NBFCs: Can banks still benefit from regulatory arbitrage?

By Sonali Sharma and Suprio Bose, Juris Corp
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Until recently, non-banking financial companies (NBFCs) were less-stringently regulated than banks by the Reserve Bank of India (RBI), and were thus considered an arbitrage boon in disguise by the financial services sector. NBFCs became a vehicle for business activities that banks were unable to undertake due to regulatory restrictions.

Sonali Sharma Partner Juris Corp
Sonali Sharma
Partner
Juris Corp

Like banks, NBFCs were sought to be regulated by the RBI (albeit through a different department), but there was a significant disparity in regulation levels. It is noteworthy that the regulatory focus was then on deposit-accepting NBFCs (D-NBFCs). This was because such entities were effectively putting retail deposits at risk (i.e. playing with public money) and in that sense had bank-like features. For a long time, non deposit-accepting NBFCs (ND-NBFCs) were lightly regulated.

While the RBI laid down various exposure norms for banks, there were no similar restrictions for ND-NBFCs. This allowed ND-NBFCs that were sponsored by banks (predominantly foreign banks) to extend loans without limits, and also to extend loans to sectors and for purposes from which banks were prohibited.

This led to regulatory arbitrage, since ND-NBFCs acted as conduits for banks to extend loans as well as undertake transactions including sponsor financing, acquisition financing and margin funding with equity as collateral.

While there were no exposure norms applicable to ND-NBFCs, banks with NBFCs were subject to consolidated exposure limits (although not heightened capital requirements) to capital markets by way of consolidated reporting.

The near parity in regulation between banks and D-NBFCs was established in 1997, with the introduction of a comprehensive regime stipulating various requirements, including that liquidity was to be maintained (in the form of deposits with banks, or by holding government securities) and that statutory reserves must be created. This was a response to the mushrooming of NBFCs in the 1980s, and their mass defaults on deposits in the mid-1990s.

The opening up of the Indian economy, the liberalization of foreign direct investment (FDI) norms for NBFCs, and the appetite for equity- or real estate- backed sponsor and acquisition financing in the 2004 boom were all prompts for financial conglomerates to leverage the regulatory disparities between banks and NBFCs, and between D-NBFCs and ND-NBFCs. Many foreign banking groups rushed to set up or acquire downstream ND-NBFCs.

Fearing both overheating and the systemic risks of overexposure to equity and real estate, the RBI began delaying the grant of registrations for new NBFCs. In response, some players instead sought to acquire existing NBFCs. Realizing that virtually dormant NBFCs were being bought “off the shelf”, the regulator imposed the requirement of an annual continuity certificate to be submitted by NBFCs so as to avoid cancellation of registration.

Suprio Bose Associate Juris Corp
Suprio Bose
Associate
Juris Corp

Due to the proliferation of ND-NBFCs – most of which were heavily leveraged and running significant asset liability duration mismatches – the RBI set up an internal committee to evaluate their systemic impact, and to consider competition, regulatory convergence and regulatory arbitrage in the financial sector. This led to the RBI’s issue in 2007 of prudential norms for D-NBFCs and ND-NBFCs.

Prudential norms regulate the funding and exposure of NBFCs in order to protect the stability of the financial system. They impose lending and investment restrictions, stringent conditions for management of risk, capital adequacy norms and exposure norms for systemically important non-deposit taking NBFCs (SI-ND-NBFCs), defined as those having total assets of at least Rs1 billion. The low threshold level (then US$25 million and now US$20 million) meant all sizeable NBFCs were covered, including almost all that were foreign owned (given capitalization norms under FDI regulations).

The committee also observed that most foreign-owned NBFCs were diversifying into areas outside the 18 permissible activities specified in the foreign investment regulation norms. The RBI accordingly required NBFCs to annually certify that they are engaged only in the 18 permissible activities.

As expected, the prudential norms have effectively lessened the attraction of NBFCs for banking groups.

Given the global economic meltdown, the RBI’s measures appear to have been timely and effective. The regulator has continued to raise standards of securitization, increasing the capital adequacy requirement for SI-ND-NBFCs to 15% in a phased manner. One cannot help but wonder whether, if US and other G7 regulators had emulated the RBI, the global credit and confidence crisis, if not the recession, could have been avoided.

The question now is whether Western markets will allow regulatory controls similar to the RBI’s to be enacted. Knee-jerk reactions, such as taxing 90% of bonuses received by employees of institutions which have received bailout assistance from the US government, add to one’s scepticism about moves that mollify public outrage but only compound the real problem.

Sonali Sharma is a partner and Suprio Bose is an associate at Juris Corp. The firm is a full-service law firm based in Mumbai and specializes in financial transactions including capital markets and securities, banking, corporate restructuring and derivatives.

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