Shadow Banking in India: NBFCs and their Role in the Financial Economy

In India’s financial pulse, Non-Banking Financial Companies (NBFCs) — Micro Finance Institutions (MFIs) are key factors for development. NBFCs are entities that provide similar services to banks but do not hold a banking license, for instance, engaged in the business of loans and advances, acquisition of shares/debenture/securities, leasing, hire-purchase, insurance, and more.

Illustration by The Geostrata

It has emerged as a vast source of financing for individuals as well as enterprises—small, medium, and large (including rural and informal sectors). This has made it a key player in realising the financial inclusion objective, apart from a financial stability perspective.

Banks still dominate the financial landscape compared to NBFCs but, NBFCs have also risen steadily over the years, which is also prominently increasing with growth.

With the evolution of technology, the digital economy has further catered to fintech companies in the NBFCs sector. Increased penetration of smartphones and internet feasibility have significantly fueled digitalization along with the Covid-19 pandemic, which pushed people to transact online, boosting the fintech ecosystem.

Increasing digital lending has equal vulnerabilities too, which raises concerns about unethical practices, privacy data, and concentration risk in NBFCs.

NBFCs IN INDIA

In India, Non-Banking Financial companies started in the 1960s as an alternative for investors and businesses whose financial requirements could not be fulfilled by the existing banking system. The NBFCs model initially encouraged investors to deposit and lease to industrial firms. This model was limited in scale and considerably volatile for investors. NBFCs were initially regulated under the Companies Act of 1956.

However, the complex nature of the operations of these companies required a separate regulatory framework. In February 1964, Chapter III-B “Provisions relating to Non-Banking Financial Institutions….and Financial Institution” was added to the RBI Act. Moving ahead, the sector attracted Indian investors amidst the masses, but after 1991’s Liberalisation-Privatisation-Globalisation (LPG) reform, there was massive growth of NBFCs.

This opened the inflow of Foreign Investment (FDI) and also raised regulatory concerns for the growing NBFC industry. In 1992, RBI’s Working Group headed by A.C. Shah in its report emphasised recommendations from a need for entry requirements, and compulsory registration, to prudential norms.

The Reserve Bank of India, considering the growth, development, and implications of financial stability introduced a Scale-based regulation (SBR) for Non-banking Financial Institutions. The SBR conceives of the principle of proportionality for the regulations of NBFCs.

As per RBI’s Master Direction, NBFCs are classified as deposit (D) and non-deposit taking. Further segregated under four categories: NBFC-Base Layer (NBFCs-BL), NBFCs-Middle Layer (NBFCs-ML), NBFCs-Upper Layer (NBFCs-UL) and NBFCs-Top Layer (TL);

Note: NBFC-D, NBFC-ND, SPDs, IDFs, CICs, HFCs, IFCs, P2Ps, AAs, NOFHCs refer to deposit-taking NBFCs, non-deposit-taking NBFCs, Standalone Primary Dealers, Infrastructure Debt Fund, Core Investment Company, Housing Finance Company, Infrastructure Finance Company, Peer to Peer Lending Platform, Account Aggregator, Non-Operative Financial Holding Company, respectively. Source: RBI.

I. NBFCs Base-Layer comprises non-deposit (NBFCs-ND) taking companies with an asset size below ₹1000 crore and NBFCs undertaking the following activities:

II. NBFCs Middle-Layer comprises deposit (NBFCs-D) taking companies and NBFCs-D with asset size above ₹1000 crore and undertaking the following activities—

III. NBFC Upper-Layer comprises companies that are specifically identified by the Reserve Bank as per regulatory requirements based on a set of parameters and scoring methodology prescribed in master directions. The top ten NBFCs under this parameter are placed in NBFCs-UL.

IV. NBFCs in the Upper Layer are moved to the Top Layer if the Reserve Bank of India recognises a systemic risk from NBFCs-UL. Ideally, the top layer of the NBFCs remains empty.

NBFCs have a diverse range of entities and operating models, which are required to be monitored systematically. These Non-Banking Financial Companies are regulated by the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), the Insurance Regulatory and Development Authority of India (IRDAI), and others based on the registration and business of the NBFC. 

Source: RBI

ROLE AND CONTRIBUTIONS

NBFCs are increasingly enacting significant roles in financial intermediation by complementing and competing with banks. Banks are often constrained from serving particular segments owing to the abiding regulatory restrictions of the central bank. One such implication is how much banks are lending against collateral. NBFCs dominate the “loan against shares/securities” business.

Banks are bound by high operating costs, a low credit risk appetite, or even the inability to access credit risk in the absence of financial documentation. For instance, a small truck fleet operator business primarily involves cash transactions. When they need to buy trucks, these businesses tend to lack documentation and even possess financial inadequacy in the traditional banking ecosystem.

In such cases, banks inability to provide credit acts as an advantage for NBFCs. This movement has also asserted financial inclusion in households. 

DIGITAL ECOSYSTEM

Growth in digital lending is an important consequence of the digital revolution. Rapid internet adoption across India has occurred since 2015. The traditional banking sector in India has been proactive since then in using information technology to deliver financial technology solutions like RuPay cards and the Unified Payment Interface (UPI).

The introduction of the RuPay card-based solution in 2014 fostered a significant share of debit card usage (prior to UPI) due to its wide acceptance in all tiers of cities. Banks and NBFCs, including fintech, have been harnessing the technological evolution to grow rapidly since the Covid-19 pandemic. 

Financial activities like the lending process, which includes the assessment of credit and documentation, loan approvals, loan disbursements, and loan repayments, are being handled electronically, lowering the operation costs for lenders and serving the unserved or informal sector.

This advancement is not only aiding NBFCs and financial institutions but also traditional banks in discovering unexplored solutions.

Data-driven analytics is a core tool for fintechs and NBFCs to understand the behavioural patterns of consumers and to develop financial products catering to these needs. Similarly, various other technologies have emerged that allow lenders to access alternate sources of information and insights, like the Reserve Bank of India Innovation Hub, a division of the RBI that facilitates the easy flow of data to lenders.

Although it does not act as a credit facilitator or regulator, it assimilates information from a financial ecosystem and aids lenders in addressing and strategising decisions.

The digital evolution of NBFCs and the financial system raises concerns about risks and vulnerabilities. Digital lending particularly poses these risks as customers tend to share sensitive information, such as location, contacts, audio, and more. Data is being collected by digital financial companies namely “third parties,” which, if not supervised can lead to identity theft, fraud and banking risks.

Vulnerability to cyber-attacks in mass is another obstacle, as NBFCs are largely segmenting the financial inclusion of MSMEs, rural and marginalised populations, and the informal sector. This loss of privacy data can lead to a loss of trust in digital transactions. 

The RBI has been taking enterprising regulatory measures to mitigate such risks. Additional initiatives like conducting global hackathons, a regulatory sandbox for testing financial products in controlled ecosystems, and its Innovation Hub for the promotion of innovation and collaborations to address policies and concerns for the ecosystem.

The focal point comprises of balancing innovation and mitigating cyber security risk in the sector. RBI is keen on the cyber security framework to adhere to cyber-security baseline and resilience, cyber-security operations centre (CSOC) and cyber security incident reporting (CSIR).

The Financial Stability Board (FSB) has released a consultative report to address the emerging challenges of increased fintechs and to help reduce fragmentation in the finance service sector.

CRISIS AND CHALLENGES

Access to funding unlike banks which have access to deposits, NBFCs rely on borrowings from banks and capital markets. This makes it demanding to complete the bank’s credit line. The Infrastructure Leasing & Financial Services (IL&FS) crisis of 2018 resulted in a massive credit crunch and disrupted the real economy. IL&FS is a major infrastructure-financing NBFC with more than 150 subsidiaries, which are mostly special purpose vehicles (SPV) setup to own infrastructure assets in a complex pattern and structure.

Registered as a Core Investment Company (CIC), it is restricted to investing in other group companies. In the first instance, the company defaulted on intercorporate deposits and commercial papers worth ₹4.5 billion. Following this credit rating agencies downgraded their ratings. Later, it defaulted on a ₹10 billion short-term loan from the Small Industries Development Bank of India (SIDBI), further lowering its credit ratings.

This triggered panic in the capital market as huge domestic and foreign investments were infused, including those of institutional shareholders ( LIC, Orix Corporation, and Abu Dhabi Investment Authority) in the organisation. All mutual funds became cautious about taking credit risks and stopped rolling commercial papers issued by NBFCs.

New bond issues decreased, and the commercial market froze creating a severe liquidity shortage in the capital markets. In the following months, the supply of funds to NBFCs dried up.

To address the crisis, the Government of India had to intervene, changing its entire board. The company is categorised as “systematically important” by the RBI, meaning that it can’t be allowed to fail. The government and RBI took into consideration measures like: (i) First Loss Guarantee Default (FLGD) to enhance the confidence of lenders, particularly in situations where borrowers may have a higher risk of default, and to ensure lenders are protected against potential losses in case of default. (ii) Bank risk weights on lending to NBFCs were reduced, loosening the monetary stress.

CONCLUSION

India’s era of digitalisation has extended vast opportunities for its financial sector, eliminating geographical barriers, reducing informational asymmetry, and increasing smartphone usage and internet connectivity, especially for fintech NBFCs. NBFC lending is seen to have a large consumption impact on the economy. Fintechs are exposed largely to the household (middle-income and middle-aged) and MSMEs sectors can make them prone to detrimental credit shocks like 2018’s IL&FS crisis.

For systematically important NBFCs, regulatory oversight is required to be thorough supervision, which shall be comprehensive and stringent. These NBFCs should be subject to extensive annual audits as well as occasional regulatory actions, such as asset quality reviews done by commercial banks in response to NPAs. 

Moreover, the proliferation of credit supply in the economy by systematic important NBFCs (NBFC-UL) can pose a risk to the financial sector. Also, it is necessary to identify significant linkages to banks and other institutions, possibly those that are too big to fail to monitor them separately.

Recognising the growing role of NBFCs worldwide, the G20 has mandated that the Financial Stability Board develop a comprehensive framework to regulate Global financial stability, underscoring the increasing reliance on NBFCs and financial institutions.

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BY ASHISH SURYAVANSHI

TEAM GEOSTRATA

info@thegeostrata.com