## Thursday, December 24, 2015

### The regulatory difficulties of NBFCs in India

by Shubho Roy.

The founder of the Shriram Group, R. Thyagarajan, who is one of the most respected people in Indian finance, spoke to Forbes India expressing concerns about the things that are being done with the regulation of NBFCs. This is important food for thought for understanding the problems of Indian finance. He talks about how the NBFC sector is being stifled with regulation and the need for moving it away from the Banking Regulator. He points out that the mind-set and objectives of RBI, in regulating NBFCs in ways that are appropriate for banks, is killing the industry.

Banks and NBFCs are different, pose different problems for financial regulation, and should be regulated differently. RBI is smothering NBFCs by applying banking thinking for them, and is thereby hampering access to credit for the firms who obtain financing from NBFCs. The FSLRC approach offers logical answers to these questions.

### What motivates regulation

Regulation must not degenerate into central planning; it must be motivated by the need to correct a precisely stated market failure. We must understand the anatomy of the market failure, and use the coercive power of the State at the precise root cause. Occam's Razor of Regulation implies that we should get the job done with the minimum use of force. The market failures associated with banks and with NBFCs are quite different. For banks, the market failure is consumer protection of unsophisticated depositors. This is the reason why we have detailed banking regulation. If there are no unsophisticated depositors in a lending institution, regulating them like banks is wrong, and harms the economy.

### Consumer protection in banking regulation

When you deposit your money in a bank, you can go and withdraw the principal at any time you want. Even for fixed deposits, the principal is protected in the case of premature withdrawal.

How does a bank pay interest on money which you can withdraw at any time? Through loans. However, when a bank gives a loan: the bank gets repaid only as per the loan terms (and not when the bank needs money). If you take a home-loan or a car-loan for five years, the bank cannot come and ask you to repay the entire money before the five years are up (unless you default). The bank can only ask for the regular predefined installments. No bank can come to you (a borrower) and say:

"a lot of people are withdrawing money this month, so please pay up your five year car loan, ahead of time, this month."

Similarly, when you (depositor) go to withdraw the money from a bank the bank cannot say (legally prohibited):

"a lot of people have delayed their loan repayments so you cannot withdraw your money today, come back after a few months."

These types of deposits are technically called deposits callable at par. i.e. Deposits you can withdraw at any time without losing the principal.

Contrast this with a term loan or a bond/debenture. When you buy a five year Tata Motors debenture in the debt market, cannot withdraw it at par before the debenture matures. i.e. If you go with the debenture to the offices of Tata Motors before the five years are up, Tata Motors has no legal obligation to repay the loan amount in the debenture. You can only get your principal and interest payments as per the terms of the debenture and not a minute before that. You may sell your debenture to someone else (secondary market), but that is not the same as getting your principal back from Tata Motors. In the secondary market you have no assurance you will get your principal amount back.

Ensuring that households are able to withdraw their deposits, whenever they need it, is not trivial. Whenever a bank fails do it, eventually, there is a run on the bank. A run happens when you households panic that their life savings will be destroyed and queue up to get withdraw their deposits. Governments know (from the history of bank failures) that you cannot trust banks to pay up to households on time. Therefore, countries create banking law and corresponding banking regulator to check the banks.

Three important components of these regulations are:

1. Deposit Ratios: This requires the bank to lend out only a part of its deposits, say 80%. The bank has to keep the rest for withdrawals on any given day.
2. Equity buffers: Banks are required to have a certain minimum equity capital. As an example, in India, the leverage of the banking system is roughly 20 times, which means that for each 20 rupees of total assets there is 1 rupee of equity capital. This acts as a buffer against losses as the shareholders bear the loss.
3. Loss Recognition: Banks are forced to recognise losses and write them off using equity capital, so as to not subvert the intent of the equity buffer.

Banks have the incentive and capability to cover up bad news about the loans they have made. If banks admit they have bad loans then the banking regulator forces them to raise money from other sources (equity market). Raising money from the equity markets is hard, expensive and, dilutes existing shareholders. Normally, a bank likes to hide and delay the fact that debtor is not repaying as long as possible.

Unlike sophisticated creditors, you and I are unable to really understand the balance sheet of a bank. I cannot judge whether the bank will have enough money to repay a fixed deposit five years from now. Without a financial agency looking over banks every day, it is easy for banks to lend money profligately and end up defaulting to depositors.

The oversight of the financial agency, and the checks imposed by these regulations, are not without benefit to banks. In return for complying with all these regulations, the government encourages the general public, to keep money in banks. The government and the central bank extends a guarantee of safety in bank deposits. The Jan Dhan Yojana does not encourage you to buy corporate bonds but put money in bank deposits. The government runs a deposit insurance program to protect helpless households who have deposits with banks.

### NBFC regulation

Non-Banking financial companies should be what their name suggests: non-banks. Sadly, this was not the case for India till about a decade ago. Because, there were few banks, Indian laws allowed NBFCs to also take deposits callable at par. i.e. Take money from depositors (unsophisticated savers) which the depositors could withdraw at any moment (working hours). These were called NBFC-Deposit Taking.

Over the last few years, RBI has gradually removed this category. Today, most NBFCs take money from the bond market or term loans (sophisticated depositors). There are no unsophisticated depositors in most NBFCs today. Since there are no unsophisticated depositors who may need their money immediately on demand, there is no consumer protection angle from deposits.

However, in spite of closing down most deposit-taking NBFCs, RBI continues to regulate NBFCs like banks, requiring them to keep liquid funds (in government securities) and also recognise problematic loans and keep capital against it. This defeats the very purpose why NBFCs are prohibited from taking deposits callable at par from household. If you are not taking deposits callable at par from households, you can go and make risky loans which banks are not going to make. There is no point in recognising and regulating NBFCs, if they are forced to meet banking regulations. We may as well call them banks and allow them to collect deposits callable at par.

### The FSLRC approach

FSLRC does not indulge in artificial distinctions between banks and non-banks. It has a clear functional test for designating something as a bank or not:

Are you taking deposits from the public?

If you are; you are a bank; and you will be regulated like a bank; by the banking regulator. If you are not; then you are not a bank and you will not be regulated as a bank.

It takes care of concerns of shadow banking (entities taking deposits callable at par without complying with banking regulation) with a principled based approach. All the regulator has to test is if an entity is taking deposits callable at par. Then whatever be its name, it should be regulated like a bank.

FSLRC recommendations are driven by informed analysis of the need for regulation. Banks have unsophisticated consumers on both sides of the balance sheet and therefore the regulations have to address the consumer protection issues on both sides of the balance sheet. NBFCs on the other hand have unsophisticated consumers only on the side of borrowers. There are no depositors in an NBFC in the same sense as banks.

FSLRC recommended that financial firms which do not do this activity should not be regulated like banks and therefore not be regulated by the banking regulator. FSLRC does not leave NBFCs out of regulation. It concentrates regulation of NBFCs in two areas:

1. The protection of unsophisticated consumers who borrow from NBFCs, in line with regulation on consumer protection.
2. Systemic risk regulation, which would be done in a consistent way for all systemically important financial firms, some of which may be NBFCs.

The concerns of systemic risk however is not limited to NBFCs. Systemic risk regulation cross-cuts across all segments of the financial sector and has its own set of instruments/regulations which are not the same as the ones in banking regulation.

### Conclusion

Mr. Thyagarajan reminds us that it's broke. We should fix it. He recommends that the central bank should not regulate the NBFC sector. The intellectual framework for regulating banks and NBFCs is so different that the same regulator cannot do it. India has a few large and stable businesses which banks can lend to. However, most of India's growth will come from new businesses which are small and risky. The small entrepreneur who buys a truck will face liquidity shocks (will miss a few of the regular installments). As long as such entrepreneurs are not being funded with household safe savings, there is nothing wrong in that. NBFCs have to be different from banks, they should be more risk taking. And yes, more of them will fail, but it will not harm the unsophisticated savers.

Regulation should be based on some rational requirement to address market failures. Without identifying market failures, regulations are no more than arbitrary injunctions from the powerful which serve no purpose.

Shubho Roy is a researcher at the National Institute for Public Finance and Policy.

1. While I agree that NBFCs need not be regulated as banks, the post seems to suggest that no regulation for NBFCs is needed. I think that is a simplistic view, particularly given what happened during the recent global financial crisis. If you recall, Lehman Brothers was not a bank, neither was Bear Sterns. Nonetheless these institutions were closely interconnected with the rest of the financial system, particularly the banking system. Here is a recent speech by Stanley Fischer, which describes the evolution of the NBFC sector in the US and what needs to be done:

http://www.federalreserve.gov/newsevents/speech/fischer20150327a.htm

1. I am not arguing for no regulation of NBFCs. There should be regulation based on identified objectives. There are two objectives in my mind:
Consumer protection for households taking money from NBFCs
Systemic Risk regulation for systemically important nbfcs

Lehman and Bear Sterns were surely SIFIs, and there are some SIFI NBFCs in India too. However, that does not require all NBFCs to be regulated like banks. Even for NBFCs which are SIFIs, we will have to think about the appropriate regulatory framework for SIFIs. Those will probably not be the same as the ones used for banking regulation. For example, loss recognition regulations do not lend to easy application to SIFI regulations. On the other hand, higher capital adequacy may do. But then those should apply to SIFI Banks too.

2. The NBFC sector is itself responsible for RBI breathing down its neck. We would be fooling ourselves if we expected the sector to self-regulate itself. Did the gold loan NBFC's institute any measures towards risk mitigation prior to RBI's stipulations? Also, aren't NBFC's being funded by "safe" household savings either directly (via retail subscription to bonds) or indirectly (via bank funding)? so why should there be an expectation of "light touch" or no regulation? RBI's regualtory measures (controlling asset / liability mismatches, interest rate mismatches, NPA recognition etc) are all sensible and given the current state of our financial system, absolutely desirable.

Please note: Comments are moderated. Only civilised conversation is permitted on this blog. Criticising me is perfectly okay; uncivilised language is not. I delete any comment which is spam, has personal attacks against anyone, or uses foul language. I delete any comment which does not contribute to the intellectual discussion about the blog article in question.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.