NBFC in India : Regulatory Challenges and concerns

Introduction NBFC?
❖ Non-bank financial institutions (NBFCs) are financial institutions that provide various
banking services but have no banking licenses. Generally, these institutions are not
allowed to withdraw traditional demand deposits, for example, funds from public
savings accounts.
❖ NBFC is a company registered under the Companies Act (other than commercial and
cooperative banks), which provides credit facilities such as loans and advances,
accept deposits, lease, rent, lease, retire, invest in securities and money trading.
market trading, mergers, underwriting opportunities, etc.
➢ NBFC largely depend on public fund (70% of total liabilities of the sector). Bank
borrowings, Commercial papers, and debentures are major source of funding. Bank
borrowing show increasing trend while debenture shows decreasing. This states banks
are compensating for reduced market access for NBFC in the wake of stress in sector.
➢ Top 10 NBFC account for more than 50% of total bank exposure while top 30 NBFC
(includes Government owned) account for more than 80% of total exposure.
➢ After IL&FS crisis, issue of Commercial Papers has reduced indicating reduced risk
appetite for them. (this brought NBFC sector under greater market discipline)

There are several factors due to which NBFCs struggle. Some of the major challenges
and issues in the way of starting an NBFC in India are as follows:

➢ Funding issue due to the absence of refinancing option

Banks in India have several options for refinancing such as RBI, NABARD, EXIM
Bank, and SIDBI. Likewise, Housing Financing Companies (HFCs) also have the
refinancing alternative, and it refinances from NHB (National Housing Bank), the
regulator of HFCs.

However, NBFCs have to hinge on banks, competitors, or the capital markets for
raising resources every time. In turn, this could be unfavourable to the sustainability of
the NBFCs growth like in the case of distress. Furthermore, the flow of funds from
these sources could dry up without much notice.

➢ Difficult compliances for NBFC in India

There are a number of NBFC compliances for different types of NBFCs which they
have to file quarterly, half-yearly, and annually. it becomes really difficult to figure out
how and when to file the prescribed returns.

➢ Absence of flexibility in the classification of loan NPAs

 For large corporates, the NPA (Non-Performing Assets) norms are quite relevant.
However, businesses with irregular cash flow have a cascading impact regarding all
the delays in payments.
Although, in the revised categorization, assets are re-categorized; therefore,
classification under NPA and greater flexibility, w.r.t scheduling is much required. The
classification of NPA norms must be based on the assets financed instead and the
borrowers’ profile or uniform system of asset classification.

➢ Limited leverage ratio for NBFCs-ND with assets sizes less than Rs. 500 crores
Small NBFCs are exempted from the maintenance of the Capital Adequacy Ratio
(CRAR). But they can’t exceed the leverage ratio beyond 7 which is quite restrictive.
Furthermore, such NBFCs borrow largely from financial institutions and banks which
in turn carry out due diligence on the NBFCs that borrow.

➢ Several representative bodies

The NBFC sector is at the development stage. Therefore, in the interest of developing
its various segments in a harmony, setting a single representative body could be a
better alternative. However, one must always ensure that every segment is represented
adequately in such an apex body that promotes the balanced growth of the NBFC
sector without any inner conflicts.

➢ Disparate tax treatment

It’s a well-known fact that there exists a big inequality in the tax structures for Banks
vs. NBFCs. For example, TDS (Tax deduction at Source), Dual taxation on lease/hire
purchase, and income recognition on NPAs. However, the current legal framework for
NBFCs doesn’t allow a tax deduction for the non-performing assets.

➢ Scarcity of defaulter database

NBFC doesn’t get defaulter lists from Banks. In turn, this leaves NBFCs susceptible to
credit risk on account of the lack of crucial information. Moreover, there is a
requirement for bringing the essential legislative amendments so that these companies
can leverage the utility payments database in the credit assessment process.

➢ Removal of Priority Sector Status to Bank Lending to NBFCs

It’s one of the biggest issues that NBFCs face. The Priority Sector status to Bank
Lending to NBFCs must be stored. Hence, the collaboration model
“wholesaler/retailer” between the NBFCs and Banks ensures the credit flow to under-
served sections of the society. This, in turn, helps NBFCs in creating assets and wealth
in semi-urban and rural parts of the country. However, RBI could specify a cap to
route a maximum of a fixed percentage of the total bank lending priority sector
through NBFC.

➢ Minimum mandatory credit rating for deposit-taking NBFC

❖ NBFCs have what is often called light-touch regulation. Compared with their closest
peers – banks, the regulatory oversight on NBFCs was decidedly light. Underpinning
this light approach was the recognition that NBFCs serve customer segments that are
un-served or under-served by banks. For a wider reach of credit, the role of NBFCs has
been seen as critical. At the same time, since banks were the major providers of
funding for NBFCs, there was also a concern that any risks that NBFCs take, will
ultimately impinge on the banking system. Since NBFCs were taking on risks that
banks did not, the funding link between them was a mechanism of transmitting these
risks from NBFCs to banks.
❖ NBFCs have limited constraints on credit and fewer compliance obligations as
compared to banks.
NBFCs had to be freed from regulatory constraints that banks face: sector
concentration norms, acceptable collateral, credit standards and processes that rely on
non-financial information, use of third-party sales channels, recovery processes, etc.
❖ Future regulations must take a comprehensive view of NBFCs and not just be focused
on their asset side. Progressively over the last few years, especially since the
Committee recommendations, the regulations on the asset side of NBFCs and banks
have been aligned. It’s now time to look at the liability side.
❖ NBFCs have no liquidity requirements such as statutory liquidity ratio or liquidity
coverage ratio, except for SLR for deposit-taking NBFCs. banks have to follow much
more stringent asset liability management rules as compared to NBFCs. Indeed, the
regulatory oversight on NBFC hitherto can be summarised as ‘much lighter on the
assets, and absent on the liabilities’. This must change. Liabilities side regulations
must be imposed, at least for the systemically important NBFCs.
❖ NBFCs are India’s shadow banks. When they were a relatively small part of the
system, we could let them grow with light regulation. This is no longer the case.
Recent events should be treated as a wake-up call and result in the tightening of
regulations, before they bring serious grief to us.(put this in the beginning)
❖ The challenges today are as follows:
First, there are law related challenges
i. there are a number of companies that are registered as finance companies,
but are not regulated by the Reserve Bank,
ii. there are unincorporated bodies who undertake financial activities and
remain unregulated,
iii. there are incorporated companies and unincorporated entities illegally
accepting deposits,
iv. there are entities who camouflage deposits in some other names and thus
illegally accepting deposits.
❖ The NBFC business model itself is flawed, to begin with. It relied on raising short-
term funds which were then lent out as long-term loans. This leads to a situation called
an asset-liability mismatch.
❖ AFTER IL&FS CRISIS, banks, mutual funds and their investors were afraid that more
such entities wouldn’t default. As this fear took hold, many institutions refused to give
money to NBFCs. The cost of funds rose by as much as 150 basis points for NBFCs.
 FUTURE CHALLENGES IN NBFC:
➢ NBFCs are facing a liquidity crunch. In other words, they don’t have money to lend or
are facing enormous difficulties in raising funds.
➢ In the last few years, especially after demonetisation, there was excess money
sloshing around in the system. That is because a lot of cash was deposited with banks
and investors parked more money with mutual funds. As fund managers of debt
schemes deployed the funds in money markets, NBFCs were able to access cheap
funds easily. They were able to grow their loan portfolios at double the pace of banks.
But on the flip side, note that mutual fund managers were chasing high returns for
their investors and so too were NBFCs and banks. This led them to take risks and put
pressure on the quality of their underwriting standards. Note that this excess money
was given not only to NBFCs but also to other companies such as infrastructure
players -- as loan against shares -- which have come back to bite now

➢ Asset quality-The problems first came to light when the IL&FS fiasco first broke out.
Most of the NBFCs had a huge exposure to IL&FS debt paper. It opened a Pandora
Box because most NBFC had lent to the real estate and the infrastructure sector in a
big way. Not only were these loans stuck but were being consistently rolled over.
Most of these loans also had a maturity mismatch because NBFCs were borrowing at
the short end via CPs and lending to real estate projects at the mid to long end. The
bigger worry is that higher fuel prices, weaker dollar and the trade war could hit the
SME sector badly. This would mean defaults by SMES, which have been a traditional
market for NBFC lending. This debate is likely to come back time and again to haunt
us in the next few month
➢ Future borrowings?
The big challenge for the NBFC is now about fund raising. They need a constant
access to low cost funds to sustain their lending business. If the momentum is lost then
overheads and size start becoming a constraint for the NBFCs. There are three
challenges that NBFCs are facing at this point of time. Firstly, the bond yields have
gone up sharply to around the 8% mark. That is making borrowing costlier even at the
short end of the yield curve. Secondly, considering their recent problems, most
existing investors are unable to find liquidity in the markets. That is forcing some of
these holders to sell NBFC bonds at yields as high as 11-12%. We saw in the case of
DSP Mutual Fund selling DHFL bonds. Lastly, investors are worried about a credit
downgrade backlash on NBFCs. That could mean huge write-offs for investors. For
now the taps are surely running dry!
➢ Regulatory changes
The biggest worry is that the IL&FS fiasco may force the RBI to regulate NBFCs as
stringently as the banks. That would mean stricter capital adequacy, NPA provisioning
etc. Those who remember the NBFC crisis of 1998 would remember how Dr. Jalan’s
NBFC regulations changed the face of NBFCs in India forever and led to a huge
disruption. The last thing NBFCs want is a repeat of the crises in the year 1998.
 Solutions to the above NBFC challenges(these r very specifically for those who
wants to start nbfc, hence we can ignore this and put dhfl crisis)

1. Co-Originating Lending for funding issues

With the help of Co-originating lending, the NBFCs can avoid the funding risk and
such several issues. Further, with co-origination, such companies can leverage their
balance sheets which will not only improve their return on equity (ROE) but will also
let them provide a better rate and experience to the customer.

2. Business plan and continuous monitory

For a beginner company/NBFC, NPAs are a big hurdle to the organization’s growth.
Therefore, even before you start, you require a great business plan and need to
monitor every activity continuously.

3. “Name and Shame” guarantors for loan defaulters

Along with Banks, NBFCs too can join the naming and shaming of wilful loan
defaulters. According to bankers, the company needs to publish the name, address,
and photographs of the guarantors if they don’t clear the dues within the 15 days of
the notice which contains the details of the original borrower

4. Risk management framework

A company, especially a start-up, is always at some kinds of risk. Hence, it’s important
for the company to implement a risk management framework.

5. Hire consultants for NBFC Documentation, License, and Compliances

These consultants have good hands-on tackling every obstacle in the path of NBFC
licensing, documentation, and compliances. Dealing with RBI is really difficult but
professionals make this easy for NBFCs

Conclusion
The challenge for the NBFC sector is to grow in a prudential manner while not
stopping altogether on financial innovations. The key lies in having in place adequate
risk management systems and procedures before entering into risky areas. As for the
regulator, it is the constant endeavour of Reserve Bank to enable prudential growth of
the sector, keeping in view the multiple objectives of financial stability, consumer and
depositor protection, and need for more players in the financial market, addressing
regulatory arbitrage concerns while not forgetting the uniqueness of NBFC sector.