Indian financial reforms aim for a deep, stable, commercially viable financial sector that can safely and efficiently finance development with inclusion.

The liberalisation that started in the 1990s followed a unique combination of domestic market/regulatory development and gradual capital account convertibility that avoided domestic crises and survived the global financial crisis (GFC) with minimal impact. But over-stimulus and pro-cyclical regulation after the GFC contributed to large bank non-performing assets (NPAs). Credit crashed with the over-regulation that followed, hurting growth.

The pandemic was expected to make things worse. Public sector banks (PSBs) were seen as fragile. But because of liquidity injections and time-barred regulatory support that built on recoveries from bankruptcy reforms, NPAs improved instead of deteriorating.

Clear lessons, in addition to the earlier ones on diversity and balance, are the importance of countercyclical prudential regulations that support in bad times and create buffers in good times, inducing better behaviour and reducing financial fragility.

Is regulation currently applying these lessons? Let us examine complaints from non-bank financial companies (NBFCs) of over-regulation from these perspectives.

Contribution of NBFCs

NBFCs have a special role in a heterogeneous India, since their prime differentiator is leveraging tacit customer knowledge to reach finance to unbanked corners thus improving financial inclusion, unlike the arbitrage of post GFC stronger bank regulation in the West, which has encouraged proliferation of hedge funds and shadow banks.

In India also regulation was lighter for NBFCs than for banks since NBFCs are largely not permitted to raise deposits from customers. Statutory liquidity ratios, etc., are not imposed but they also do not have advantages of banks such as access to the RBI’s liquidity windows. Lender of last resort (LOLR) facilities are provided against the collateral of G-secs. The dominant source of liquidity for NBFCs is banks with 40-50 per cent share.

After 2014, NBFCs’ credit creation boomed, especially in consumer and real estate credit, making up for slowing bank-lending. NBFCs grew to 20 per cent of bank balance sheets. Some, however, borrowed short and lent long in 2017 when excess liquidity followed the demonetisation episode. IL&FS, a large systemic NBFC, had non-transparent governance that hid a stretched balance sheet. But absence of a LOLR contributed to illiquidity, becoming insolvent in 2018 as aggregate liquidity tightened. After it defaulted, lending to NBFCs froze. They were in deep trouble with the inability to roll over short term credit and funds tied in long-term loans. Banks were refusing to lend to them and they had no access to LOLR facilities. Systematic spillovers inevitably followed. Conditions eased as liquidity was expanded in 2019. But after this episode regulations are being tightened.

Since NBFCs number about 9,000 and vary in size the RBI is following a tiered approach, which is stricter for the large possibly systematic NBFCs. As they lose the regulatory advantages without getting facilities banks have, their business models are no longer viable. Some may follow the path of HDFC housing finance, which merged with its parent bank, thus reducing diversity in financial services. Those without supportive parents are exiting wholesale credit, going into other businesses or seeking foreign funds.

There is more awareness of risks, after the lessons of the last decade. In 2021, when liquidity was again in excess due to the post-Covid stimulus, only three NBFCs had large short term commercial paper exposures very different from 2017. Many hold liquidity in excess of regulatory requirements, raising their cost of lending.

Regulatory moves to improve corporate governance, loan standards and asset quality for all led to protests that smaller NBFCs lack expertise and clients such as MSMEs were not used to rigid reporting requirements and would find it difficult to comply. But better capital adequacy, disclosure, accounts, risk-based lending and consumer protection are in NBFCs’ own interest.

In today’s digital age, formalisation will allow NBFCs to gain cheaper credit from diverse sources, to innovate responsibly and do well. Production and use of reliable data is the way forward rather than making excuses for poor standards. Those with better processes are the ones that will do well. Adequate buffers encourage appropriate risk-taking. Eventually, even smaller NBFCs may be able to get a good rating, based on objective criteria, despite rating agencies size bias. Borrowing, as well as lending, can be cash-flow based if data generating systems are reliable. Diverse sources of funds can become available. For example, credit back-ups for lower rated bonds require good financial information.

Thus, data issues are beyond audit functions and apply to the larger universe of NBFCs. They can build on India’s digital public infrastructure; help with leveraging local information to sustain advantages in distribution while ensuring data privacy; prevent loan pushing.

A self-regulatory organisation can oversee a dynamic process of capacity building. An industry that suffered from the failure of a member has much to gain by building in peer monitoring and knowledge sharing to raise and maintain industry standards.

The role of regulators

While industry angst against regulation often results from a short-term costs view that ignores long-term benefits, or an inability to understand how counter-cyclical regulation works, regulation that keeps the overall objective of furthering inclusive development in mind can evolve towards a better balance between discipline and support. Industry that sees the one must also see the other; loosening must follow tightening when there is space.

Since regulators intervene at multiple points, trade-offs between instruments can be actively utilised. For example, if risk-weights are tightened for areas where credit growth is excessive, aggregate liquidity can be kept neutral. Feedback from industry, when informative and in the aggregate interest, can help rationalise and reduce compliance costs. The tendency to over-react and generalise from one episode must be avoided.

To illustrate these principles, consider co-lending, which combines low-cost bank fund sources with NBFC distribution skills. It should be a win-win since it builds on natural synergies. It was actively encouraged by regulators as a way to lower loan costs and expand reach. But it is growing very slowly. With the recent tightening of risk-weights, bank credit growth to NBFCs fell from 34.7 per cent in July 2023 to 8.2 per cent in July 2024. While interconnectedness increases spillover risks it also raises efficiency. Co-lending is an example of the latter type as it leverages comparative advantage. Stability must not be at the expense of efficiency.

Conflicting messages are going from the regulator. One message is banks must limit exposure to NBFCs. But what are the alternatives? Possibilities on the liability side must be first expanded. Given NBFC heterogeneity, uniform liquidity access may not be possible. If larger ones are given access conditional on holding collateralisable securities they may reduce liquidity hoarding. But more alternatives need to be actively worked on, such as re-financing mechanisms, availability of ESG finance, specialised credit from NABARD, credit warranties and other measures to develop bond markets.

The financial sector has surprised positively after the pandemic. Regulators made major contributions. NBFCs also demonstrated resilience, flexibility and learning. But more is required to achieve the financial inclusion necessary for broad-based sustainable growth.

The writer is Emeritus professor, IGIDR