COMMENTS TO RESERVE BANK OF INDIA ON DISCUSSION PAPER ON REVISED REGULATORY FRAMEWORK FOR NBFCs

 

Harshita Aggarwal (CS), Neha Vasishta (CMA), Ritika Kapoor (LL.B),

Sagrika Jayee (CS), Vasishali Manchanda(CS), Saksham Khillan (CS Intern)


NBFCs have become a systemically important component of the financial system, over the years. They have steadily increased in number and become an integral part of the Indian Financial System playing an important role by financial inclusion into the lesser penetrated market and tapping the underutilized opportunities. In a short span of time, NBFCs have scripted a great success and growth story.

 

NBFCs have emerged as important financial intermediaries, particularly for the retail sectors, small-scale and underserved areas and it was expected that this will continue to grow and create opportunities in the days to come.

 

NBFCs act as Core Catalyst in Indian Financial System. NBFCs are regulated and supervised by Reserve Bank of India. The regulatory framework of NBFCs has evolved over years.

 

REGULATORY TRANSITION OF NBFCs:

In 1964, RBI acquired regulatory and supervisory powers over NBFCs with the insertion of Chapter III-B in the Reserve Bank of India Act, 1934 (‘RBI Act’).

In 1974, the RBI Act was amended to give the Reserve Bank more powers with respect to NBFCs, including the power to inspect NBFCs, enhanced penalties for contravention of RBI directions, obligations on statutory auditors, etc.

Prudential norms were prescribed to NBFC sector in 1994 based on the recommendations of the Shah Working Group.

In 1997, process for regulating NBFCs was initiated and Registration for the same was done.

In January 1998, the Reserve Bank issued a new regulatory framework for NBFCs building upon its newly acquired powers under the RBI Act.

In 2006, considering the increasing significance of the sector, the Reserve Bank introduced differential regulation and classified NBFCs with asset size of ₹ 100 crore and above as ‘Systemically Important NBFC-ND (NBFC-ND-SI)’. Prudential regulations such as capital adequacy requirements and exposure norms were made applicable to them.

Revised Regulatory Framework in 2014 – providing for Requirement of Minimum NOF of 2 Crores for legacy NBFCs and Revision of threshold of systemic importance from 100 Crores to 500 Crores.

Now in 2021, with NBFCs growing to unprecedented size and scale, their impact on the financial system is growing significantly, which is driving the need for increased regulatory oversight, based on their relative impact, threat on the whole financial system and the business model of the Economy. The RBI in order to reform the current regulatory framework recommended few changes in order to align the working of the NBFC and to maintain arbitrage of banks and NBFCs.

OBJECTIVE

 

The objective of this discussion paper is to re-examine the board principles which highlight the current regulatory framework and examine and where there is need to develop a scale based approach to regulation from a ‘systemic significance’ vantage point and recommend appropriate regulatory measures in support of a strong and resilient financial system. The primary focus of the discussion paper is examination of the principles and processes for identification of NBFCs THAT HAVE SIGNIFICANT SYSTEMIC RISK SPILL-overs and development of a conceptual framework on which regulations could be based. So, RBI hereby, proposes the regulatory framework for the NBFCs and unbridled growth aided by less rigorous regulatory framework within an interconnected financial system can sow the seeds of systematic risk. Failure of any large and deeply interconnected NBFC is capable of transmitting shocks in to the entire financial sector and cause disruption even to the operations of the small and mid-sized NBFCS. Under such circumstances, regulatory framework needs to be reformed in order to keep balance with the dynamic scenario.

 

INEVITABLE EVENTS WHICH HAVE AFFECTED NBFC WORKING

 

NBFCs market was drastically hit by the Demonetization in 2016. The NBFC sector is more SME and large corporate oriented, with these sectors contributing approximately 59% of overall exposure. The NBFCs and MFIs strives to cater to the financial needs of small sections of the society, such as daily wage workers, farmers, small traders, and retailers hailing from rural areas as well as remote urban areas. Therefore, an instalment on credit is usually collected on a weekly or even a daily basis.  Demonetization hampered the cash transactions thereby leading to defaults in the payment of instalments as well as final repayment. Most of the customers of the NBFCs and MFIs do not have bank accounts and their livelihood depends upon cash transactions. Because of lack money Liquidity in the market and ongoing exchange of money between the banks and the public. Collections by NBFC-MFIs declined during November 2016-February 2017 vis-à-vis April-October 2016, but witnessed an improvement during the months of March, May and June 2017. Bank credit to NBFCs decelerated from 5.1 per cent (y-o-y) in October 2016 to 1.3 per cent in November 2016; however, it subsequently improved to 10.9 per cent in March 2017. In terms of the returns submitted by the reporting NBFCs, loans and advances by NBFCs increased broadly at the same rate in the year ending March 2017 (16.4 per cent) as in the year ending March 2016 (16.6 per cent).

 

Living in its initial stage of recovery the market was hit by another jerk of COVID -19 in 2020. Further, pandemic has exacerbated the woes of non-banking financial companies (NBFCs). The decline in non-bank credit growth, which started in the second half of fiscal 2019, continued through fiscal year 2020, accentuated first by economic slowdown and then – more vigorously – by the pandemic. While the impact of economic slowdown was expected to be gradual, providing time to build some kind of defence, the impact of the pandemic has been immediate and debilitating. The ramifications are being felt across the sector, though some segments have been impacted more severely than others.

 

Owing to these two major events which drastically affected the economy in their active form, non-banking lending sector were already hit by a funding squeeze. NBFCs currently form an essential part of the on and off balance sheet aspects, and after analysing it is under doubt that whether the smaller and weaker NBFCs will still find survival and equivalent favour with the implementation of the proposed regulatory framework as mentioned in the discussion paper.

 

RBI DISCUSSION PAPER DATED JANUARY 21, 2021 AT A GLANCE

 

Proposal 1:

The basis of forming the classification of NBFCs under the new rule of proportionality is:

PRINCIPLE OF PROPORTIONALITY IN REGULATION

Degree of proportionality is justified making a cover on all the NBFCs except the ones’ categorized as Type I NBFCs such as NBFC P2P, NOHFC, NBFC AA, Non deposit taking NBFCs. These NBFCs form part of the base layer irrespective of their asset size and activity base. For instance, if the asset size of these NBFCs increases the prescribed limit then stricter regulations should be imposed on these NBFC as a part of regulation.

CONCERN ON CORE INVESTMENT COMPANIES (CICs)

The Core Investment Companies (NBFC CIC) are the ones that have their assets primarily as investments in shares for holding stake in group companies but not for trading purpose, and do not carry on any other financial activity. These kind of companies have a minimum 90% of their investment in the group concerns either in the form of equity, preference shares or convertibles bonds or loans and 10% in money market. As per this discussion paper Reserve Bank of India is proposing to place NBFCs CIC in Middle layer. As there would be negligible working of such companies, keeping them at Middle layer would not serve any purpose. However, in case unforeseen systemic risk, regulation in that regard can be framed.

We hereby suggest that as this category of NBFC is not going to effect the financial sector. It is requested to keep these NBFCs in base layer only and retaining the exemption from Net Owned Funds and Registration with RBI.        

Proposal 2:

SCALE BASED FRAMEWORK:

 In order to combat the systemic risk i.e. the risk imposed on small NBFCs as a result of the activity of the large NBFCs, RBI has proposed scale based framework in order to simplify the complexity of the NBFCs. According to the proposed framework NBFCs would be categorized into four layers, specifically known as NBFC base Layer, NBFC Middle layer, NBFC Upper Layer and NBFC top Layer.     

 

 

 

Major Concerns

  1. The layers specified in the discussion paper is justified to the extent of the operationally of the NBFCs and the regulations imposed on the NBFCs. Imposing too much stricter regulations on the NBFCs belonging to Top layer and Upper Layer, RBI has suggested bank like regulations to Top Layer NBFCs which is not justified to the extent that it would reduce the benefits enjoyed by NBFCs over the banks.
  2. There is need to consider NBFC-HFC, IFC, IDF, SPD & CIC under the category of Base Layer and enjoy the benefits of less compliance keeping in view the size of such NBFCs. CICs must be kept at the base layer and exemptions being enjoyed at present should continue.

Proposal 3:

THRESHOLD LIMITS

Proposed Suggestions

The threshold limit is proposed to be revised to Rs. 1000 crore as against the prevailing limit of Rs. 500 Crores. The total count of Non deposit taking NBFCs is 9425 out of which 9133 NBFCs will for part of the Base Layer NBFCs. The proposed threshold limit of systematic significance is raised to Rs. 1000 Crores. The number of NBFCs will go up by 76 which will lead to increase in the count of NBFCs under the base layer.

  • Increase in Net Owned Fund from Rs. 2 Crore to Rs. 20 Crore.
  • The extent NPA Classification norms of 180 days will be harmonised to 90 days.
  • The board will have adequate mix of experience and educational qualification

Major Concerns:

  1. The increase in net owned funds to Rs.20 Crore is not justified.The transition period of Five years for the prescribed increased is not defensible as this creates a supreme burden and extra threat on the current working of the NBFCs.  This will tent amount to closure of existing NBFCs and thereby adversely impacting the economic activity. To increase the limit of NOF from Rs. 2 Crores to 20 Crores within a period of 5 years is not feasible as the promoter of small NBFCs would be constrained to bring in additional capital.

As a suggestion, the more viable possibility of the increase in NOF should be twice or maximum thrice the limit of the original NOF, more precisely the limit should be increased to the maximum of Rs. 5 crore taking all thing into consideration i.e. the GDP growth, COVID impact, demonetisation and increased cost inflation index.

 

  1. INCREASED IN UNORGANISED FINANCING BUSINESS

Government of India in 1997 brought registration of NBFCs with an objective to organise and regulate the lending business and to eradicate the informal lending business consisting aarhtiye and other money lenders. This informal lending is being done at ROI ranging from 5 percent to 10 percent per month. Over the years, NBFCs have been penetrating the rural markets and have been successful in capturing the informal lending through Micro Finance and other Small Enterprise loans. With the proposal to increase the NOF form 2 Crores to 20 Crores the smaller NBFCs lying between the NOF of 2 Crores to 10 Crores which were playing the significant role in financial inclusion will vanish and it will defeat the purpose of formation of new NBFCs.  This will consequently increase the unorganised business. It is therefore in the interest of promoting the inclusive growth that small NBFCs contributing to the MSME sector should flourish.

  1. The Union Budget specifies tax exemptions for start-ups in order to encourage business in INDIA. At the same time as proposed in the discussion paper, increase NOF and stricter financial framework tends to become a prohibition in the opening of new companies or in other words this would limit the formation of new NBFCs as an alternative to banking sector running in the financial model of the Indian Economy.
  2. Larger NBFCs will dominate the market which will reduce the competition in the market. This will in turn lead to control the business in fewer hands.
  3. As a suggestion 180 days for calculating the NPAs of the companies should be retained for base layer NBFCs as the same are not a systemic risk. The reduction of period to 90 days period will have an adverse impact on financial the progressive poor thereby impacting the economy at large and further promoting unproductive and unethical recovery measures from the have nots.

POSSIBLE ADVERSE IMPACT ON SMALLER NBFCS

 

SECTORS COVERED BY SMALL NBFCs & MFIs:

 

EXISTING

 

Small NBFCs are those NBFC which is categorized as NBFC-ND-NSI, whose asset size is less than Rs. 500 Crore and whose NOF is Rs 2 Crores.

 

These NBFCs are scattered all over the India and providing funds to the poor / needy people with less compliances. These NBFCs provide loans of small Ticket Size ranging from 5 lacs to 25 lakhs for home improvement, construction small houses, MSME working capital, farm equipment, Dairy etc.

 

Following are the sectors to whom these NBFCs provide loans:

  1. Two Wheeler Loans
  2. LAP (FOR reconstruction, renovation of the house).
  3. Loans to MSME Sectors.
  4. Used Wheelers (whether car, three wheeler or Four Wheelers etc).

There are 9133 NBFCs in our country which are categorized as Small NBFCs.

IMPACT ON SMALL NBFCs

 

The framework proposed is very harsh on small NBFCs as they will be heavily regulated vis-a- vis their scale of operations. Due to the increased cost of compliance and regulations the cost of operations as a whole will increase which tends to tilt back the regulatory arbitrage back in favor of banks, as they can lend at more competitive rates than NBFCs. The framework inadvertently will further lead to closure of small NBFCs as their businesses will become unviable. The existence of larger NBFCs will lead to concentration of lending market in few hands where in the large NBFCs can dictate their terms to the borrowers with borrowers having no choice but to accept them. This will adversely impact the Micro and Small businesses, as they will have to borrow at higher rates, further making their businesses unviable. This framework will be against the government policy of supporting Micro and Small businesses. Digging further from the sectorial lending perspective, increased cost of operations in small NBFCs lending in the used vehicle and commercial vehicle space will ultimately trickle down to the borrowers which will adversely impact the used vehicle and commercial vehicle business landscape.

 

The increased regulation and compliance will make the small NBFCs business unviable in the medium to long term, thereby further impacting the creation of jobs and opportunities for the workforce in the country.

 

WAR AGAINST MSME

MSME plays an important role in the Overall development of the Country. Government has acknowledged this and started various schemes for the development of this Sector. Over the years NBFCs have become a better choice of MSMEs for obtaining loans and start their business.

MSMEs have generated millions of jobs in the previous years. They have become the backbone of the Economy to contributing almost 30% of the GDP of the Country.

The proposed Regulatory Framework will be detrimental to the Growth of this Sector. The Major threats posed to MSME Sector are:

  1. Unemployment

As per the proposed regulations NOF of the NBFCs has been increased by 10X i.e 2 Crores to 20 Crores. Small NBFCs will find it very difficult to infuse it within a Limited span of time. The new entrants will not be able enter the market and many existing NBFCs may have to be shut down which might result in massive unemployment. 

  1. Unfair Competition:

The newly proposed framework aims to increase the threshold of Systemic Importance to 1000 Crores. The Companies with 100 or 1000 crores will be put in the same bucket of Compliances. Smaller Companies will have the same compliances as bigger market players. The competition will be very demotivating in those circumstances.

  1. Underserved to unserved:

In India, 70% of the population lives in the rural areas. NBFCs cater to these areas. With the negative impact on the NBFCs operations, the underserved areas will be also be adversely impacted.  Still more than 90% of the lending business is held by the informal sector. With the stringent and enhanced net worth requirement, the informal sector will increase.

  1. Contradicting the economic Goals:

In the recent times, government has focused on the growth of MSME sector aiming to increase the overall GDP of the economy. This decision of government might reverse the growth rate of the economy.

CONCLUSION

 

To reiterate, if this proposed regulatory framework comes into picture or gets implemented, it will have worse impact on the smaller NBFCs. The Proposal for tighten the rules & regulations for NBFC categorized under NBFC-UL, NBFC-ML will lead to over compliances and also results into increase cost of compliances & increase cost of operations for NBFCs-UL & ML and this will also result in eliminating the arbitrage between the banks and NBFCs  and thereby impacting the inclusive growth of the country. 



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