Shadow Banks: Navigating the complex landscape of NBFCs

NBFCs, India's shadow banks
Effective regulation of shadow banks is imperative to promote stability while harnessing the potential of India's non-bank financial sector.

Shadow banks are financial intermediaries that resemble traditional banks but operate outside the scope of traditional bank regulations. While they engage in activities such as maturity and liquidity transformation and leverage, they lack the ability to borrow from central banks in times of emergencies or provide deposit insurance to their customers. Raghuram Rajan attributed significant blame to shadow banks for the credit market freeze during the global financial crisis.

Despite the tightening of regulations on banks, assets have shifted to entities like Structured Investment Vehicles (SIVs), conduits, private equity, hedge funds, and other similar shadow banks that remain unregulated. The lack of transparency surrounding these entities, coupled with their reliance on market-based funding, can lead to systemic risks, particularly when banks interact with them.

The transfer of risk in markets plays a critical role in promoting financial innovation and depth. Initially, there was an argument that lightly regulated or unregulated institutions would effectively manage risks through market discipline and self-regulation. However, past experiences have shown that neither market discipline nor self-regulation is effective. Therefore, regulating banks ensures that their risk management practices align with systemic stability, extending beyond their core operations.

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In the past, there was complacency in assuming that banks possessed strong capital and would implement robust risk management practices driven by their self-interest. Diversifying risk away from the banking system was seen as positive. Currently, there is a shift in India towards suggesting that banks should refrain from providing long-term infrastructure loans and instead encourage such lending through bond markets.

This approach is deemed beneficial for reducing systemic risk by moving risk away from the banking system, especially in infrastructure lending. As a result, extending the regulatory framework to include shadow banking entities has become a conventional part of policy frameworks over the past decade.

Significance of shadow banks

It is important to recognize the advantages of non-bank financial intermediation and its significance for a functional and sustainable financial system. Non-bank financial entities offer modern and sophisticated methods of efficiently sharing risks, acting as complementary channels for funding that can support the growth of the real economy.

Additionally, they promote financial inclusion by providing credit access to businesses and individuals who lack access to traditional bank financing. However, not all non-bank entities pose the same level of financial stability as banks. The goal of regulation is to transform shadow banks or non-bank financial intermediation into resilient market-based finance or intermediation.

In India, the non-bank financial sector, known as NBFCs, is extensive, diverse, and complex, comprising various business models. Over the years, this sector has experienced significant growth in terms of size, operations, technological sophistication, and expansion into new areas of financial services and products. There are intricate interconnections between NBFCs, banks, capital markets, and other entities within the financial sector. Unfortunately, the sector has also witnessed the emergence of untrustworthy players. However, technology can be leveraged to adopt innovative business models that can address the issue of untrustworthy players.

While a less robust non-bank intermediation channel provides a flexible backup option to the economy and fuels growth with lighter regulations, it can also pose potential risks to the system. The regulatory framework in India allows NBFCs to have operational flexibility, develop expertise in specific sectors and regions, and offer a wide range of financial services with ease of access.

Regulatory measures concerning shadow banking should be carefully designed to target the externalities and risks created by the shadow banking system. These measures should be proportionate to the sector’s size and the risks it poses to the financial system. It’s worth noting that the term “Shadow Banks” is not commonly used in India. NBFCs are categorized into ten different types, with investment and credit companies being dominant, followed by infrastructure finance companies, microfinance institutions (MFIs), and housing finance companies.

India has also witnessed the emergence of peer-to-peer lending companies, factoring, and other alternative lending and capital raising models. These models have the potential to maintain the market dynamics of traditional lenders and intermediaries. It is important to mention that NBFCs have been under regulation since the 1960s.

Initially, the focus was on protecting depositors, but it was later realized that many of these entities were making poor investment choices, resulting in defaults by depositors. As a result, they were brought under the registration framework. The definition of deposits was expanded to include other forms of public funds, such as funds raised through intermediaries like mutual funds or in the bond market, all of which are treated as equivalent to deposits and regulated accordingly.

In 2006, a regulatory framework was established to address systemic risk and prudential capital requirements, exposure norms, and liquidity management, primarily for systemically important NBFCs. The threshold for defining systemically important NBFCs was initially set at above 100 crore but was later raised to above 500 crore. Systemically important financial NBFCs are those with assets above 500 crore. In 2014, regulations were revised to not only address systemic risk but also to ensure customer protection.

Measures such as the fair practice board were introduced, and after the IL&FS and DHFL crises, a more rigorous regulatory framework was implemented. Liquidity coverage ratios were introduced for NBFCs with assets above 5000 crore. The most recent regulatory change is the introduction of scale-based regulation, categorizing NBFCs into the base layer, middle layer, and top layer based on their asset size. The top layer consists of the top 10 NBFCs and certain NBFCs in the top 50 identified by the RBI as contributing to systemic risk.

NBFCs have faced various challenges in the past decade, including the failures of IL&FS, DHFL, and the COVID-19 pandemic. Despite these pressures, NBFCs have demonstrated resilience by building capital reserves, maintaining liquidity buffers, and strengthening their balance sheets. It is crucial for them to sustain this momentum. In the fiscal year 2024, NBFCs are expected to achieve a growth rate of 13 to 14%, with growth spread across all retail segments. However, two key risks should be monitored.

Firstly, competition from banks, especially in traditional retail sectors like home loans and new vehicle loans, is intensifying. Banks are leveraging technology and improving consumer proximity. Secondly, the rising interest rate environment is increasing borrowing costs for NBFCs, thereby limiting their competitiveness in certain asset classes.

NBFCs play a vital role in credit delivery, and a strong regulatory framework is essential to support their sustainable growth. This framework should enable them to diversify their funding sources and form partnerships that contribute to overall economic growth. Even lenders recognize the importance of effective regulation in this sector. In this regard, India’s model of appropriate regulation could serve as a suitable example, promoting growth with stability.

(Shyamala Gopinath is a former Deputy Governor of the Reserve Bank of India. This article is the edited transcript of her speech at a webinar organised by EGROW Foundation.)