Banking Central | How many big NBFCs would want to become banks?

A speech from M Rajeshwara Rao, the new deputy governor of the Reserve Bank of India (RBI) last week gives us good insights to what does the central bank think on the regulation of non-banking finance companies (NBFCs) going ahead. Rao’s speech indicates that the central bank is preparing for tighter regulation of bigger NBFCs.

Rao said larger NBFCs with significant externalities and which contribute substantially to systemic risks must be identified and subjected to a higher degree of regulation.

The design of prudential regulatory framework for such NBFCs can be comparable with banks so that beyond a point of criticality to systemic risks, such NBFCs should have incentives either to convert into a commercial bank or scale down their network externalities within the financial system, Rao said at the ‘National E-Summit on Non-Banking Finance Companies’ organized by industry body ASSOCHAM.

He added that this would make the financial sector sound and resilient while allowing a majority of NBFCs to continue under the regulation-light structure.

Let’s look at these statements in detail.

To begin with, what are NBFCs? A simple definition is that NBFCs are financial intermediaries that are positioned between full scale commercial banks and a category of borrowers who typically don’t get funding from banks, for instance small scale real estate developers and businesses.

But, the RBI has always seen NBFCs with a bit of extra caution since these entities have high interconnectedness with the mainstream banking system. At the end of September, banks have a loan outstanding of Rs 8 lakh crore to NBFCs which has gone up from Rs 5.4 lakh crore in 2018. MFs too have exposure to the papers issued by NBFCs, although this has come down in the recent years.

The NBFC segment has faced a roller coaster ride in the past post the collapse of IL&FS in 2018 and the subsequent mess at DHFL. Banks shut the door for most NBFCs, especially the smaller ones. It took more than a year for the risk aversion to subside. This (the liquidity crisis) has changed the risk perception on these firms, thus leaving banks worried  about their  existing exposure to the sector.

Even before the 2018 crisis, the RBI has had bitter experience with smaller lending institutions in 2010 when the Andhra Pradesh microfinance crisis broke out. This led to the creation of NBFC-MFIs later in December, 2011. This was the last major reform in the NBFC-segment.

So what does RBI want to do with bigger NBFCs?

The message is very clear. NBFCs, which grow beyond a point and expand their interconnectedness with the financial system will have to a) either become a bank to operate as a regular bank subject to tighter regulations by the RBI  or b) keep the interconnectedness (network externalities) with the rest of the financial system under check and scale down growth. A typical large NBFC borrow from banks, mutual funds, raise money from public through NCDs or raise money through ECBs.

How many of the big NBFCs would like to become banks?

There are a few large NBFCs which had expressed interest in becoming banks but later pulled down from the race saying they are content to continue as NBFCs. In an interview to The Economic Times in 2019, Sanjiv Bajaj MD and CEO, Bajaj Finserv, had said that his company is not looking at a bank licence at that point and the country needs larger NBFCs for financial inclusion. There could be other big players who share this opinion.

But, as mentioned above, the RBI is not comfortable in letting big NBFCs grow bigger endlessly. The central bank wants doesn't want another crisis in the NBFC industry. The recent guidelines on co-lending too should be seen in the context of this. When banks become the lead lenders in joint lending, the entire set of lending activities come under direct scrutiny of the RBI.

To be sure, the deputy governor has not said that big NBFCs must convert to banks. What he said is large NBFCs have an option to choose either of the two — become a bank or cut down their systemic linkages. It is up to the NBFCs to decide their path ahead.