India is a bank-dominated financial system with about two-thirds of all financial assets in the economy belonging to the banking sector. Yet, it does not match the size and outreach of banking sectors as prevailing in other emerging economies. With banking sector credit depth being low and concentrated to specific sectors, non-deposit taking NBFCs (NBFC-ND) have begun to fill part of the financing gap.
NBFCs are becoming dominant in segments such as microfinance, consumer durable loans, construction equipment finance and auto finance. In the specific case of MSMEs, the share of NBFCs in total credit exposure has increased from 2 per cent in 2010 to 21 per cent in 2018.
In recent months, the regulation of NBFCs has taken centre-stage. At the sixth bi-monthly monetary policy statement earlier this year, the RBI Governor emphasised that there will be a movement towards harmonising the regulatory regime across all types of NBFCs. This, however, raises concerns regarding the harmonising of regulations across NBFC-ND and banks. A significant concern is over the application of capital regulation for banks and NBFCs.
Even though NBFC-ND do not have access to public deposits and rely mostly on wholesale funding, the minimum capital adequacy ratio requirement or CRAR is higher for NBFC-ND-SI (SI being ‘systemically important’) at 15 per cent compared to 9 per cent for banks. Similar curbs exist for non-systemically important NBFCs in the form of leverage ratio.
Protecting poorly performing intermediaries from failure should not be the prerogative of capital regulation. Managing failure of such intermediaries is, and should be, the function of a robust resolution framework which currently doesn’t exist in India for financial firms. Rather than moving towards creating a resolution framework, the current regime assigns higher capital requirements as a substitute for lighter touch regulation in terms of risk management, conduct and supervision.
To quantify the severity of the problem, consider this: If the NBFC sector held the same capital adequacy ratio of the banking sector in FY19, there would approximately be ₹1.8-lakh crore of excess capital that could have been used for lending. More broadly, this poses two problems: a violation of institution neutrality and is an inefficient way of addressing the actual risks that these entities may pose to the system such as consumer protection.
As the RBI moves to make changes to the regulatory regime applicable on NBFCs, it may be helpful to keep in mind two basic principles. The first is the principle of proportionality of regulation: “greater regulatory restrictions for greater risk and equal treatment of equal risk” as perfectly phrased by the Financial Sector Legislative Reforms Commission.
The second is the guiding principle for setting the capital adequacy requirements as given by Santomero & Watson in 1977. : “Capital requirements should be in such a way that the marginal returns from keeping adequate capital, that could be used to mitigate risks (marginal returns on stability), should be equal to the marginal opportunity cost of this capital”.
The role of the NBFC sector is to service regions, sectors and customer segments that are considered unprofitable for banks. Regulatory capacity should be directed towards better risk-management and governance across the system rather than create capital redundancies that curtail the growth of small specialist entities.
The writer is with Dvara Research, Chennai