In June 2021, the Reserve Bank of India issued prudential guidelines on the dividend pay-out ratio of non-banking finance companies (NBFCs) to bring in uniformity and enhance transparency in the sector.

Per these guidelines, NBFCs may declare dividends from FY22 onwards if their net non-performing assets (NPAs) are less than 6 per cent in each of the last three financial years. Further, deposit taking and systemically important NBFCs have to maintain a minimum capital adequacy ratio of 15 per cent of their aggregate risk-weighted assets.

Shadow banking practices

NBFCs in India are shadow banking entities, with light-touch regulation from the RBI. Shadow banks are a group of financial intermediaries facilitating creation of credit in the financial markets but not subject to full-suit regulatory surveillance. This allows them to be agile to exploit new business opportunities but may also lead to creative accounting and financial engineering. Similar shadow banks exist in Bangladesh, China, and Indonesia.

In India NBFCs, typically, lend at high interest rates, by sourcing funds from commercial banks. Post demonetisation in 2016, banks had abundant liquidity and their credit growth had been lacklustre mainly due to higher NPAs followed by Covid-19 pandemic conditions.

Besides, some public sector banks were put under the RBI’s Prompt Corrective Action framework, which restricted growth of their business. As a result, some NBFCs capitalised on this opportunity and expanded their balance-sheet size rapidly. In the process, NBFCs ended up giving loans to non-creditworthy/non-investment grade borrowers, too.

NBFCs like Infrastructure Leasing & Financial Services (IL&FS) and Dewan Housing Finance Ltd (DHFL) became ‘gone concerns’ primarily due to lack of corporate governance and non-disclosure of possible NPAs. For instance, IL&FS paid a total dividend of ₹1,418.1 crore to its shareholders during 2015-2018, though it had continuous negative cash flows from operations and investments during this period.

The Il&FS group consisted of a maze of 347 inter-connected companies (mostly special purpose vehicles that were shown as off-balance sheet, or OBS, items). However, credit rating agencies turned a Nelson’s eye to its OBS items. Its board meetings hardly lasted beyond an hour. Therefore, in its communication to the IL&FS board, the government categorically said “the affairs of IL&FS were being conducted in a manner prejudicial to the public interest.”

A forensic audit by KPMG and found that DHFL disbursed loans aggregating ₹24,594 crore with insufficient legal documentation to 65 shell companies. Of these, 35 entities with ₹19,754 crore, were directly or indirectly controlled by the promoters. However, DHFL had not disclosed these related-party transactions in its annual reports. The review revealed that a few trusted employees of DHFL were generating thousands of fake accounts, using customised software to create retail borrowers for the money flowing into its various group companies.

Borrowing short term and lending long term is a common practice among NBFCs. They borrow through money market instruments such as Commercial Paper for cost effectiveness and keep rolling them over to fund their long-term loan assets, thereby facing asset-liability mismatches apart from liquidity and re-pricing risks.

Some NBFCs misused the ‘Loan against Property’ (LAP) product to the hilt. To illustrate, Company A has given an LAP of ₹25 crore to a borrower on Day 1. After two years, Company B will buy that loan from Company A for ₹30 crore (principal plus interest, which the borrower defaulted). Later, company C will pick up this loan from Company B at ₹40 crore comprising principal, interest, and interest on interest, etc. This ever-greening process is a perpetual phenomenon in NBFCs as part of their regulatory arbitrage.

The way forward

NBFCs have grown exponentially in the recent past and their size has become systemically important in view of the financial stability of the economy.

Hence, the RBI should tighten its supervision by following ‘fit and proper’ criteria while selecting the top management of NBFCs. As banks and mutual fund houses source savings from retail depositors (public money) and lend to NBFCs, there is a compelling need to intensify regulation. Further, systemic risks should be properly mitigated by preventing NBFCs from maintaining incestuous relationships with banks/financial institutions (for example, NBFC’s investment in a bank’s equity capital and the bank in turn gives high value loans to the former).

As some NBFCs are permitted to collect deposits from the public and on-lend, the RBI has to work on multiple lending, over-indebtedness of the borrowers and coercive recovery practices of NBFCs. Though the size of the operations of NBFCs led to greater economies of scale over the years, the same has not translated into any perceptible decline in their lending rates.

NBFCs are at an inflexion point. They have to reinvent themselves to stay put in the dynamic financial markets.

One viable option for NBFCs is that they may become full-fledged universal banks. It may be a good idea if NBFCs (endowed with better loan origination capability and lower operating cost model) and banks (with deep pockets) opt for co-lending in respect of priority sector loans.

The RBI has to ring-fence NBFCs by constantly monitoring them through CAMELS (Capital adequacy, Asset quality, Management efficiency, Earnings, Liquidity, Systems), and risk based performance supervision frameworks. The RBI should inspect NBFCs based on their ‘systemic size’ besides focussing on deposit-taking companies.

So far, the RBI had extended every possible support to promote financial innovation for furthering financial inclusion in the country; however, it is time to strengthen the regulatory framework of NBFCs on a par with the banks to preserve financial stability and uphold fiduciary trust of the investors.

Srikanth is Associate Professor and Director (Finance), DDU-GKY, National Institute of Rural Development and Panchayati Raj, Hyderabad, and Indu is former General Manager of State Bank of India. Views are personal.

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