Will RBI’s Cocktail Of Regulations Make NBFCs Healthier?

In the last 24 months, the Reserve Bank of India has come up with at least eight regulations impacting non-banking financial companies. The likely triggers for the volley of regulations are the IL&FS and DHFL fiascos. The benefits of some of the regulations, particularly those that will reduce constraints on NBFC funding access, are palpable. Regulations such as the implementation of Indian Accounting Standards, liquidity coverage ratio, scale-based regulation, and most recently prompt corrective action, taken individually, appear sound. However, taken cumulatively, it is possible that they may end up pushing NBFCs to adopt business models resembling that of banks and thus forego their flexibility. But, NBFCs will not have the benefits that banks do, such as RBI’s liquidity windows, customer deposits, and low-cost equity.

Can Another IL&FS Be Averted?

It is not unthinkable that at least some of these regulations may create a different type of risk-build-up, replacing one type of risk with another. While the regulations will increase the cost of compliance for the NBFCs as well as add to RBI’s monitoring load – doubts remain whether they can prevent another IL&FS from happening or prevent the recurrence of a funding liquidity crisis that happened in the aftermath of the IL&FS meltdown.

At its core, both IL&FS and DHFL were massive failures of risk management and internal control. Inadequate disclosure requirements, an endemic shortcoming in Indian financial services, may have prevented stakeholders from disciplining these lenders. At any rate, it allowed various stakeholders—institutional investors and rating agencies among others—to look the other way. In fact, it may be argued that DHFL, with all its governance shortcomings, may have continued for some more time, but for the stretched funding liquidity conditions after IL&FS.

Current Rules A Cocktail Of Forward-Thinking And Dusty Archives

RBI has come up with regulations that have the correct intent of enhancing risk management and transforming NBFCs. Let us review the more important ones and how they may or may not be beneficial.

1. Improved Funding Access In Normal Times

Banks' lending to NBFCs for on-lending to small ticket borrowers, subject to some checks, is to be treated as priority sector lending. Further, securitisation, which has been an important source of funding for an NBFC, may get a push thanks to clarifications provided in the guidelines. However, none of these funding sources can help during stressed market conditions.

2. Liquidity Risk: Erring On The Side Of Caution

The regulatory ask of granularly looking at net cash-outflow over the following 30 days and putting a cap on the maximum allowable negative liquidity position is a best practice. Prudent NBFCs may have already been following it, but thanks to RBI it will now be adopted more widely.

Additionally, RBI required NBFCs that accept public deposits or have assets over Rs 5,000 crore to invest in high-quality liquid assets or HQLA to the extent of 30-days of total cash outflow for a stressed period. HQLAs are typically very low credit risk assets such as cash or government bonds and thus offer very low returns. The expectation is in times of stress the HQLA can be sold by the NBFC to meet their cash requirements. While it does create a buffer, one wonders if it is too much of a good thing.

Even for a deposit-taking NBFC, their deposits are in the nature of fixed deposits and not demand deposits, so a ‘bank run’ like scenario is less likely than even mutual funds.

Besides, NBFCs do not typically issue lending products such as classic working capital lines, letters of credit, and guarantees. So, they are unlikely to have a risk of sudden drawdowns of credit lines. Maintaining liquidity coverage ratios comparable to that of banks may be over-compensating the risk. In fact, one unintended outcome may be that NBFCs to make up for the low yields on HQLA may start chasing yields in riskier credit.

3. Ind AS Put NBFCs Ahead Of Banks In Provisioning

The Indian Accounting Standards call for maintaining provisions on a forward-looking basis based on expected future losses. This allows for build-up of provision, somewhat preemptively. This is a better system than keeping provisions on a loss-as-incurred basis. The latter is the erstwhile system that banks continue to follow.

4. Scale-Based Regulatory Arbitrage

Scale-based regulation proposes a tiered supervision structure. Here, the top 10 NBFCs will be supervised by RBI on the lines of banks. Further, monitoring and compliance requirements reduce by size and complexity. NBFCs who do not take deposits and have asset books of below Rs 1,000 crore will have the least compliance burden. For the largest of NBFCs, the cost of compliance is the highest. However, we’ll have to wait to see whether they become safer or not. Remember, Yes Bank, Punjab National Bank were full-fledged banks when crisis stuck them.

It is possible that scale-based regulation may trigger regulatory arbitrage. There may be a further proliferation of small and mid-sized NBFCs. Such NBFCs are likely to have limited motivation to improve risk management and internal controls. The banking, sector which will continue to fund them, may end up with a large aggregated exposure to such NBFCs.

So while the current rule hopes to solve a ‘too-big-to-fail’ NBFC problem, a large number of too-small-to-care in aggregate NBFCs may still create systemic risk.

5. Hardly Prompt, Arguably Corrective

The Prompt Corrective Action restrictions typically kick in either when the bad debt spikes, or the lender’s equity has eroded. So, in many ways, the horses have already bolted from the stable. The action includes a focus on recovering the bad debt, limitations of dividend, and enhanced compliance burden, including those which impact further lending or product launches and the like. When PCA was imposed on government banks, they lost market share, at times good customers left as well.

Had it not been for the government-facilitated mergers, one wonders whether PCA would have turned around the banks by itself.

While for larger NBFCs the benefit of PCA may still be open to debate, smaller NBFCs are likely to enter PCA at a faster pace and one doubts how many will come out successfully.

Better Surveillance Is Different From More Surveillance

One can understand that a worried RBI, in trying to control systemic risk, is taking more surveillance load by increasing the number of entities it monitors closely. But execution uncertainty remains. It is high time RBI adopts and leverages diverse stakeholders to enforce discipline and provide feedback to entities. To start with, this can be done with much better and more frequent disclosers by all NBFCs regulated by RBI. Irrespective of scale, NBFCs can be asked to disclose the following information on their websites on a quarterly basis:

Delinquency Metrics: Bounce rate, days past-due rate (30+, 60+,90+, 120+,180+) by product portfolio, region and ticket size basis.
Liquidity Metrics: Liquidity gap by 7-day, 15-day, 30-day.
Funding sources and source-wise cost of funding.
Forward guidance on delinquency level.

Any prudent NBFCs would anyway be looking at such metrics at a high frequency so it should not be too much trouble for them to disclose the data. Given the lower cost of data processing and basic IT infrastructure, these disclosures should not be a challenge for any NBFC. With this information, lenders, rating agencies, and other stakeholders can keep close tabs on even the smallest, unlisted NBFCs.

A well-functioning NBFC sector is critical for the economy, which needs to be efficiently regulated.

Deep Narayan Mukherjee is a financial services professional and a visiting faculty on risk management at the Indian Institute of Management, Calcutta.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.