFCs, the current regulatory framework has significant inconsistencies which create regulatory arbitrage between different types of NBFCs. Finally, for regulation to be effective, it needs to be complemented by a robust supervisory mechanism and a quick resolution process; both are presently lacking.
A Modern Regulatory, Supervisory and Resolution Framework
In our position paper, we address these gaps by articulating our holistic vision for the role of NBFCs in the credit ecosystem and the corresponding regulatory, supervisory and resolution frameworks that should apply to them. We envisage NBFCs as non-deposit taking credit intermediaries that operate in the periphery of the banking system and take on credit risks that banks are unable to. Correspondingly, we lay out a scale based regulatory framework based on the asset size of the NBFC, and beyond a threshold of asset size, based on its risk-profile and systemic significance. In this framework, the smallest category of NBFCs must not have any minimum capital regulations. At the other end of the spectrum, the largest category of NBFCs must be allowed to convert to either full-service or wholesale banks. Those NBFCs which do not want to convert will have additional capital requirements to mitigate the systemic risk they pose. However, all NBFCs having retail customers, irrespective of size or risk-profile, would have to follow uniform conduct regulations and have reporting requirements on their credit activities to enable the Reserve Bank of India (RBI) to monitor the credit market.
Complementing this regulatory framework, we also propose a scale-based approach for off-site supervision of NBFCs. The principle here is that the degree of supervision must be commensurate with the risks that an NBFC poses. In this approach, very small NBFCs with insignificant linkages to the broader financial system have limited reporting requirements, while the large NBFCs have significantly higher reporting requirements in terms of the quantum, granularity and frequency of data. We layout a set of principles to identify systemically significant NBFCs. We propose that NBFCs identified as systemically significant be subjected to additional supervisory oversight by the RBI, closer to that undertaken for banks.
To be able to take on risks that banks are unable to, NBFCs must be able to fail and shut down with minimal systemic impact. This requires a robust and quick resolution mechanism for failing, but not yet insolvent, NBFCs. We argue that the resolution framework for NBFCs applicable under the Insolvency and Bankruptcy Code (IBC) is inadequate particularly for large and systemically significant NBFCs. What is needed for them is a resolution framework similar to what was proposed in the Financial Sector Legislative Reforms Commission (FSLRC).
The RBI needs to clarify what it sees as the role for NBFCs in the banking system and should apply regulatory and supervisory frameworks in line with its vision. The regulatory and supervisory frameworks should be risk-based and consistently applied across all NBFCs. All this requires a shift away from the current institution based regulatory regime to a function-based regulatory regime.
The full paper is available here.
See Table VI.2 of Report on Trend and Progress of Banking in India, RBI, Dec 2020
 See Chart VI.2 (b) of Report on Trend and Progress of Banking in India, RBI, Dec 2020
 The government had notified the FSP Rules to provide a generic framework for insolvency and liquidation proceedings of systemically important Financial Service Providers (FSPs) other than banks.
 Chapter 7, Vol. I: Report of the FSLRC, Vol I: Analysis and Recommendations, 2013