Plug bank-NBFC regulatory gaps

The Reserve Bank of India released its regulatory framework for scale-based regulation of non-banking finance companies in October 2021, and last week it released a list of 15 entities which constitute the upper layer of this framework.

Apart from the “upper” layer, there are three other categories per the RBI — top, middle and base.

Apart from these four, one important category of NBFCs which requires special attention are those owned by commercial banks and engaged in the same/similar line of activity as the promoting parent bank.

This is because the financial sector, by definition, will be interconnected and “conflict of interest” is quite stark between parent and subsidiary if they operate in the same line.

Therefore, there is need for a hard look at such structures existing in the banking sector even now. In banking supervision, identifying actual or potential areas of “conflict of interest” is crucial for ensuring long-term sectoral stability. Ironing out these overlaps will enhance governance standards and bolster the credibility of the system. Regulatory nudges and “suasion” based on principles can eliminate such overlaps as soon as they are found.

In the absence of precise definitions, issues of conflict of interest can be put through the touchstone of “smell test” on ethics and standards in governance and management. There have been several instances where the RBI has applied the smell test to pre-empt patently unacceptable practices.

For instance, it was reported that it had turned down a proposal of a new generation private bank to float an asset reconstruction company. That would have created a cosy edifice between the bank and its cousin ARC — one which creates assets, with the other ready to take them over when they turn bad.

Quite rightly, the regulator has not issued any circulars or instructions on this matter because of the clear-cut conflict of interest and violation of ethics here — certain principles of conduct are too obvious to be iterated as instructions. You only need a nose for ethics to sense it.

When banks and their NBFC subsidiaries operate in the same line of activity it creates opportunities for arbitrage for such structures vis-a-vis competition. It leads to an uneven playing field too, putting some players at positions of competitive advantage.

For instance, NBFCs do not have the same norms for statutory liquidity like banks. They do not also have the priority sector targets that the banks have. Even taxation norms under the I-T Act provide opportunities for amortisation of income leading to tax benefits. With the possibility of transfer of assets being afforded, there is benefit in an NBFC originating assets and its parent bank holding the assets through the assignment route.

‘Gold loan, home loan, loan against property, business loan, I need money,’ is a typical title tag of such NBFCs. This is an obvious case of “regulatory arbitrage” ,“gaming of rules” and “innovation” to get around regulations. As a Nobel laureate said years ago, “the major impulses to innovation have unfortunately come from taxes and regulations”!

More generally speaking, the NBFC space has historically witnessed periodic turmoil upending systemically important entities like the IL&FS and Dewan Housing group. Earlier too, NBFCs have folded up often with one belonging to even the renowned Tata group being wound up, though the ethical promoters ensured that none of the depositors lost their money.

Tightening the noose

The RBI has been sensitive to the risks of contagion posed by NBFCs — broadly called the shadow banking sector — and has been trying to tighten regulation for these entities. After tightening the noose continuously, two years ago, the RBI announced that the “regulatory structure for NBFCs shall comprise four layers based on their size, activity, and perceived riskiness”. This scale-based regulation was drawn up in view of the complexities and interconnectedness of the NBFC sector.

This change in the regulatory approach was one of the key reasons for a much-vaunted mega merger in the banking sector recently. This group’s chief in fact was quoted as saying in 2022 that “the last three years had seen harmonisation in the regulations which reduced the regulatory arbitrage (sic) of running a separate home finance company”. It was surprising that a venerated captain of business could state indirectly that “regulatory arbitrage” was the reason for this structure. It was indirectly an admission that the group was deriving the benefits of “arbitrage” on account of the application of “differentiated regulation” for the “same activity”. Being a housing finance company, this large NBFC did not have a priority sector loans target to be achieved and was not required to comply with statutory liquidity ratio or cash reserve ratio mandates for its liabilities.

Through a transfer of these assets, the bank in the group benefited from this arrangement. It was precisely this arrangement that got disrupted through the indisputable principle of “same activity-same regulation”.

The fact is that in India even now, there are at least three private banks, one of old vintage and two new-gen private banks, with subsidiary NBFCs that market and book exactly the same loan products as the parent. These subsidiaries maintain books created through MSME loans, gold loans and in one case, even home loans. The conspicuous cohabitation of these NBFC-bank siblings raises concerns in terms of systemic risks.

It sets questionable precedents for other players. Prudential regulation, demands that a parent and its NBFC subsidiary should not engage in the same line of activity or business. Besides, two subsidiaries of the same parent should also not be undertaking the same activity.

The RBI is internationally regarded for its balanced approach towards both development of the sector as well as oversight and regulation. Perhaps, it is aware of the scope for “innovative” practices posed by the incongruity of universal banks and their NBFC subsidiaries being in the same line of activity. But more than the regulator, it is the banks’ own boards and their chiefs who should address these anomalies. One need not wait for the regulator to read out an ethics handbook for making governance corrections.

The writer is a commentator on banking and finance

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