New RBI norms for NBFCs are good but may give rise to new set of illegal lenders

On 29 August, 2011, when the Usha Thorat panel set up by the Reserve Bank of India (RBI) to rewrite regulations for the non-banking finance companies (NBFCs), it highlighted two major risks pertaining to such entities.

One, in the backdrop of the 2008 global financial meltdown, there is a higher risk of growing interconnectedness of such entities in the financial system, especially given the risks arising out of regulatory gaps.

Second, there is a clear possibility of a transmission of risks from the relatively lightly regulated NBFCs to the banking sector in the face of a steady increase in bank credit to NBFCs over many years.

By then, the central bank had already begun to tighten its grip on NBFCs, albeit gradually.

First, it happened with NBFCs operating in microfinance sector.

When these companies, giving small loans to poor borrowers, often at usurious rates of interest, resorted to arm twisting methods to get the money back, that lead to a series of suicides in the southern state of Andhra Pradesh, prompting the state government to enact laws to control these companies, resulting in a crisis in the sector.

The RBI soon stepped in and acted mainly on two areas. For one, it linked the rate of interest microlending NBFCs can charge to their borrowers to their profit margins. Second, it brought in place a system of accountability in their operations.

This was done by a series of rules to cap the maximum amount that can be lent to a single borrower to control over indebtedness and forcing these lenders to stick to their core business by stipulating 85 percent qualifying asset criterion.

Any failure to comply with these rules would disqualify NBFCs to avail loans from commercial banks under the priority sector lending.

Next came gold loan NBFCs.

These NBFCs, which are engaged in lending against gold ornaments, grew rapidly for a long period, especially between 2005 and 2010 - sometimes with an annual loan book growth as high as 200 percent.

The RBI stepped in to tighten regulations by restricting the loan-to-value ratio, the amount NBFC can lend against a certain value of gold, first to 60 percent and later to 75 percent. Also, the RBI forced gold loan NBFCs to make auction process transparent.

Post regulations, the growth rate of the industry has declined to a rate of 25% to 35%. In short, the RBI had initiated closer monitoring on NBFC space ever since these companies embarked on a high growth path.

Why the RBI is so much concerned about NBFCs even though only a handful of them take public deposits? The reason lies in the significant exposure of commercial banking system to NBFCs.

For most NBFCs, bank loans constitute their major part of resources to do business. These companies then on lend the borrowed money to segments of customers commercial banks typically do not lend or do not have the expertise to deal with.

Over years, some of the NBFCs have grown their loan books bigger than some of the commercial banks and have added more number of customers than smaller commercial banks. Ultimately, if an NBFC fails, it is the exposure of the bank, which has lent to the NBFC takes a hit.

The central bank possibly didn’t want to expose banks, the guardians of public money, to such high risk.

In fact, due to the RBI’s gradual process of tightening regulations for NBFCs in recent years, banks have already begun to cut down their exposure to NBFCs. Total loan outstanding of banks to NBFCs, as on 19 September, stood at Rs 2,93,600 crore, slightly lower than Rs 3,07,000 crore a year-ago.

But the figure still works out to be about 5 percent of the total bank loans.

These entities, being systemically connected and interlinked with the banking system could pose threat to the overall financial system in the event of a failure.

By treating NBFCs with asset size of over Rs 500 crore as systemically significant and stipulating tighter rules for them, the central bank wants to have a strong hold on the shadow banks.

The RBI has also made the asset recognition norms at par with banks by asking NBFCs to classify an asset as bad loan if it is overdue more than 90 days. At present, NBFCs classify an asset as bad only after a period of six months of non-payment.

More importantly, as per the new norms, NBFCs have to raise the tier I capital to 8.5 percent by the end of March 2016 and 10 percent by 31 March 2017. Also, the provisioning on standard loans needs to be raised to 0.4 percent by the end of March 2018, at par with commercial banks.

Currently, every NBFC is required to make a provision for standard assets at 0.25 percent of the outstanding.

The RBI has also increased the entry capital barrier to NBFCs to Rs 2 crore as against Rs 25 lakh now. Even the old ones will have to raise it to this level by 2017.

The new regulations will weed out weak and non-serious players from the NBFC business.

But, many of them, which fail to survive in the new regime, would continue to operate underground by becoming private money lenders, who make their own laws.

Monitoring such a transition in the shadow banking system will be a bigger challenge for the regulator.

Until now, regulators haven’t had much success in controlling illegal financiers.