Workers gather round an excavated ditch in the Parel area of Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

NBFCs: 70 Years Of Potholes And Repair Work

BloombergQuintOpinion

The rise and decline of India’s non-banking financial companies is a familiar story. As the banking crisis intensified, the stability of the NBFC sector was celebrated by analysts and policymakers. Now the NBFC sector itself is under trouble starting with the IL&FS fallout to engulfing much of the sector. Just like the long history of banking crises in India, we have had crises in the NBFC sector as well.

In fact, one can safely say NBFCs, as we understand the term today, have existed long before banks came into being. India has a long tradition of money lenders and indigenous banks which, if looked closely, were more like NBFCs than banks. In the south-western region, century-old chit funds were nothing but NBFCs and were eventually classified as NBFCs when the regulations of the sector were first written. More on this later.

Start Of NBFC Light-Touch Regulation

The start of NBFC regulation is itself an interesting part of India’s financial history. The discussions to enact a law for NBFCs started in 1953 when Pune-based depositors complained to the Reserve Bank of India that several firms which accepted deposits had gone into liquidation. The Banking Regulation Act (1949) had allowed trading and manufacturing companies to take deposits as there were limited abuses. The manufacturing companies in Bombay and Ahmedabad had been accepting deposits earlier and there were no problems which had led to this thinking. On investigation, RBI did find that the abuses were limited to Pune.

The government wished to prohibit these joint-stock companies from accepting these deposits. However, RBI was of the view that the share of deposits in total liabilities was a mere 1 percent in 1,000 public limited companies. These companies could raise resources via debentures but preferred deposits for its flexibility.

RBI’s thinking started to change in the early 1960s. It found that several companies were raising deposit funds offering higher interest rates, with little disclosure of quality of management and deployment of these funds. Banks also raised concerns that these deposits were repayable on demand and reserve requirements should be applied on them too.

This led both RBI and the government to bring this non-banking activity into the regulatory ambit. RBI got comprehensive powers to issue directions and inspect the non-banking finance companies. The bill was passed in Parliament in December 1963 and took just three months from initiation to finalisation.

The early NBFC regulation was more light-touch. As long as NBFCs complied with deposit norms, no action was taken against them. In case of violation, the regulator could prohibit NBFCs from accepting deposits.

RBI defined NBFCs into two types: non-banking financial institutions and non-banking financial companies.

  • An NBFI financed its activities by issuing shares, bonds, debentures, etc. It also included insurance and chit fund companies.
  • Non-banking financial companies were those who financed business via deposits.

Nearly 2,300 companies gave details and this showed that the volume and share of deposits were much higher than expected. Most deposits were of short maturity and withdrawable at notice. Textile companies held about one-third of deposits followed by trading companies at 10 percent.

This led to discussions between the government and the RBI which resulted in a minimum deposit tenure of 1 year for non-banking companies and 6 months for hire purchase companies. Firms were also required to reveal their financial information while placing advertisements for deposits.

These restrictions did not achieve desired purposes as NBFC deposits continued to grow. After reviewing conditions, RBI issued fresh guidelines restricting the volume of deposits of companies to a quarter of their paid-up capital and free reserves, prescribed liquidity requirements for hire-purchase and housing finance companies of 10 percent of their outstanding deposits.

1970-1991: NBFCs Continue To Grow

In 1975, in another showdown between government and RBI, the control of non-banking non-financial companies was transferred to the government. RBI continued to monitor non-banking financial companies. In 1982, the Chit Funds Act was passed, which transferred the regulation of chit funds to the state governments.

Despite restrictions and regulations, NBFCs continued to mushroom. There were always enough entities which could not get credit from banks. This was because of the limited branch network as well as customers who did not like the rigid processes for availing bank credit. NBFCs competed with the banking sector by filling these gaps. The disadvantage to the system as a whole was that this made monetary policy more ineffective.

The total number of NBFCs of different types doubled from 5,356 in 1983 to 10,166 in 1989, and aggregate deposits raised by them rose two and a half times from Rs 9,176 crore to Rs 24,917 crore in the same period.

NBFC deposits as a percentage of bank deposits, though, declined from 22 percent in 1984-85 to 20.8 percent in 1986-87.

Harshad Mehta Scam And 1991 Reforms

After the 1991 reforms, several challenges emerged for the NBFC sector. In the Harshad Mehta scam, it was revealed that NBFC subsidiaries of public sector schemes had accepted large-scale deposits and intermediated these funds into stock markets through stock brokers.

The NBFC sector was not limited to just traditional seeking of deposits and giving of loans, but also invested in the securities markets, and there was no authority governing these activities.

This led to changes within the RBI. A Board of Financial Supervision was established to supervise the financial system, including NBFCs, in an integrated fashion. The BFS was a six-member body, with the governor as chairman, a deputy governor as full-time vice-chairman and four members from the central board.

After the 1991 Narasimham Committee on Banking Sector Reforms, a committee was established under AC Shah in 1992 to study NBFCs, which suggested a significant strengthening of prudential norms. One major change was a shift in approach from the liability side to the asset side. Registered financial companies with new-owned funds of Rs 50 lakh and above were required to achieve minimum capital adequacy of 8 percent by 1996. Once the companies complied with these norms and obtained a rating from credit rating agencies, RBI deregulated deposit interest rates charged by NBFCs. The 1995 PR Khanna Committee suggested a new supervisory framework for NBFCs. Accordingly, the RBI Act was amended in 1996-97 giving more supervisory powers over NBFCs.

However, just after these norms, we saw a major crisis.

CRB Capital Market Ltd., an NBFC which was also given a licence to open a bank, got into trouble. This led to friction between RBI and Securities and Exchange Board of India over whose jurisdiction the matter fell into. Soon after, came the South-East Asian crisis which highlighted the importance of focusing on an asset-liability mismatch and bad investments.

At the time, SP Talwar, then RBI deputy governor said, in a speech that there were talks within policymakers to implement deposit insurance for NBFCs. It was felt that deposit insurance could be started after six years of reforming the sector. However, this is yet to see the light of day.

Over time, the NBFC sector could be divided into two broad categories: NBFC accepting public deposits (NBFC-D) and NBFC not accepting deposits (NBFC-ND). The first set was tightly regulated and the latter lightly regulated. In 2006, NBFC-NDs over Rs 100 crore were designated as systemically important, and prudential requirements were applied on them as well. Call it another premonition at the RBI, but these NBFCs created problems in the global financial crisis.

Also read: When RBI Played Angel Investor To India’s Early Financial Institutions

Thorat Committee

In 2010, RBI established a committee under Deputy Governor Usha Thorat, to reflect on the global financial crisis which had cast a shadow over NBFCs worldwide. The total number of NBFCs in India at the time was 12,662.

  • Deposit-taking NBFCs: 311
  • Non-deposit taking systematically important NBFCs: 295
  • Non-deposit taking NBFCs: 12,056

The number of deposit-taking NBFCs had declined from 1,429 in 1998 to 311 in 2010 and the volume of deposits had fallen from Rs 23,770 crore to Rs 17,273 crore. Deposits have increased to Rs 31,900 crore in 2017-18 but it is just 0.28 percent of bank deposits.

NBFCs: 70 Years Of Potholes And Repair Work

NBFCs were relying more on their own capital and bank borrowing as source of funds. This was the result of consolidation as well as closure induced by regulation to clean up the NBFC sector, much like what RBI did with banks after the crisis in the 1960s.

However, NBFC assets increased from Rs 34,790 crore in 1997-98 to Rs 6.6 lakh crore in 2009-10, suggesting the sector had become more concentrated.

The Thorat Committee made recommendations across the sector from harmonising the definition of an NBFC to streamlining exemptions and enhancing regulatory framework. The committee noted that the regulations should evolve along with changing risks and technological advancement in the NBFC sector. It also pointed out that the RBI Act continues to mention chit funds and insurance companies as NBFCs, which should be done away with, as both are regulated by different regulators. It also noted that the entry capital limit for NBFCs of Rs 2 crore was much lower than that for insurance (Rs 100 crore) and stockbrokers (Rs 10 crore). The complexity of the NBFC landscape was laid out by RBI Executive Director Vijaya Bhaskar in a speech:

NBFCs: 70 Years Of Potholes And Repair Work

Despite these early intentions and interventions, the recent IL&FS crisis has again put the spotlight on NBFCs. The deep interlinkages of NBFCs with banking system and broader financial system is again being tested. The nature of the financial sector is such that all these pieces are interconnected, and any one of them being trouble, could create stress for the entire financial system.

NBFCs: 70 Years Of Potholes And Repair Work
NBFCs: 70 Years Of Potholes And Repair Work

To be fair, it is not as if RBI has ignored these risks. As far back as 2013-14, top RBI officials spoke about high growth in NBFCs and the need to review the supervisory framework.

Also read: The Regulatory Dilemma With NBFCs

Conclusion

The broad history of NBFCs suggests that they emerge and evolve to fill the gaps left by banks. India’s NBFC sector evolved from deposit-seeking to hire-purchase financiers and then to the broader financial services offered today.

It is here that there is a regulatory dilemma. If the regulator checks this growth right at the beginning, the sector will not be able to innovate and grow. If it allows the growth unchecked, there are chances of a crisis.

The inter-linkages of the financial system are such that the crises can move from banking to non-banking and the other way round as well.

This is not just an Indian problem but a global one. The origin of the 2008 crisis was in the sub-prime mortgage market. This non-banking source of finance was once celebrated for providing home ownership to low-income borrowers who had been turned down by banks. In stable times, these assets promised higher returns, which led to a large number of U.S. and global financial firms increasing their exposure to these assets, only to see them melt down during the crisis. Global regulators and researchers continue to grapple with the non-banking problem. In India too, similar questions are being asked, and there is no clear answer.

Amol Agrawal is a faculty member at Ahmedabad University. He has a PhD in Indian Banking History and writes the Mostly Economics blog.

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