Aworking group headed by Usha Thorat, a former deputy governor of the Reserve Bank of India (RBI), has submitted a report on issues pertaining to non-banking financial companies (NBFCs). If the report is accepted, it will change some fundamentals. The group continues the Y.V. Reddy style of looking at regulation: Be extremely conservative and careful with size, be liberal and encouraging small efforts that do not pose a systemic risk. The report is an illustration of this style.

There are two questions that need to be asked. Does the report address the issue of systemic risk? Will its recommendations create a barrier for newer and smaller institutions in continuing operations without regulatory overload?

The approach of the report is refreshing because it gets the sense of proportion right. The overall approach is to reduce clutter and possibilities of arbitrage. Unlike several specialist groups that look into niche areas and end up writing reports that are divorced from the big picture, this is neatly located in the financial space. It recognizes the regulatory priorities, the fundamental differences with the banking system and the arbitrage points to be plugged.

While the report touches upon four important aspects relating to NBFCs—the requirement of registration; the sub-classification of NBFCs; governance and the reporting requirements—two sections pertaining to registration and governance have some fundamental issues.

By Jayachandran/Mint

The significant differences between banks and NBFCs are largely on the liabilities side. After 1998, with the mandatory requirement of registration with RBI and a tighter regulatory oversight, the space has fundamentally changed in favour of larger NBFCs. RBI stopped registering any new deposit taking NBFCs. The Thorat report seems to put a permanent lid on that option, by recommending the continuance of that stance. So, over time we will have only non-deposit taking NBFCs, which could be tiny, medium and large.

When large NBFCs get integrated into the financial system, they could pose a systemic risk. The argument that they are not a part of the payments system and, therefore, the contagion of failure could be limited is not tenable. The report appropriately identifies that indirectly the larger NBFCs could be embedded even on the liabilities side indirectly through issue of structured retail instruments. Therefore, it is necessary to extend the regulatory cover on them, but this regulation has to be calibrated based on the situation.

Apart from the functional classification, there are three peculiar animals in this space:

NBFCs promoted by banks where they enjoy regulatory arbitrage because of lighter regulatory requirements posed on NBFCs. The report strives to nullify the regulatory arbitrage by aligning all the prudential norms on risk weightage fully with banks. In case of NBFCs promoted/owned by government, the group recommends alignment with other NBFCs without any special dispensation. In case of “captive" NBFCs working as an extended arm of a commercial entity, the group recommends that the risk assessment should take into consideration the risks of the parent as well.

The report is forward looking in exempting players from registration requirements, thereby allowing smaller and newer players to enter the market and register as they become important enough for RBI to have a look at them.

It has taken a serious look at governance, particularly where there are management/ownership changes due to sell-off, mergers or acquisitions. The report recognizes the “management" premise on which registration is granted and how that premise changes. Thus, the recommendation is that such changes should also go through regulatory approvals. The report is practical in recommending changes in the regulatory norms for governance, which it believes should converge with the banking system. But in the interim they recommend that the larger NBFCs should at least comply with Clause 49 of the listing norms, even if they are not listed.

It is good to see a refreshing report that is practical, forward-looking and thoughtful. Unfortunately, the report keeps residuary non- banking companies and microfinance institutions (MFIs) out of its recommendations. The Yezdi Malegam committee that looked into these issues favoured large MFIs (minimum capital of 15 crore). In this light it is refreshing to see that this group believes in a space for smaller players with lighter regulation. If this approach were applied to microfinance, the situation would have been reassuring.

M.S. Sriram is an independent researcher and consultant and a former professor at the Indian Institute of Management, Ahmedabad.

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