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Regulation of NBFCs

Regulation of NBFCs

Why in news?

  • The Reserve Bank of India (RBI) has suggested a tougher regulatory framework for the non-banking finance companies’ (NBFC) sector to prevent the recurrence of any systemic risk to the country’s financial system.
  • In its discussion paper on revised regulatory framework for NBFCs, the RBI has said the regulatory and supervisory framework of NBFCs should be based on a four-layered structure: Base Layer, Middle Layer, Upper Layer and a possible Top Layer.
  • It has also proposed classification of non-performing assets (NPAs) of base layer NBFCs from 180 days to 90 days overdue.
  • The proposed framework is aimed at protecting financial stability while ensuring that smaller NBFCs continue to enjoy light regulations and grow with ease.

What are NBFCs?

  • It is a financial institution that does not have a full banking license or is not supervised by a national or international banking regulatory agency.
  • A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property.
  • The most important difference between non-banking financial companies and banks is that NBFCs don’t take demand deposits.
  • A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments by way of contributions or in any other manner, is also a non-banking financial company (Residuary non-banking company).
  • NBFCs as a collective play a crucial role in the banking sector by increasing the penetration of financial products to unbanked areas, providing innovative products for both rural and urban customers, catering to the need of infrastructure lending and to other areas where long term financing is needed.

Key Characteristics Of NBFCs

  • NBFCs do not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/ construction of immovable property.
  • NBFCs are categorized:
    • In terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs,
    • Non deposit taking NBFCs by their size into systemically important and other non-deposit holding companies (NBFC-NDSI and NBFC-ND) and
    • by the kind of activity, they conduct.

Major categories of NBFCs | Regulation of NBFCs

  • Major categories of NBFC include-
    • Loan companies,
    • Asset Finance Companies,
    • Investment companies,
    • Systemically Important Core Investment Company (CIC-ND-SI),
    • Infrastructure Financing companies (IFCs),
    • NBFC-Micro Finance Institution (MFI),
    • Infrastructure Debt Funds (IDFs),
    • NBFC-Factors,
    • Mortgage Guarantee Companies (MGC) and
    • NBFC- Non-Operative Financial Holding Company (NOFHC) among others.
  • These companies get NBFC License with the Reserve Bank of India (RBI). But they are regulated by different agencies based on the role they play.

The proposed Four-Tier Structure of NBFCs

  • BASE LAYER: If the framework is visualised as a pyramid, the bottom of the pyramid, where least regulatory intervention is warranted, can consist of NBFCs, currently classified as non-systemically important NBFCs (NBFC-ND), NBFCP2P lending platforms, NBFCAA, NOFHC and Type I NBFCs.
  • MIDDLE LAYER: As one moves up, the next layer can consist of NBFCs currently classified as systemically important NBFCs (NBFC-ND-SI), deposit taking NBFCs (NBFC-D), housing finance companies, IFCs, IDFs, SPDs and core investment companies. The regulatory regime for this layer will be stricter compared to the base layer. Adverse regulatory arbitrage vis-à-vis banks can be addressed for NBFCs falling in this layer in order to reduce systemic risk spill-overs, where required, the RBI said.
  • UPPER LAYER: Going further, the next layer can consist of NBFCs which are identified as systemically significant among. This layer will be populated by NBFCs which have large potential of systemic spill-over of risks and have the ability to impact financial stability. There is no parallel for this layer at present, as this will be a new layer for regulation. The regulatory framework for NBFCs falling in this layer will be bank-like, albeit with suitable and appropriate modifications, it said.
  • TOP LAYER: It is possible that considered supervisory judgment might push some NBFCs from out of the upper layer of the systemically significant NBFCs for higher regulation/supervision. These NBFCs will occupy the top of the upper layer as a distinct set. Ideally, this top layer of the pyramid will remain empty unless supervisors take a view on specific NBFCs. In other words, if certain NBFCs lying in the upper layer are seen to pose extreme risks as per supervisory judgement, they can be put to higher and bespoke regulatory/supervisory requirements.

Need For Strict Regulation | Regulation of NBFCs

  • Threat of systemic risks: Financial issues faced by key NBFCs like Infrastructure Lending and Financial Services Limited (IL&FS) and Dewan Housing Finance Corporation Limited (DHFL) has raised the threat of systemic risks posed by the NBFC sector to the overall financial sector.
  • Allowing large NBFCs to seamlessly become banks: Recently, RBI’s Internal Working Group (IWG) has revised the licensing norms for the Banking Industry. Since key NBFCs are to potentially become Banks, there is a need to bring consistency in regulation of Banks and NBFCs, so that the transition of NBFCs to Banks is seamless.
  • Emergence of FinTech Sector: Emergence of the Financial Technology sector has changed the way Banking sector operates by creating innovative financial services which do not fit in traditional definitions. In this light, reforms in regulation of NBFCs can bring synergy between seamless operation and interaction of Banks, NBFCs and newly emerging element of FinTech.

What is difference between banks & NBFCs?

  • NBFCs lend and make investments and hence their activities are akin to that of banks; however there are a few differences as given below:
    • NBFC cannot accept demand deposits;
    • NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself;
    • deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.

Potential Impact Of These Changes

  • Increased transparency in the sector: The primary issue that the NBFC sector faced was the lack of transparency which created financial risks for the overall banking system. Thus, more transparency in NBFCs via regulatory route would enable seamless flow of information, thus improving the transparency and risk assessment for the whole financial sector.
  • Balance between flexibility of NBFCs and the potential systemic risks: The four-layered structure entails a largely laissez-faire approach for smaller NBFCs, plugging some of the arbitrages available to mid-sized NBFCs vis-à-vis banks, and imposing tougher ‘bank-like’ capitalization, governance and monitoring norms for the largest players and those which could pose a systemic risk due to the nature of their operations.
  • Improved trust and confidence in the NBFC Sector: Stricter regulation by RBI alongside early reporting of NPAs will instill confidence in the NBFC market potentially driving up the share prices, attracting more depositors and translation to better credit ratings.

ALSO READ: https://www.brainyias.com/iasbuzz/banking-reforms-in-india/

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