Revised Regulatory Framework for NBFCs’, launched final Friday, is its concern that the issues of non-banking monetary firms (NBFCs) mustn’t lead to systemic threat and endanger monetary stability. Not solely as a result of monetary instability can threaten financial stability (as seen after the Lehman Brothers collapse in 2008), but additionally as a result of any spillover of issues from NBFCs to banks impacts the well being of banks with far reaching penalties. Most significantly, the failure of a giant sufficient financial institution represents a possible declare on taxpayer cash.
The reason being easy. World over, taxpayer cash is used to bail out banks, because the draw back threat of permitting a big sufficient financial institution to go below is much worse. Therefore the time period ‘ethical hazard’. Therefore additionally why banking alone stays a licensed and extremely regulated exercise even in free-market economies.
RBI is cognisant of this. So, the logic of constant with light-touch regulation for NBFCs on the base of the pyramid, that account for the overwhelming majority of NBFCs with asset dimension of greater than Rs 1,000 crore whereas dividing the remaining into three classes in a pyramid-like construction with extra stringent regulation reserved for NBFCs larger up the pyramid, is sound.
However the place it errs is in assuming extra regulation of NBFCs will mechanically imply higher security. This isn’t true, as we noticed within the context of the spectacular collapse of Yes Bank and Lakshmi Vilas Bank. Regulation that’s not backed by sufficient and efficient supervision merely provides to compliance prices for the regulated entity with out serving the target of economic sector stability.
So, if extra regulation alone won’t serve the objective of economic stability, what’s going to? To reply that one wants to look at three key points: regulatory arbitrage, inter-connectedness between banks and NBFCs, and following from that, threat to monetary stability.
Potential of Stability
Take regulatory arbitrage. Even with the upper dose of regulation proposed within the dialogue paper, there’ll nonetheless be massive variations within the regulatory framework governing NBFCs and banks. Even the most important and most-tightly regulated NBFC shall be much less regulated than the smallest industrial financial institution. Banks, for example, preserve money reserve ratio and statutory liquidity ratio, are licensed by RBI with promoters topic to a ‘fit-and-proper’ take a look at, and many others. There are additionally strictures relating to what they will and can’t do. Most significantly, banks have a a lot larger capability to trigger systemic threat and endanger monetary stability.
Right here, let me digress somewhat. What will we imply by “systemic threat” and monetary stability? Keep in mind, a key distinction between banks and NBFCs is that banks alone are licensed to take deposits repayable on demand. If one financial institution fails, there’s a threat that the general public at massive might lose religion within the banking system and rush to withdraw their deposits in different banks, too, leading to a ‘run on banks’. Since financial institution deposits are withdrawable on demand, banks could have no alternative however to pay.
However below the fractional reserve system that’s the foundation of recent banking, banks preserve solely a fraction of their deposits in money/ liquid type and lend out the remaining. Subsequently, banks can’t probably pay their depositors, if all of them rush to withdraw their cash on the similar time.
In distinction, NBFCs (even these allowed by RBI to take public deposits) can’t take deposits repayable on demand. The minimal maturity is one yr. Therefore the failure of an NBFC can’t lead to a run on different NBFCs. It may possibly shake the arrogance of the general public in different NBFCs, however can’t result in a run as within the case of banks.
So, does this imply no NBFC must be allowed to fail? No. There isn’t any inherent systemic threat within the failure of an NBFC. Badly run NBFCs should be allowed to fail. However the failure of an NBFC might give rise to ‘systemic’ threat, and have repercussions for the steadiness of the monetary system, if the NBFC in query is so intently related with banks that failure might doubtlessly endanger the financial institution’s steadiness sheet.
Therefore the foundation trigger for systemic threat from failure of NBFCs lies within the interconnectedness between banks and NBFCs. If banks have an excessively massive publicity to an NBFC, it might compromise the protection of banks and monetary stability. That is the place the hazard lies. In response to the RBI paper, NBFCs now get hold of greater than 50% of their funding from banks.
That is what we have to guard in opposition to. Positive, NBFCs carry out an important position within the economic system, and as their quantity and dimension will increase, scale-based regulation is sweet. However in any market-driven economic system, nonetheless well-regulated, it’s a on condition that NBFCs will fail periodically. Sadly, the treatment instructed within the dialogue paper — extra regulation — doesn’t deal with the foundation explanation for a doubtlessly far more harmful illness.
That is the danger to monetary stability arising from extreme interconnectedness that ends in the issues of NBFCs ending up on the steadiness sheets of banks, doubtlessly constituting a drain on taxpayer cash. It’s this extreme interconnectedness that RBI must nip within the bud, even because it plugs a few of the extra egregious regulatory gaps.