The Reserve Bank of India plans to strengthen the regulatory framework for non-deposit taking systemically important non-banking finance companies as tightening of the regulation for the banking sector has increased the incentives for regulatory arbitrage by moving business to NBFCs.

Pointing out that setting up an NBFC is a more attractive option as entry point norm for them (at present net owned funds of Rs 2 crore) is low as compared to that for banks (Rs 300 crore) and that they are subject to relatively lighter touch regulation, the RBI, in its second financial stability report said “some concerns remain especially in the context of the rapidly expanding NBFC sector.”

Among the reasons why regulatory gaps need to be plugged include NBFCs not being subject to any restrictions regarding investment in the capital market thereby leading to enhanced market risk; nor do they have any restrictions on setting up of subsidiaries, thereby allowing setting up of possibly opaque structures with concomitant transparency issues. Further, quality of corporate governance and management can give rise to serious concerns, the report said.

Another concern that arises is in the context of definition of an NBFC in terms of its “principal business” which makes it possible for an NBFC to conduct some other non-financial activity by deploying funds in non-financial assets, leading to a lack of level playing field vis-à-vis banks.

Multiple regulators for non-banking financial entities in the country and an entity-based approach to regulation gives rise to possible regulatory gaps — functional activities remaining unregulated, gaps in regulation permitting surrogate raising of public funds, leveraged activities by entities like merchant banks, portfolio managers and brokerages not being subject to prudential regulation. These, according to the report, will need to be urgently addressed.

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