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RBI’s Revised Regulatory Framework for NBFC – RBI proposed 4 Tier Structure of NBFCs

RBI’s Revised Regulatory Framework for NBFC – RBI proposed 4 Tier Structure of NBFCs

Relevance

  • GS 3 || Economy || Banking & Financial Sector || NBFC

Why in news?

  • The Reserve Bank of India (RBI) has proposed a tighter regulatory framework for non-banking financial companies (NBFCs) by creating a four-tier structure with a progressive increase in the intensity of regulation.
  • It has also proposed a classification of non-performing assets (NPAs) of base layer NBFCs from 180 days to 90 days +6

Aim

  • NBFCs are financial institutions that offer various banking services but do not have a banking license.
  • The proposed structure is structured to safeguard financial stability while ensuring that smaller NBFCs continue to enjoy and expand easily with light regulations.

Proposed Four-tier structure (NBFC)

  • The regulatory and supervisory system for NBFCs should be based on a four-layer structure:
    • Layer Base
      • The lower layer of NBFCs will be known as the NBFC-Base Layer (NBFC-BL).
      • Less regulatory action is warranted for NBFCs in this class.
    • Middle Layer
      • The middle layer of NBFCs will be known as the NBFC-Middle Layer (NBFC-ML)
      • Compared with the base layer, the regulatory regime for this layer would be tighter.
      • For NBFCs falling within this layer, adverse regulatory arbitrage vis-à-vis banks can be tackled to minimize systemic risk spill-overs where appropriate.
    • Upper Layer
      • The NBFC will be known as the NBFC-Upper Layer (NBFC-UL) in the Upper Layer and will call for a new regulatory superstructure.
      • NBFCs that have a significant potential for systemic risk spill-over and can influence financial stability would populate this layer.
      • At present, there is no counterpart to this layer, since this would be a new layer for regulation. The regulatory structure would be bank-like for NBFCs falling into this layer, but with appropriate and appropriate modifications.
      • If for four consecutive years, an established NBFC-UL does not meet the classification requirements, it will step out of the enhanced regulatory structure.
    • Top Layer
      • This layer is preferably intended to be empty.
      • It is possible that supervisory judgment could force some NBFCs for higher regulation/supervision out of the upper layer of the systemically relevant NBFCs.
      • As a distinct set, these NBFCs will occupy the top of the upper layer. Ideally, unless supervisors take a view on particular NBFCs, this top layer of the pyramid will remain empty.
      • If, as per supervisory judgment, some NBFCs lying in the upper layer are seen to pose extreme risks, they may be put to higher and more tailored regulatory/supervisory criteria.

Non-Banking Financial Company (NBFC)

  • A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956engaged 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.
  • NBFC does not include any institution whose principal business is that of agriculture activity, industrial activitypurchase or sale of any goods (other than securities), or providing any services and sale/purchase/construction of the immovable property.
  • 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 installments by way of contributions or in any other manner is also a non-banking financial company (Residuary non-banking company).

Features of NBFCs

  • NBFC cannot accept demand deposits.
  • NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on themselves.
  • The deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs.

Significance of NBFCs in India

  • Catering to the diverse financial needs
    • They played a vital role in diversifying the financial sector, giving impetus to financial stability, and made the sector more efficient.
    • In fostering inclusive growth in the region, NBFCs play an important role in catering to the diverse financial needs of bank-excluded clients.
  • Providing credit
    • NBFCs provide credit to that part of the Indian economy where the private sector banks prefer not to lend(either because the risks are too high or because the returns are too low).
    • Many NBFCs specialize in lending in a particular sector, and develop skill sets unique to that customer base; for example, SMEs and real estate.
    • Many unbanked borrowers avail credit from NBFCs and later use their track record to become bankable borrowers.
  • Funding to businesses
    • Non-bank firms fund everyone from poor entrepreneurs to business titans looking to roll over debt. By covering a wide spectrum of customized services and innovative products, NBFCs have played an active role in strengthening the economy.
    • They play an important role in sustaining consumption demand as well as capital formation in small and medium industrial segments.
  • Helping in financial inclusion
    • NBFCs have contributed to addressing economic demand, and that has helped in financial inclusion.

NBFC crises

  • The shortage of funding for lenders is having a direct impact on economic growth which has recently slowed to a decadal low.
  • The liquidity issue in NBFC has caused a fall in credit to the auto, real estate, agriculture, and small and medium enterprises sectors.
  • With economic growth slowing, compounded by rising fuel prices and a falling currency, the country cannot afford the NBFC crisis.
  • The current NBFC crisis needs to be resolved on a priority basis to revive the corporate earnings growth and the government needs to play a major role to spur demand in the economy.

Malegam Committee

  • The Board of Directors of the Reserve Bank of India, formed a Sub-Committee of the Board to study matters and concerns in the microfinance sector insofar as they are related to the entities regulated by the Bank. The Sub-Committee was under the chairmanship of Y.H. Malegam.
  • The terms of mention of the Sub-Committee included framing the description of ‘microfinance’ and ‘Micro Finance Institutions (MFIs)’ for the point of regulation of non-banking finance companies (NBFCs) undertaking microfinance by the Reserve Bank of India and giving proper recommendations.

Dewan Housing Finance Corporation Ltd (DHFL)

  • With the recent fall, the DHFL stock had plummeted around 96% from the 52-week level of Rs 690, leading to significant losses for the investors.
  • DHFL owes close to Rs 1 lakh crore to banks and investors.
  • It recently said the company’s ability to raise funds had been substantially impaired and the business had been brought to a standstill.
  • It also raised significant doubt on the ability of the company to continue as a growing firm.

IL&FS Default

  • The problem with IL&FS was that it borrowed very short-term cash to invest in infrastructure ventures, which have very long and often very unpredictable gestation periods, through trade papers (CP) and deposit certificates (CDs).
  • The susceptibility to asset-liability mismatches has increased (ALM; this refers to the fact that these lenders have short-dated borrowings and long-dated assets).
  • The shortage of cash depleted liquidity for several months in the aftermath of demonetization in 2016, thereby slowing loan recovery. As IL&FS crashed, the system was just about emerging from the effects of demonetization.
  • When the cash flows were not completed on time from its many roads and other infrastructure ventures, IL&FS found itself with a serious mismatch in its borrowing and lending tenors.
  • This led to the eventual default and spilling of the fallout to other NBFCs and mutual funds (MFs).

Measures by the government

  • The government launched a 25,000 Crore Special Window, subject to certain conditions, to revive stuck ventures.
  • The government provided PSBs with a one-time partial credit guarantee in Budget 2019-20 to purchase high-rated (basically less risky) pooled assets of financially sound NBFCs.
  • While NBFCs are still awaiting these funds, there has been no follow-up by risk-averse banks.
  • Such deals between banks and NBFCs can also be known as ‘securitization’ deals or ‘pass-through certificates’ in the absence of clarity weather (PTC).

Way forward

  • Because NBFCs have stepped in where banks feared to tread, their role has become far more significant now. Hence reviving confidence in the NBFC sector will benefit all stakeholders and the economy at large.
  • Given the recent stress in the sector, it has become imperative to re-examine the suitability of this regulatory approach, especially when failure of an extremely large NBFC can precipitate systemic risks, the RBI paper said.
  • The regulatory framework for NBFCs needs to be reoriented to keep pace with changing realities in the financial sector.

Mains model question

  • In India, shadow banking has its advantages, but it also involves many risks. Corroborate.

References