Opinion

NBFCs: Tighter regulations, not the way forward

VP Nandakumar | Updated on November 01, 2019 Published on November 01, 2019

Any attempt to prevent downside risks in the NBFC sector by heavy-handed regulations will stifle innovation. Introducing risk-based capital norms and deepening the bond market will be steps in the right direction

After the IL&FS debacle, NBFCs have come under the microscope of regulators, investors, analysts and the wider public. Predictably, there are calls for further tightening of regulations in the belief that a move from the light-touch to the more heavy-handed will somehow improve matters.

To get to the crux of the issue, let’s begin by asking, why do NBFCs exist in the first place? After all, it should theoretically be possible for banks to take over this space. But then, the banking system’s coverage has well-known gaps that exclude large sections, precisely the failing that has allowed non-banks to thrive. Examples include sectors requiring specialised knowledge like infrastructure, or cost-effective ways to cater to the marginal borrowers. NBFCs address these constituencies with specialised knowledge acquired through focussed attention, and innovations that help contain the extra risks.

A case in point is loans against second-hand trucks, by logic a troublesome asset to finance. It depreciates rapidly and you never know for sure where the asset is at any point in time. Besides, borrowers are most often truck drivers high on hope and short on money. A regulator evaluating this business would see red flags everywhere.

And yet, Shriram Transport Finance plunged headlong into it and triumphed brilliantly. It did that by learning the nitty-gritty of the trade and building an entire eco-system around it, ensuring that its truck would face minimum downtime, and eventually fetch a good resale price.

Regulations versus innovations

Regulations are a product of rational thought, whereas innovations emerge from out-of-the-box thinking. Innovations cannot thrive under a heavy hand and encouraging the innovation culture requires a higher tolerance for failure. Innovations are like start-ups where the failure rate is high, yet the one that survives, and flourishes, goes on to redefine the sector.

In banking, failures come at a high cost and therefore the need for rigorous regulations to prevent downsides. That’s why NBFCs have been at the forefront of innovations in financial services, which banks go on to adopt later. Any attempt to prevent downside risks by tighter, heavy-handed regulations will stifle innovation.

Besides, regulators also have a fiduciary responsibility to facilitate the growth of NBFCs. After all, NBFCs have led the way in product and services innovations, such as financing second-hand trucks or instant loans against gold jewellery. Lending against gold was for long ignored by banks, pushing borrowers towards moneylenders and pawnbrokers. The entry of NBFCs redefined the category with innovations in products and processes that brought millions into the ambit of institutional credit.

Change with the times

Regulations must evolve with the times. For example, in the era of digital lending, making gold loan NBFCs seek prior approval before opening new branches serves little purpose. There’s a need to strike a balance between preventing downside risks and allowing businesses to grow to their potential. Surely, the time is right for introducing risk-weighted capital requirements for NBFCs at par with banks.

Existing rules prescribe a uniform 100 per cent risk-weight across all assets irrespective of the tenor. If lenders taking on excessive risk is the worry, risk-based capital norms are the way to go. Only those who understand the risks and have the capital to bear the consequences will remain in the fray now. They will also become free to drive innovations and lead the herd.

Likewise, moving away from blanket caps on loan-to-value (LTV) ratios towards risk-weighted capital will catalyse innovations in the risk underwriting process. As loans go further above a base LTV, regulators may prescribe higher and higher capital. The current LTV cap of 75 per cent on gold loan amounts to a one-size-fits-all approach. It pushes small borrowers back towards informal sources where rules don’t apply and constricts product innovations by withdrawing the lender’s incentive. Moreover, it is an anomaly that one can borrow any amount without security under personal loans but not when one furnishes liquid security.

Needed, a developed bond market

Does the case against tighter regulations and for greater tolerance of failure mean that we should resign ourselves to more fiascos like IL&FS? Not necessarily. IL&FS had drastic repercussions because India’s financial markets are still a work-in-progress and there’s a dearth of alternatives to bank funding, especially for the long-term. Over-reliance on short-term funding for long-term lending is always worrying.

Our bond markets are still undeveloped, compelling NBFCs to borrow more from the banking system. Therefore, the imperative is to develop and deepen India’s bond markets to free NBFCs from dependence on banks and make the occasional failure less traumatic. A good start will be to have on-tap public issue of bonds directly to investors, enabling NBFCs to raise funds regularly at lower issuance cost.

The writer is MD and CEO of Manappuram Finance Ltd. Views are personal.

 

Published on November 01, 2019
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