Expanding Access To Bank Credit By Building The NBFC PeripheryBloombergQuintOpinion
In the 70 years since independence, it is clear that we in India have done a poor job of expanding access to credit, in terms of availability, in ensuring consistent risk-based pricing, and in providing good product designs. While most well-run financial systems, such as in the United Kingdom and Australia, report credit-to-GDP ratios exceeding 150%, in India not only is the aggregate number low at 60%, but it ranges from an estimated under 10% in the Kurung Kumay district (Arunachal Pradesh) to a high of 100% in Pathanamthitta (Kerala). These very low numbers suggest that poor access to credit may be acting as the single biggest impediment to the nation’s growth and equitable development.
While this problem’s existence is evident, strategies for a nation-wide rapid and sustainable expansion of credit are less well understood. Attempts by policy to push credit at these markets by forcing large banks to mechanically and directly lend to them at steeply-subsidised rates have not only had limited impact but have also made the balance sheets of these banks riskier. Further, instead of responding to signals from the real sector and carrying out careful needs and risk analyses, mechanical lending at low rates by banks using badly designed financial products, with poor selectivity, has adversely impacted the growth and job creation potential of these sectors. Additionally, such lending, by introducing fixed financial leverage in a high-risk environment, has not only not helped borrowers but has instead served to magnify the impact of real-sector risks such as rainfall and agriculture-price shocks on them.
The thousands of non-deposit-taking non-banking financial companies that already exist in India have historically proven to be effective at this task and, on average, maintained their asset quality at a level that is equal to or better than the banking system. There are however several regulatory constraints that have prevented the orderly growth of this sector and have prompted many of them to desire to grow to convert to small finance banks. Each time this has happened, systemic risk has gone up due to more high-risk lenders being allowed to accept retail deposits, simultaneously with a loss of risk-absorption capacity of the system because now the SFB has to maintain a considerably lower risk-profile than it could sensibly do earlier. Some of these constraints are discussed here.
Three Regulatory Anomalies
One, inefficiencies in capital deployment arise from the regulatory ‘pancaking’ of capital, where the bank which lends to the NBFC, and additionally—unlike in case of any other corporate borrower of the bank—the NBFC which lends to the end borrower, are both required to allocate capital against the same underlying risks.
This has no risk-related rationale since a bank lending to the same end-borrower does not have to set aside that extra capital.
However, it results in a sharp increase in the rates charged by NBFCs, and the cost of loans to the end-borrower, often a low-income household. These requirements are applied to NBFCs with more than Rs 500 crore in assets because they are considered systemically important (and as a result, de facto applied to all NBFCs by banks and rating agencies), even though they have no deposit-taking capacity.
For a bank on the other hand, with a far higher level of systemic-risk impact, this designation has been applied at a level that is at least 400 times the threshold for NBFCs. These strictures appear to be reflective not of prudential concerns but of the view that NBFCs are competitors of the banking system and not their partners in the financial access journey.
Two, bank exposures to NBFCs are viewed with far more concern than are their exposures to other corporate borrowers, and the NBFC market has seen far more regulation-driven hurdles in their ability to access loans from the banking sector. Additionally, the requirement to hold pass-through certificates or PTCs on banks’ trading books, irrespective of the banks’ desire to hold them to maturity, artificially lowers the demand for PTCs, thus further restricting the flow of funds to NBFCs.
Three, distinctions between different licensing-types of NBFCs along business model lines, and product-level prescriptions on them distort credit allocation and further reduce their competitiveness.
- NBFC microfinance institutions, for example, cannot offer more than two microloans to a borrower, while non-MFI NBFCs and banks have no such restriction on them.
- Bank loans to MSMEs can be classified under priority sector irrespective of the interest rate whereas, if banks are to hold securitised paper comprising NBFC loans to MSMEs, such paper would qualify as priority sector only if the underlying loans are priced within a cap calculated as the base rate of the investing bank plus 8%.
If the periphery has to be developed to fully serve the needs of the country, an overhaul of the regulatory and supervisory framework for NBFCs is in order.
Revamping NBFC Regulation
First, the regulation-driven capital adequacy and leverage levels for all non-deposit-taking NBFCs would need to be removed and be left to their lenders to decide. Rating agencies and lending banks would have to assess the risk of each NBFC just as they would for a corporate borrower and any losses on their NBFC-books be borne by banks themselves. For a bank that claims to have good underwriting capabilities, as any good bank should, there is no need for any additional protections through the route of higher micro-prudential prescriptions on NBFCs, and neither should decisions by banks to work entirely with a range of NBFCs to serve broader markets be discouraged.
Second, to ensure that banks and rating agencies have transparent access to the quality of the balance sheet of the NBFC, it would instead be helpful if the RBI mandated a high level of technological capability from all NBFCs. A revamp of off-site reporting formats for NBFCs is in order as the first step towards market monitoring and to better graded supervision. Since NBFCs, unlike the banks, have already migrated to provisioning under IndAS, this would also allow the RBI to track interconnectedness and any build-up of system-wide risks.
Third, only NBFCs that cross the size of, say Rs 50,000 crore, need be required to considerably reduce their risk-exposures and become better capitalised because of the systemic impact of their failure. In fact, RBI should develop a transition pathway for the mandatory conversion of such NBFCs into wholesale banks, or, where appropriate, full-service banks. Their activities can then be more directly supervised by RBI; it can also ensure that adequate levels of capital are being maintained by it, commensurate with the additional risks of contagion, and tools such as ‘lender of last resort’ become available to be applied.
Taking these steps would ensure that there is an orderly growth in access to credit across the length and breadth of the country without any increase in overall systemic risk or risks to the soundness of the banking system. The current approach being followed, driven by competitive and not prudential concerns, is making NBFCs safer with higher levels of capital and requiring banks to become riskier by forcing them to originate high-risk credit at high costs without either the specialised knowledge or the design capability to do so.
Nachiket Mor is a former banker and has served on the Board of Directors of the Reserve Bank of India and its Board for Financial Supervision for many years. Dwijaraj is Research Associate at the Financial Systems Design Initiative at Dvara Research. Dvara Research is an Indian financial inclusion and policy research institution. Its parent organization, Dvara Trust, is a financial inclusion conglomerate that holds multiple businesses including NBFCs.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.