The government, in consultation with the Reserve Bank of India [Get Quote], is considering modifications in the foreign direct investment norms for non-banking finance companies to check unbridled acquisitions by foreign banks.

The RBI had raised the issue with thegovernment, stating that foreign banks buying majority stakes in non-deposit-taking NBFCs (NBFC-ND) would provide room for regulatory arbitrage.

The RBI had also appointed an internal group to evaluate issues relating to level playing field, regulatory convergence and regulatory arbitrage in the financial sector.

There are restrictions on the number of branches all foreign banks together can get in a year, which hinders their growth.

Since there are no regulatory permissions required for setting up of branches by NBFCs like banks, foreign banks find the NBFC route an easier option to reach areas, which otherwise would remain inaccessible for a long time.

At present, foreign investments in existing NBFCs are through the automatic route. In other words, for investment in an existing NBFC, foreign institutions have to take approval from the Foreign Investment Promotion Board.

The RBI does not seem to be very happy with foreign banks using this route as they do it basically to take advantage of regulatory arbitrage. The British banking group, Barclays, recently acquired Chennai-based NBFC Rank Investments and Credits.

The RBI had given the bank only three branch licences in Mumbai and the other two in remote locations such as Kanchipuram in Chennai and Nelamangala on the outskirts of Bangalore. A foreign banker questioned, "How can Barclays do their retail banking business with branches in remote locations as their target customers would be in cities?"

Last year, Asia Financial Holdings (AFH), a wholly owned subsidiary of Temasek, took over Chennai-based Dove Finance, which has now been recapitalised and renamed as First India Credit.

AFH has increased its stake to close to 98 per cent  from 80 per cent initially. It has already opened over 30 branches in Chennai, Thane on the outskirts of Mumbai and other cities. Foreign banks such as Standard Chartered and Citibank already have an NBFC. HSBC has applied for a licence to set up an NBFC.

Banking sources indicate, "Foreign banks trying to create a retail asset base are picking up stakes in non-deposit taking NBFCs. This route gives them the reach as well. It is also seen that banks that have picked up stakes in NBFCs raise bulk deposits and lend it to the NBFC. Hence, indirectly NBFCs do get access to public and bulk deposits as well. This clearly gives them an advantage over other foreign banks operating in India through the branch banking route.''

Banks with limited branch presence, particularly foreign banks, find the NBFC route convenient for business expansion by circumventing the branch licensing requirement. This was one of the concerns raised by the RBI internal group.

Currently, all foreign banks receive the RBI approval to set up about 18-20 branches every year, which is more than India's commitment of 12 to the World Trade Organisation.