Goodbye shadow banking

News: Recently RBI passed a string of new norms to strengthen the regulations for NBFC sector

What is a shadow bank?

A shadow bank is into the business of lending but is not subject to any regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.

What is the significance of NBFCs?

As of January 2021, there were 9,507 NBFCs registered with the RBI. Of these, just 64 were deposit-taking NBFCs, six of them have been barred from taking fresh deposits.

Collectively, deposit-taking NBFCs and non-deposit-taking NBFCs have lent around Rs 29.04 trillion till March 2021.

Why there is a need to strengthen the regulations for NBFC sector?

Infrastructure Finance and Leasing Services Ltd and Dewan Housing Finance Corp Ltd had collapsed in 2018.

Bankruptcy proceedings have recently started against Srei Infrastructure Finance Ltd, Srei Equipment Finance Ltd and Reliance Capital Ltd.

All these firms collected money from the public. Such NBFCs need to be tightly regulated as they pose systemic risk.

Particularly those that are interconnected, with exposure to mutual fund and insurance businesses, should not be left unregulated.

What are the new rules for NBFCs?

– Read here

What is scale-based regulation?

The scale-based regulation divides the NBFCs into four layers in accordance with their size, activity and perceived risks.

The base layer consists of a) NBFCs with an asset size of under Rs 1,000 crore, b)  Peer-to-peer lending platforms, c) Account aggregators, d) Non-operative financial holding companies, e) NBFCs not accessing public funds belong to this category.

The middle layer consists of a) All deposit-taking and non-deposit-taking NBFC’s with an asset size of Rs 1,000 crore and above,, b) The primary dealers who buy and sell government securities, c) Core investment companies, d) Housing finance companies and Infrastructure finance companies.

The upper layer: it consists of ten largest NBFCs by asset. According to RBI, they warrant close scrutiny based on a set of parameters and scoring methodology.

The top layer: it remains empty for now, but any NBFC in the upper layer may migrate to the top layer if the RBI senses it can become a risk for the system.

How the PCA framework impacts the NBFCs now?

First, according to rating agencies, Rater Crisil Ltd, most of the medium and large NBFCs rated by it should not face any challenge, either on capital adequacy or asset quality.

Second, according to Icra Ltd, some NBFCs could breach the net bad loan criterion (more than 6 per cent) if the asset quality does not improve.

At least three large NBFCs with assets of Rs 25,000 crore or more have already breached the non-performing asset (NPA) criterion.

Third, the uniform income recognition, asset classification and provisioning norms for lenders across segments that are already in place could impact the balance sheets of many NBFCs.

Fourth, Bad loans in certain segments will definitely rise following the new norms. Because, now the RBI wants NDFC’s to treat loan as a standard asset only when the entire arrears of interest and principal are cleared by the borrower.

Source: This post is based on the article “Goodbye shadow banking” published in Business Standard on 27^th    Dec 2021.