Hi,
There are several regular discussions in finance that come and go on a perennial basis. The regulation v innovation debate is a fairly common one - and it's always a knowledge v wisdom conundrum. Knowledge advocates heavy financial system regulation for safety, while wisdom focuses on innovating within strict regulations.
When we look at the history of NBFCs in India, it has gone from one of under-regulation to over-regulation. Policymakers have swung from one extreme to the other in their attempts to reign in risks.
What strikes me about this is - NBFCs grew out of a need to finance high-risk assets that banks weren’t willing to touch. By virtue of being in high-risk lending, the industry should have been under the radar from the outset. However, lighter and distinct regulations provided NBFCs with operational flexibility, enabling them to develop expertise in specific sectors and geographies, facilitating credit to even the most remote areas.
This regulatory “arbitrage” was by design, not by mistake.
Then came the IL&FS and DHFL crises, which is when the RBI stood up and took notice.
The discussion we need to have on a perennial basis isn’t regulation v innovation alone. It needs to get more nuanced -
Indefinitely chase down risks, wherever they go. This would leave the RBI perpetually behind with an ever-expanding mandate.
OR
Grant banks greater autonomy in managing risks while imposing rigorous regulations, especially in monitoring their risk management processes.
Keep chasing
In October 2021, the Reserve Bank of India introduced a scale-focused regulatory framework for non-banking finance companies (NBFCs). The scale-based approach relies on the principle of proportionality, which emphasises that regulatory measures should align with the level of risk posed by the entity to the financial system.
Size has a significant impact, leading to what the RBI frequently refers to as 'systemic importance.' In simple terms, this implies that a financial company's extensive interconnections with other institutions in the economy could result in catastrophic ripple effects if it were to fail.
The RBI has provided an illustration to clarify this concept.
.
A couple of weeks back, the RBI identified 15 entities as part of the top tier under this framework. Besides this top tier, the RBI categorises NBFCs into three additional groups: top, middle, and base.
Essentially, as the sector gets bigger, the RBI will make its leash shorter.
But this has its pitfalls -
Under CARE 2021, NBFC-UL firms are treated like Scheduled Commercial Banks, but they don't reap the same benefits. The top 15 NBFCs by asset size always fall into the UL category, regardless of their current status. This can lead to financial issues.
Previously, NBFC-BLs had 180 days to identify bad loans, but new rules aim to cut it to 90 days, aligning with their lending practices. The Finance Industry Development Council (FIDC), representing NBFCs, worries about the challenges this poses, especially for those serving underserved populations.
This sector heavily relies on SCBs for funding, with limited info on refinancing. Sharing such data, particularly among small and medium-sized NBFCs, can reduce their reliance on banks.
What I’m trying to say is…
While stricter regulations may work in the short term, relying solely on past data to predict policy impacts is like driving by looking in the rear-view mirror. The next crisis may be different ; more rules won't guarantee a foolproof system, just as Basel norms didn't prevent the global financial crisis.
Greater autonomy to banks
Let me preface this by saying that this strategy, i.e., allowing banks greater autonomy for risk was effectively the pre-2008 crisis status quo and it didn't work out great.
However, bank resilience is crucial in this scenario is that banks can provide funding without relying on the market. Non-banks, even the most bank-like ones, would have to issue securities like repos, whereas banks can create deposits with a keystroke. During the early stages of the Global Financial Crisis (GFC), banks tried to support the market but faced their own balance sheet problems. This could potentially be avoided with higher capitalization levels.
Strong banks also have easier access to central bank balance sheets compared to other market participants. While this access has decreased, banks still play a crucial role as operational intermediaries. Moreover, banks' access to central bank support usually requires fewer emergency declarations, which can have legal or market drawbacks.
Imposing bank-like regulations in the NBFC-upper layer, without bank-like access to capital could hinder company growth. These regulations should be carefully selected to balance systemic risk mitigation and upper layer company growth.
NBFCs play a crucial role as substitutes and complements to banks in India. With banks facing ongoing stress and the economy expanding, there is a growing need for credit that NBFCs can fulfil. In this favourable growth environment, imposing stricter regulations on the middle and upper layers while setting a lower threshold at the base layer for NBFCs would likely impede the overall growth of the NBFC sector.
Regulation is tricky..
And they are penalties for bad behaviour instead of rewards for good behaviour. This Economics and Political Weekly (EPW) analysis neatly explains why chasing after a growing monster is futile and suggests a framework to incentivise good behaviour.
If penalties are affordable, then there is little incentive to follow them, potentially encouraging undesirable/fraudulent business practices since risk begets rewards.
Case in point - HSBC. In 2012 when HSBC, a prominent financial services institution, faced allegations of money laundering on behalf of a Mexican cartel. Despite amassing substantial profits totaling $15 billion through these activities, the United States Treasury imposed a relatively modest fine of $1.92 billion as punitive measures for their violations.
Offer carrots as the default, while the stick is reserved for severe breach of conduct.
We’re now in the NBFC over-regulation era and herein, the perennial question is ‘how much to regulate and where to draw the line?’
I’d love to know your thoughts.
Cheers,
Rajat