Highlighting the fancy among most non-banking financial companies (NBFCs) to do more of the same thing, such as retail unsecured lending, top-up loans or capital market funding, RBI Deputy Governor Swaminathan J cautioned that over reliance on such products may bring grief at some point in time later.

Swaminathan asked the heads of risk function at NBFCs to pay attention to the business model that is being adopted for their continued viability and also periodically scan the portfolio mix to prevent any possible build up of risks such as concentration risk.

“There appears to be a fancy among most NBFCs to do more of the same thing...It is also observed that the risk limits that are fixed for certain category of products or segments, say like unsecured lending, in some entities, is way too high to be sustainable in the long run.

“I hope risk managers make a professional assessment of such risks that may be building up in their books,” the Deputy Governor said at the conference of heads of assurance of NBFCs in Mumbai on May 15.

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Swaminathan observed that it is imperative that heads of assurance, in their internal presentations to the board, capture forward looking thoughts in risk management.

The entities also need to invest in early warning systems, stress testing capabilities, vulnerability assessments, cyber key risk indicators monitoring, targeted evaluations of compliance with KYC (know-your-customer)/AML (anti-money laundering) norms and transaction monitoring capabilities.

Risks from rule-based lending models

Referring to many NBFCs increasingly turning to rule-based credit engines to accelerate the growth of their lending portfolios, Swaminathan said while automation can enhance efficiency and scalability, NBFCs should not allow themselves to be blinded by these models.

“It is crucial to recognise that rule-based credit engines are only as effective as the data and criteria upon which they are built. Over-reliance on historical data or algorithms may lead to oversights or inaccuracies in credit assessment, particularly in dynamic or evolving market conditions.” he said.

Therefore, NBFCs must maintain a clear-eyed perspective on their capabilities and limitations, supplemented by continuous monitoring and validation of credit scoring models.

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He underscored that “It is incumbent upon the supervised entities to keep the rule engines and models calibrated from time to time taking into account real-time learnings and emerging scenarios.

“It is also imperative to have these models validated periodically, either internally or externally, as the case may be, to ensure that the models stay relevant at all times. I would like to call upon the heads of risk and internal audit here to pay special attention to this requirement.”

Liquidity risks

The Deputy Governor highlighted liquidity risks arising from the concentration of funding sources and maturity mismatches as one of the key risks.

“Reliance on a limited number of funding sources can amplify liquidity vulnerabilities, especially during periods of market stress or disruptions in funding channels.

“Moreover, maturity mismatches between assets and liabilities can exacerbate liquidity risk, making NBFCs susceptible to funding squeezes or rollover difficulties,” he said.

Swaminathan emphasised that prudent liquidity management practices, including diversification of funding sources, maintaining adequate liquidity buffers, monitoring maturity profiles and putting contingency lines in place are essential to mitigate liquidity risks and ensure uninterrupted operations,

Additionally, stress testing and scenario analysis can help NBFCs assess their resilience to adverse liquidity shocks and proactively manage liquidity risks.

“This is an area, we observe, that the internal audit functions in most entities have not measured up to the requirement of periodically auditing the assumptions and inputs that go into calculating various statutory ratios relating to liquidity risk management.

“We also observe that even in some large NBFCs, there is lack of capacity building in their mid office and back-office functions, which can seriously compromise the assessment and monitoring of the ALM and liquidity risk,” the Deputy Governor said.

Swaminathan also expressed concern that NBFCs have the lowest average number of compliance staff relative to their size compared to other sectors like commercial and cooperative banks.

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“Despite regulatory measures aimed at ensuring the autonomy of these functions, it is disheartening to encounter instances where heads of assurance functions are given junior positions within the hierarchy or there is lack of direct access to the board.

“Further, instances of dual-hatting with other roles is also observed. Such practices undermine the effectiveness and independence of assurance functions, potentially exposing NBFCs to heightened risks, thereby attracting enhanced regulatory scrutiny,” he said.