Non-Banking Finance in India – Regulatory challenges and concerns

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Bhavya Arora

The Commercial Paper exposure of NBFCs has fallen from 38.2% to 21.2% from Oct’18 to Oct’19. The funds parked by mutual funds in NBFCs have also fallen during the same period, hinting at eroding confidence in NBFCs and further deepening the liquidity crunch.

Introduction

Of late, the Indian economy has been going through a lot of turbulence, which has been affecting almost all the sectors that drive growth. The finance sector has been at the core of this, thus, having ripple effects on the real GDP, growth and investor sentiment. Our emphasis here is to study the NBFC crisis, in the light of recent events, package announcements and try to find out plausible solutions for the same. It started in 2018, when IL&FS reported its inability to meet the repayment obligations. The company had taken up several infrastructural projects but a glitch in land acquisition made it difficult to take them to culmination. The total debt squared off to INR 91,000 crore. Subsequently, it sparked tension amongst the several banks and Mutual Funds that had their money tied up in various investments with the company. The credit extension and investment activity has been tightened since then, thus disrupting the flow of funds. This, coupled with the languid buying by the customers, increasing conservatism and protectionism at the global level, falling automobile demand, reducing salaries, low employment and  instability was reminiscent of another 2008 crisis repeating itself, after a decade, but to only hit India more this time. In 2008, credit in India was expensive so corporates found lending from abroad a more viable option. But with the growth of financial sector back home, the situation had improved and inland financing was a significant source of credit nowadays. Thus, any sort of problem was bound to have ripple effects on the entire economy.

Following graphs aim to capture the essence of the role NBFCs have played in the economy-

rbi11

Source: RBI[1]

rbi2

Source: RBI[2]

But as soon as the crisis began getting the attention of the policy makers, the blow by pandemic-induced lockdown made the situation grim, as the demand, which was already weak, hit another low, production halted and finance for production dried. At this time, there were no takers and providers for the shadow banks’ credit; the commercial banks were way too cautious in their lending operations. As expected, the government had to step in with its largesse consisting of full guarantee (INR 30,000 crore) and partial guarantee schemes (INR 45,000 crore) for keeping the NBFCs afloat. But this support falls short by a huge margin against the lending abilities of NBFCs, roughly totalling INR 27 lakh crores, as pointed out by Abizer Diwanji, Partner, Financial Services at EY. Along with this, the debtors of Microfinance Institutions who are largely the MSMEs are also receiving collateral free loans along with moratorium periods. This indirectly helps the situation of NBFCs somewhat, but not entirely.

The fundamental drawback of all these reform measures is that they choose to ignore the already tattered state of economy before the lockdown and expect the industries to emerge from the ashes like a phoenix. The V-shaped recovery becomes especially impossible in the light of blatant ignorance of demand side reforms by the government. Unsold inventories were the highlight of the story before the lockdown also, causing automobile industry to reduce activity much before the lockdown. In such a situation, the takers of finance will be defaulters, wilful or not. Therefore, the situation of all lenders becomes worse, if not the same because of COVID-19.

Regulation of NBFCs – present situation

The NBFCs are established under the Companies Act, 2015. They are primarily governed by Reserve Bank of India (RBI), except for some NBFCs which are governed by other statutes or relevant institutes, for instance: the insurance companies are regulated by the Insurance Regulatory and Development Authority (IRDA); Venture Capital and stock broking companies are regulated by the Securities and Exchange Board of India (SEBI); Nidhi companies by the relevant provisions of the Companies Act;  and Stock Exchanges, Mutual Benefit companies and Chit Fund companies by the Chit Funds Act 1982. The aim is to ensure there is no overlap or dual regulation for the NBFCs. The NBFCs are required to have INR 2 Crores as net owned funds[3]. Essentially, before the crisis hit the town, NBFCs weren’t as strictly regulated as they are now, because of their nature, as they aren’t exactly banks since they do not accept demand deposits and are not part of the payment and settlement systems. But after the NBFC-HFC (Housing Finance Company) sector showed signs of collapse, it served as a clarion call and several steps were taken to increase the scope of scrutiny. Government granted RBI the power to supersede the board of NBFCs (other than those owned by the government) and work out the resolution of financially distressed entities by either mergers or splitting them up into viable and non-viable units called bridge institutions as well as decide the remuneration of senior management. It also has the powers to conduct the audit of any NBFC, when it deems necessary and remove auditors. Hence, the systematically important NBFCs will be watched closely now. Also, RBI has been entrusted with power to regulate the HFCs (as against the previous arrangements). Apart from these, certain changes were brought to ensure safety of debt, for instance, mandatory maintenance of Debenture Redemption Reserve (DRR), in addition to a special reserve required by RBI, for public debt and on-boarding NBFCs on the Trade Receivables Discounting Systems (TReDS) platform. TReDS is an electronic platform for facilitating the financing / discounting of trade receivables of Micro, Small and Medium Enterprises (MSMEs) through multiple financiers. Last year also, the Finance Minister had announced INR 70,000 crore capital infusion scheme for capital market and dropped the surcharge on FPI (Foreign Portfolio Investment).


Challenges and concerns

The Financial Stability Report of RBI brings out some key learnings about the NBFC sector, which can be summarised as follows –

34

  • In the above table and picture, it can be seen that because of the eroding confidence in NBFCs, the growth of share of commercial papers in total borrowings has declined drastically, which has been compensated by bank borrowings. This was because of swift actions taken by the government by increasing the exposure of banks to NBFCs from 15% to 20%.

5

Source: Livemint

6

  • Gross Non-Performing Assets (GNPA), excluding interest receivable) has been seen an upward trend while Net Non-Performing Assets (NNPA, calculated as GNPA-Interest Suspense Account, DCGC, ECGC claims, part payment received and total provisions held) increased substantially in 2016-17 and decreased marginally only in the last year. On the other hand, major concern is Capital to Risk Assets Ratio (CRAR) has been decreasing since 2014, which is a cause of concern. It is still above the adequacy ratio of 15% for banks, but a constant fall calls for action.
  • The crisis is taking a hit on the real estate sector as the supply of funds had reduced by 80% during the period from September 2018 to May 2019. The banks are also hesitant in lending to this sector, which could be detrimental for the economic health of the country.

Recommendations

There are a slew of regulatory and institutional measures which can be taken to stead fasten the slipping NBFC sector’ growth.

  • Carrying out regular inspections and audits of NBFCs and cancelling the licenses of those who do not comply with the norms. RBI cancelled the licenses of 1,701 NBFCs in FY 2019, as against only 26 the previous year.
  • The image of NBFCs catering to huge corporate clients and handling big projects at mass scale needs to be shaken off. A sincere effort needs to be made to expand the market share and enter into newer customer segments, through innovative products and kits, made for each segment. This will ensure sustainable growth for the NBFC sector as a whole. NBFCs had been stealing the market share of public banks steadily over two years as in the diagram below, but during 2019 their share declined from 13.7% to 12.6% from March’19 to June’19, also the period when their NPAs rose (according to a report on MSMEs by SIDBI).

7

Source: Livemint

  • Introducing Quality Reviews for various asset classes of NBFCs will function as stress tests to ascertain the loss taking ability of an NBFC. RBI has still not incorporated Asset Quality Reviews in the mandate however rating agencies take this parameter into account.
  • In 2009, RBI had set up a SPV to channelize funding to the NBFCs, wherein the vehicle received direct funding from RBI and this was used to lend to NBFCs through commercial papers and debentures. The same move can be used again to bolster the confidence in NBFCs.
  • More emphasis needs to be laid on microfinance institutions. Following matrix talks about access and sustainability. The NBFCs need to identify their target clients, assess whether they are able to reach them and ascertain where they lie in the matrix and work accordingly.

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  • The depositors, creditors and borrowers could be made shareholders to ensure that they have sufficient incentive and most importantly, to ensure that interests of both are adequately represented and taken care of.
  • The efforts of promoters could also be rewarded by monetising their contribution to the NBFC. This will serve the twin purpose of accountability and ownership.
  • Introducing a slab rate for requirement of Net Owned Funds to ensure penetration of NBFCs to all levels, instead of having a blanket figure of INR 2 Crore will be instrumental in revolutionising the NBFCs.
  • Cross institutional and industrial learning should be promoted, so that best practices are replicated everywhere and default risks are minimised.
  • The importance of having financial history and records of the population of country needs to be realised. This will enable in assigning a credit score to individuals. A study by PWC in association with Assocham says that a mere one-fifth of Indian population has credit score, thus restricting their access to organised credit.

Conclusion

The failure of IL&FS and Dewan Housing Finance Corporation Limited (DHFL) served as a clarion call for the regulatory authorities to spring to action to correct the lackadaisical attitude of NBFC-HFC sector in the country. This was important because finance vertical is the most important pillar of any economy as all other sectors are related to it. The crisis led to a significant crunch in liquidity of the NBFCs, but with the combined effort of government and banks, these were bailed out temporarily. The blow from COVID-19 served to erode the temporary effects whatsoever. Appropriate action calls for long term solutions to the problem. This can be done by repackaging the entire NBFC element and sell it with a fresh outlook and clean slate to make the rebuilding process easier.

[1] The per cent of total financial assets occupied by shadow banking, a term used to collectively refer to financial institutions except banks and post offices, is 14%, which is significantly close to that of developed nation like US. It signifies their importance in the development of economy.

[2] India’s external debt to GDP ratio growth has been at par with the growth of NBFC credit to commercial sector as shown here. With increasing uncertainty in the global trade and subsequent currency rates, it is important to shift the locus of credit to inland sources.

[3] Net owned funds comprise the paid-up equity capital, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of assets but not reserves created by revaluation of assets.


The author is a B.Com(Hons) student at Hansraj College.

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