It is hard to have a fool-proof system that cannot be dodged by determined participants. This has happened in banking as well as NBFCs, and having stringent regulation is only one part of the story.
The Reserve Bank of India’s proposed framework for NBFCs, which has taken a scale-based approach, is quite timely given that there have been several irregularities in this sector in the last two years. NBFCs have already been classified as being systemically important, but the regulator now believes that there needs to be a change in approach to regulation that is more manageable.
The raison d’etre for having such regulation is that being financial intermediaries they pose a risk to the rest of the financial system and hence merit attention. True, these NBFCs do not raise deposits and hence are not like banks. However, they do raise bonds and any failure in that market has repercussions for the banking system as they are a large borrower from both the credit and debt markets. Every year nearly 70% of the bonds issued in the debt market are by the financial services segment. Further, around 8-9% of the outstanding bank credit is to this sector. Therefore, the systemic risk in terms of repercussions is quite sharp in case of failure.
A pertinent question here is that if RBI is concerned about this segment, which can have a default in the bond market, would the same principle hold for non-financial borrowers? Probably not, as they are not in the financial sector, and hence fall outside the ambit of the central bank’s regulation. For NBFCs it affects banks as well and hence they require such close monitoring.
Scale-based regulation makes a lot of sense given that there are over 9,000 such entities; and intuitively the larger the size the greater should be the oversight and regulation. NBFCs have a loan book of around Rs 25 lakh crore, which is a quarter that of the banking system. Further, the group is heterogeneous ranging from MFIs to infrastructure finance companies. Evidently, their sizes are different and hence require differential treatment. Also, monitoring all of them closely is onerous and the 80-20 principle can be used to define the perimeter of regulatory watch.
The criteria laid down for these NBFCs would be threefold: base layer, middle layer and upper layer, with the level of regulation increasing as one moved up the line. Such stratification makes sense as it would also not impose a burden on the regulatory bandwidth of the central bank. The classification of companies into these sub-groups would be driven by size, interconnectedness, complexity of operations, nature and type of liabilities, group structure and segment penetration. This is fairly comprehensive, as also are the norms that have been laid down.
The regulatory changes proposed have been clubbed under capital regulation, concentration norms, governance and disclosures. As the norms are read for the upper layer firms (NBFC-UL), they closely resemble those that are applicable to banks. The compensation norms for management could be tricky for these institutions as they would mirror those of private sector banks which will hence override their discretionary power of paying their senior personnel. The clause of eventual listing is something that some of them will have to reconsider. NBFCs at the higher end will find regulation tighter and have to adapt, while those that were not following the rules especially under governance would have to work hard to comply with the new framework.
The problem however in India, when it comes to irregularities in the financial sector, is not so much the absence of regulation but the adherence to the same, which is the Achilles’ heel. First is the issue of deviations that are purported by the promoters or management (even in professionally-driven banks). It has been noticed that in all cases of failure in the financial sector, the issue was not the absence of regulation but the compliance part. Second, even at the regulatory level, it is hard to do a forensic audit all the time, and until the bubble bursts it is difficult to identify such irregularities.
For example, the issue of interconnected lending is a tough nut to crack. A financial institution keeps lending to companies A, B, C, D, etc, which all look different and are run by different people and seem diversified. It is only after failure that it is realised all these parties have interconnected investments and are all owned by X. This information never stands out when any due diligence is done, and it is only after probing deeper that these facts are known, leading to a lot of umbrage being expressed.
The fascinating part of the corporate structure is that they are known to host several subsidiary companies whose names feature in the Annual Report, but one can never figure out what activities are carried out. Such opacity is responsible for heavy camouflage which helps in tax avoidance, credit procurement, channelling of funds and building oligopolies. This is a problem all across the world.
Can the new regulation stop such practices? Appointment of a Chief Compliance Officer (CCO) is a good idea, but making sure that all the rules are complied with is a challenge, especially if the CCO is an internally appointed person. It has been observed that even the best professionally-managed FIs have managed to dodge several regulatory requirements. In fact, the more hurdles put by the regulator in the form of regulatory requirements, the greater are the chances of companies circumventing the same. And these things never come out when the CCO reports to the CEO who could be driving these deviances. An appointment by RBI makes more sense to ensure that compliance is carried out in true spirit and where the authority has the right to demand and get information from the management. For this, the CCO should not be appraised by the internal management, or else there will be incentive to be compliant to the CEO rather than the regulator. This has to be a 24×7 job and very different from the annual audit and inspection done by RBI for probably just a week or two in the current structure.
How would NBFCs react to this new framework? Obviously, no entity likes more regulation, and the traditional mode of operation will have to be altered to be in consonance with the guidelines. There could be some incentive not to be in the upper layer but remain in the middle layer to have fewer or less stringent compliances. This cannot be ruled out. Others may work on these tighter stipulations to ensure that they get closer to qualifying for getting a banking licence.
Now, taking this scale-based regulation further, RBI can use the compliance of this structure route to award licences on an automatic basis to NBFCs that are desirous of converting to banks. A thumb rule that a track record of three years with minimal negative points for deviation from these rules will qualify the institution can be a positive incentive provided.
The issues raised by this framework should be read with the proposed guidelines of RBI for issuing licensing in banking to corporates. There was apprehension expressed in allowing corporates to enter the fray for the same issues that have been addressed by RBI here. The crux is on ensuring compliance. The regulatory framework provided by RBI is strong and in line with the global best practices. The challenge for regulators across all markets is to ensure that the participants do not game the system. This is why regulation should not be static and has to be altered regularly to close the gaps.
It is admittedly hard to have a fool-proof system that cannot be dodged by determined participants. This has happened in banking as well as NBFCs, and having stringent regulation is only one part of the story. The test starts in monitoring them and ensuring that there are few failures.
The author is Chief economist, CARE Ratings, and the author of ‘Hits & Misses: The Indian Banking Story’. Views are personal