Non-Banking Finance in India: Regulatory Challenges and Concerns
By Kunal Dhir, Saurabh Kulkarni and Swati Sachdeva under the guidence of Prof. Balagopala Gopalakrishnan
1. Introduction
Non-Banking Finance Companies (NBFCs) — a ₹2.96 lakh crore industry[1] — play a pivotal role in India’s financial system, serving the borrowers at the grassroots who are otherwise excluded from the formal banking sector. Historically, NBFCs were involved in providing financial services for small-ticket personal loans, two/three-wheelers, farm equipment, and working capital[2]. Over the years, they have started competing with banks in providing housing and infrastructure finance. They accounted for almost a third of all new credit issued over the past three years, as India’s conventional banks were struggling with the bad-loan crisis. As a result, NBFCs’ share in the credit system rose from 15.2% in FY14–15 to 19.2% in FY18. As of today, they also capture more than 50% of new retail loans to ‘new to credit’ customers (See Figure 1).
However, the trend is on a decline with NBFC credit dropping 31% to ₹1.96 lakh crore in March’19 from ₹2.83 lakh Crore in the previous year[3]. With the likes of IL&FS, DHFL, and Reliance Capital defaulting, the confidence in the NBFC sector has seen a hit. A collapse in the NBFC sector may have a multiplier effect and hit the Indian economy at large. This may lead to a slowdown in India’s growth trajectory and a rise in unemployment.
In this essay, we attempt to identify the challenges by looking into internal as well as external factors. We would then discuss possible reforms covering both preventive and curative measures.
2. Challenges Identified
We have identified four challenges plaguing the sector; the first two: ALM and sub-prime lending — internal factors — are rooted in day-to-day activities while the latter two: corporate governance and box system — external factors — are a result of opacity and limited monitoring of these entities.
2.1 Internal Factors
2.1.1 Asset Liability Mismatch (ALM)
The ALM finds its roots in the business model of NBFCs. Almost all (99.7% of NBFCs)[4] work on borrowing short term and lending long term. Short-term borrowings through commercial papers — which are cheaper than bank loans — are used to fund projects with longer gestation periods. This creates a mismatch where the returns on the projects are not immediate, but the pay-outs are at regular intervals, leading to the evergreening of loans.
NBFCs primarily borrow from banks and mutual funds (see Figure 2). High NPAs and their resolution process reduced the wherewithal of banks to lend to NBFCs. A lack of confidence post-IL&FS crisis aggravated this. As a result, mutual funds also reduced their exposure to NBFCs.
The Housing Finance Companies (HFCs) were further affected as the real estate sector faced a liquidity crunch after demonetization and hindrances in infrastructure projects. This resulted in a switch to short-term financing alternatives as long-term borrowings had become costlier, creating a mismatch. It went to such an extent that some NBFCs like DHFL and IIFL altogether stopped borrowing for the long term(see Table 1).
The current situation is such that the ALM, coupled with defaults by IL&FS and DHFL, has brought down the confidence level in the market even further. As a result, banks started lending selectively to big-NBFCs, further putting a strain on the smaller NBFCs.
2.1.2 Subprime lending
Banks are perceived to be much safer than NBFCs due to the various liquidity mechanisms followed by the former. Thus, the majority of prime borrowers approach banks. The borrowers who are not served by banks due to less collateral and uncertainty in future payments end up reaching out to NBFCs. As a result, NBFCs deal with sub-prime borrowers and have a higher exposure to defaults[7].
2.2 External Factors
2.2.1 Box System
The report by Risk Event-Driven and Distressed Intelligence (REDD) on DHFL and Reliance Capital brought in the limelight the Box System, which is used to evade reporting of funds given to related entities[8].
RBI mandates reporting if an NBFC has to fund its related entity; to avoid this, the parent company creates box companies. Let’s say the parent company creates three subsidiaries of its own and has a 50% stake in each of these companies. These box companies would then buy from the parent company the shares of the other two companies, thus eliminating the stake of the parent company. The NBFCs can then fund these box companies without needing to report the funding. This system opens up the possibility of subverting the regulators.
2.2.2 Corporate Governance Failure
The default in debt repayments by IL&FS exposed the corporate governance risks in the NBFC sector. IL&FS created a complex network of nearly 350 subsidiaries, which made the whole group unmanageable[9]. The media have argued that the CEO used the company for private gains, and ex-IAS officers were hired for executive positions to create an illusion of IL&FS being a public entity. More scrutiny could have avoided these improprieties.
3. Recommendations
In light of the above challenges, we propose two classes of reforms. Preventive reforms to ensure long-term stability in the NBF sector and curative reforms to address short-term liquidity concerns.
3.1 Preventive Reforms
3.1.1 Voluntary Asset Quality Review (AQR)
NBFCs may be given an option to go for an annual asset quality check conducted by RBI or RBI empanelled auditors. The NBFCs opting to do so can be incentivized by reducing the current minimum CRAR[10] of 15% by 250–300 bps. This will improve the market sentiment and increase the inflows from MFs owing to better valuations and good asset quality.
3.1.2 Chief Risk Officer (CRO)
Banks follow the 3LD model for risk management, which is not currently present in NBFCs. Implementation of a similar governance structure along with the mandated appointment of a Chief Risk Officer (CRO) — in systemically important NBFCs — may prove effective in controlling risk. CROs may then be made responsible for an internal rating model to segregate assets based on riskiness, to release the model in the public domain to welcome market scrutiny.
CROs could consistently monitor the low-rated assets and release a quarterly report to the RBI. Consistent monitoring of assets would also enable the NBFCs to take prompt corrective action whenever required. Immediate conversion of high-rated assets to NPAs may help identify corporate governance issues.
3.2 Curative Reforms
As the asset-liability mismatch is a significant problem in the coming 1–3 years, we propose the following measures to increase the short-term liquidity in the system.
3.2.1 Increasing the refinancing limit of NHB[11]
The current refinancing limit of NHB is ₹30,000 crore, which may be increased to ₹35,000 crores to provide a much-needed impetus to the liquidity of Housing Finance Institutions. This upper limit needs to be reviewed every year as per the liquidity conditions in the industry.
3.2.2 Increased exposure of Banks to NBFCs
The banks’ exposure limit to NBFCs may be increased from 20% to 22.5%. In the absence of bank loans, NBFCs resort to short-term sources, which further aggravates the problem of ALM. The exposure of a bank by way of PCE to bonds issued by each NBFC-ND-SI/HFC may be increased to 1.25% of capital funds of the bank within the existing single/group borrower exposure limits[12].
3.2.3 Minimum Retention Requirement (MRR)
The MRR for the securitization of loans may be reduced from 20% to 12.5% of the book value of loans, or the cash flows from the assets assigned.
3.2.4 Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR)
SLR of deposit-taking NBFCs to be reduced from 15% to 12.5% of aggregate deposits with CRR unchanged at 4%. Along with this, LCR for the first seven days of the month may be separated from SLR.
3.2.5 Setting up a refinancing body
We propose to set up a new refinancing body comprising of the likes of the NABARD[13], SIDBI, [14], and NHB. This will serve as a last resort to NBFCs after ensuring that the defaulting company has taken all possible measures like raising equity, securitization of assets. The NBFC will then come under PCA[15] with RBI taking over the management control.
The refinancing can be done through a mix of debt and equity, debt to reduce the exposure to risk and equity (similar to TARP[16] implemented by the US treasury) to generate higher returns. Once the NBFCs manage their ALM, the entire amount can be recovered at a profit.
3.2.6 Structural Monitoring
NBFCs may be monitored differently based on their size and type to improve efficiency (see Table 3).
4. Conclusion
With the growing importance of NBFCs in India’s economy, addressing the regulatory concerns are indispensable as the current liquidity issue may soon become a solvency one. An implementation of both curative and preventive measures may prove beneficial in reinvigorating the health of the NBF sector. Curative to address the immediate liquidity concerns and preventive to ensure long-term stability in the sector. Regular scrutiny is inevitable, given the systemic impact of a possible crisis in this sector. A healthy NBF sector translates into a healthy economy.
References
[1] Indian Express. (2019, July 02). Why India’s USD42 billion shadow banking system is spooking the market. Retrieved from INDIAN EXPRESS: https://www.newindianexpress.com/business/2019/jul/02/why-indias-usd42-billion-shadow-banking-system-is-spooking-the-market-1998498.html
[2] RBI. (2017, January 10).FAQ. Retrieved from RBI: https://www.rbi.org.in/Scripts/FAQView.aspx?Id=92
[3] ET Markets. (2019, June 26). Slump’s real. NBFC credit falls 31%. Over to RBI, govt. ET Markets | News, p. 1
[4] Livemint. (2019, December 11). Making Sense of NBFC Puzzle box. Retrieved from LiveMint: https://www.livemint.com/industry/banking/making-sense-of-the-nbfc-puzzle-box-1560690341527.html
[5] The names of the NBFC are as listed on the stock exchange
BAF- Bajaj Finance; CIFC- Cholamandalam Finance; LICHF-LIC Housing Finance; MGMA-Magma Fincorp; MMFS-Mahindra & Mahindra Finance; SCUF- Shriram City Union Finance; SHTF-Shriram Housing Transport Finance; IHFL-Indiabulls Housing Finance; DEWH-Deewan Housing; PNBHOUSI-PNB Housing; CANF-Canfin Homes
[6]5 NBFCs- DHFL, IIFL, RCAPT, PNBHOUSI, SCUF
[7] INC42 Brand Labs. (2018, June 26). INC 42 | Resources. Retrieved from INC 42: https://inc42.com/resources/nbfcs-and-fintechs-are-leveraging-an-integrated-technology-approach-and-great-customer-service-to-corner-banks-in-the-lending-market/
[8] Moneylife. (2019, June 08). DHFL and Reliance Capital Used the ‘Box System’ to Avoid Disclosure, says REDD Report. Moneylife News and Views, p. 5.
[9] Mohan, T. T. (2018, November 17). IL&FS was an avoidable crisis. Economic and Political Weekly, pp. 1–4
[10] CRAR: Capital risk adequacy ratio
[11] NHB- National Housing Board
[12] RBI. (2018, November 2). Partial Credit Enhancement (PCE) to Bonds Issued by Non-Banking Financial Companies and Housing Finance Companies. RBI Circular. RBI.
[13] NABARD- National Bank for Agriculture and Rural Development
[14] SIDBI- Small Industries Development Bank of India
[15] PCA- Prompt Corrective Action
[16] In the aftermath of the Global Financial Crisis 2008, the U.S. Treasury ran a Troubled Asset Relief Program (TARP) which generated a cumulative income of $45 billion. (Source: US Treasury Department)
[17] Bank based: Backed by banks.
[18] Captive: A wholly owned subsidiary of automakers or retailers.
[19] Mortgage based: Mortgage-backed securitized asset holding companies.
[20] Other: Microfinance and other NBFC.
