Banks and NBFCs are different, pose different problems for financial regulation, and should be regulated differently. RBI is smothering NBFCs by applying banking thinking for them, and is thereby hampering access to credit for the firms who obtain financing from NBFCs. The FSLRC approach offers logical answers to these questions.
By Shubho Roy
The founder of the Shriram Group, R. Thyagarajan, who is one of the most respected people in Indian finance, spoke to Forbes India expressing concerns about the things that are being done with the regulation of NBFCs. This is important food for thought for understanding the problems of Indian finance. He talks about how the NBFC sector is being stifled with regulation and the need for moving it away from the Banking Regulator. He points out that the mind-set and objectives of RBI, in regulating NBFCs in ways that are appropriate for banks, is killing the industry.
Banks and NBFCs are different, pose different problems for financial
regulation, and should be regulated differently. RBI is smothering NBFCs by
applying banking thinking for them, and is thereby hampering access to credit
for the firms who obtain financing from NBFCs. The FSLRC approach offers logical
answers to these questions.
What
motivates regulation
Regulation must not degenerate into central planning; it must be motivated by
the need to correct a precisely stated market failure. We must understand the
anatomy of the market failure, and use the coercive power of the State at the
precise root cause. Occam's Razor of Regulation implies that we should get the
job done with the minimum use of force. The market failures associated with
banks and with NBFCs are quite different. For banks, the market failure is
consumer protection of unsophisticated depositors. This is the reason why we
have detailed banking regulation. If there are no unsophisticated depositors in
a lending institution, regulating them like banks is wrong, and harms the
economy.
Consumer
protection in banking regulation
When you deposit your money in a bank, you can go and withdraw the principal at
any time you want. Even for fixed deposits, the principal is protected in the
case of premature withdrawal.
How does a bank pay interest on money which you can withdraw at any time?
Through loans. However, when a bank gives a loan: the bank gets repaid only as
per the loan terms (and not when the bank needs money). If you take a home-loan
or a car-loan for five years, the bank cannot come and ask you to repay the
entire money before the five years are up (unless you default). The bank can
only ask for the regular pre-decided installments. No bank can come to you
(borrower) and say:
"a lot
of people are withdrawing money this month, so please pay up your five year car
loan, ahead of time, this month."
Similarly,
when you (depositor) go to withdraw the money from a bank the bank cannot say
(legally prohibited):
"a lot
of people have delayed their loan repayments so you cannot withdraw your money
today, come back after a few months."
These types of deposits are technically called deposits callable at par.
i.e. Deposits you can withdraw at any time without losing the principal.
Contrast this with a term loan or a bond/debenture. When you buy a five year
Tata Motors debenture in the debt market, cannot withdraw it at par before the
debenture matures. i.e. If you go with the debenture to the offices of Tata
Motors before the five years are up, Tata Motors has no legal
obligation to repay the loan amount in the debenture. You can only get your
principal and interest payments as per the the terms of the debenture and not a
minute before that. You may sell your debenture to someone else (secondary
market), but that is not the same as getting your principal back from Tata
Motors. In the secondary market you have no assurance you will get your
principal amount back.
Ensuring that households are able to withdraw their deposits, whenever they
need it, is not trivial. Whenever a bank fails do it, eventually, there is a run
on the bank. A run happens when you households panic that their life
savings will be destroyed and queue up to get withdraw their deposits.
Governments know (from the history of bank failures) that you cannot trust
banks to pay up to households on time. Therefore, countries create banking law
and corresponding banking regulator to check the banks.
Three important components of these regulations are:
- Deposit Ratios: This requires the bank to lend out only a part of its deposits, say 80%. The bank has to keep the rest for withdrawals on any given day.
- Equity buffers: Banks are required to have a certain minimum equity capital. As an example, in India, the leverage of the banking system is roughly 20 times, which means that for each 20 rupees of total assets there is 1 rupee of equity capital. This acts as a buffer against losses as the shareholders bear the loss.
- Loss Recognition: Banks are forced to recognise losses and write them off using equity capital, so as to not subvert the intent of the equity buffer.
Banks have the
incentive and capability to cover up bad news about the loans they have made.
If banks admit they have bad loans then the banking regulator forces them to
raise money from other sources (equity market). Raising money from the equity
markets is hard,expensive and, dilutes existing
shareholders. Normally, a bank likes to hide and delay the fact that debtor is
not repaying as long as possible.
Unlike sophisticated creditors, you and I are unable to really understand the
balance sheet of a bank. I cannot judge whether the bank will have enough money
to repay a fixed deposit five years from now. Without a financial agency
looking over banks every day, it is easy for banks to lend money profligately
and end up defaulting to depositors.
The oversight of the financial agency, and the checks imposed by these
regulations, are not without benefit to banks. In return for complying with all
these regulations, the government encourages the general public, to keep money
in banks. The government and the central bank extends a guarantee of safety in
bank deposits. The Jan Dhan Yojanadoes not encourage you to buy
corporate bonds but put money in bank deposits. The government runs a deposit
insurance program to protect helpless households who have deposits with banks.
NBFC
regulation
Non-Banking financial companies should be what their name suggests:non-banks.
Sadly, this was not the case for India till about a decade
ago. Because, there were few banks, Indian laws allowed NBFCs to also take deposits
callable at par. i.e. Take money from depositors (unsophisticated savers)
which the depositors could withdraw at any moment (working hours). These were
called NBFC-Deposit Taking.
Over the last few years, RBI has gradually removed this category. Today, most
NBFCs take money from the bond market or term loans (sophisticated depositors). There
are no unsophisticated depositors in most NBFCs today. Since there are
no unsophisticated depositors who may need their money immediately on demand,
there is no consumer protection angle from deposits.
However, in spite of closing down most deposit-taking NBFCs, RBI continues to
regulate NBFCs like banks, requiring them to keep liquid funds (in government
securities) and also recognise problematic loans and keep capital against it.
This defeats the very purpose why NBFCs are prohibited from taking deposits
callable at par from household. If you are not taking deposits
callable at par from households, you can go and make risky loans which banks
are not going to make. There is no point in recognising and regulating NBFCs,
if they are forced to meet banking regulations. We may as well call them banks
and allow them to collect deposits callable at par.
The FSLRC
approach
FSLRC does not indulge in artificial distinctions between banks and non-banks.
It has a clear functional test for designating something as a
bank or not:
Are you
taking deposits from the public?
If you are;
you are a bank; and you will be regulated like a bank;
by thebanking regulator. If you are not; then you are not a bank and
you will not be regulated as a bank.
It takes care of concerns of shadow banking (entities taking
deposits callable at par without complying with banking regulation) with a
principled based approach. All the regulator has to test is if an entity is taking
deposits callable at par. Then whatever be its name, it should be regulated
like a bank.
FSLRC recommended that financial firms which do not do this activity should not
be regulated like banks and therefore not be regulated by the banking
regulator.
Conclusion
Mr. Thyagarajan reminds us that it's broke. We should fix it. He recommends
that the central bank should not regulate the NBFC sector. The intellectual
framework for regulating banks and NBFCs is so different that the same
regulator cannot do it.
India has a few large and stable businesses which banks can lend to. However,
most of India's growth will come from new businesses which are small and risky.
The small entrepreneur who buys a truck will face liquidity shocks (will miss a
few of the regular installments). As long as such entrepreneurs are not being
funded with household safe savings, there is nothing
wrong in that. NBFCs have to be different from banks, they should be more
risk taking. And yes, more of them will fail, but it will not harm the
unsophisticated savers.
About The Author:
Shubho Roy is a researcher at the National Institute for Public Finance and
Policy.
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Publication Details:
This article was originally published at Ajay Shah's Blog on December 2015.
All Rights Reserved by the
Original Publisher.