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NBFCs are not banks!

January 09, 2019 11:32 IST

'We are all in a tizzy about NBFCs in the aftermath of the IL&FS default.'
'We tend to jump to the notion that an NBFC is like a bank. But banks make a promise that deposits are liquid and have an assured return.'
'NBFCs make no such promises,' points out Ajay Shah.

The IL&FS headquarters in Mumbai

The big primary markets for equity and debt securities are not unsophisticated households.

All that is required in the primary market is sound disclosure, and after that professionals on this market make good gatekeepers.

NBFCs that finance themselves through banks or bonds thus require no micro-prudential regulation.

If an NBFC deals with a consumer on the lending side, we require consumer protection on how consumers are treated.

 

We are all in a tizzy about NBFCs in the aftermath of the IL&FS default.

But we should be careful in understanding the market failures and putting in the right regulatory responses.

Let's start at their borrowing.

The RBI has correctly closed off deposit taking by most NBFCs, as deposit taking is what defines a bank.

In the future, deposit-taking NBFCs should graduate into banks, and this involves some transition issues.

But there is no real difficulty on this score.

The troubled NBFCs of the last year were not deposit takers.

If an NBFC does not borrow from the public, how does it raise capital?

The primary market for equity and debt is the source of capital.

We have a well-understood doctrine about how this should work.

The only gatekeeper in this market is the investor.

Persuading investors to fork out capital is the hurdle that a firm has to cross.

This is not just about NBFCs.

The primary market for equity and debt capital is the key gatekeeper in modern capitalism.

The projects and management teams which are able to gain the respect of the primary market get funded, and others do not.

This is a healthy market mechanism for allocating capital.

All that the primary market requires is sound information disclosure.

The Securities and Exchange Board of India must define what this packet of information is, and we should follow through with common law concepts of fraud when this information is false.

We need to move to IFRS (International Financial Reporting Standards) style forward-looking market-based valuation of assets.

An NBFC asking for capital from the bond market, armed with IFRS accounting data, is no different from Tata Steel asking for the same.

After the IL&FS default, the Indian bond market got very concerned about NBFC paper.

This has translated into a tough stress test for NBFCs.

Bond market investors are now looking beyond credit ratings, and asking tough questions of each issuer.

The better NBFCs are getting capital while others are not.

While this is a painful response, and while this should have come about in better ways, this is market discipline at work.

It is the rational and sound response.

NBFCs are fundamentally different from banks and insurance companies in that they make no promises to unsophisticated households.

When a household places money in a bank, the bank makes a promise that this deposit is callable and that there is an assured rate of return.

We then require micro-prudential regulation in order to make sure that the bank is always solvent and liquid, and can live up to this promise.

In contrast, NBFCs make no promise to households, and thus they require no micro-prudential regulation.

Sophisticated lenders (banks or bonds market) choke off the leverage of Tata Steel or HDFC, and we do not need a government to write rules about the maximal leverage that is permissible for these firms.

If all this is so clean and tidy, why did we have an NBFC/bond market/mutual fund crisis?

The first element was the lack of IFRS accounting.

If forward-looking market-based valuation was used, this marking to market would have shown stress in IL&FS accounting data a while ago, and choked off their market access.

The second element was the use of credit ratings in financial regulation.

Particularly in the Indian environment, it is too easy for an institutional investor to make bad decisions and then pass the buck to the credit-rating agency.

Credit rating agencies are a valuable opinion on the credit risk of an issuer, but they are no more than an opinion.

Regulators should stop requiring that credit ratings be obtained.

Institutional investors should have to think for themselves, and then they can choose whether they want to buy credit ratings to assist their decision process.

The third element was the failure of Indian bond market development.

A well-functioning financial market in India is the equity market.

It has electronic trading, free entry, derivatives, algorithmic trading, foreign investors, ample speculation, short selling, etc.

This gives liquidity, sound prices and then the possibility of building a mutual fund industry.

All these pieces are lacking on the bond market.

We have gone too far in building a large mutual fund industry on feet of clay.

This gave a run on mutual funds, and a sharp collapse in purchases of bonds issued by NBFCs.

Collective investment schemes based on bonds need to be illiquid, reflecting the lack of liquidity of the bond market.

Let's run through the standard checklist about financial regulation in the NBFC context.

All financial regulation falls under four buckets:

Systemic risk regulation, resolution, micro-prudential regulation, and consumer protection.

Systemic risk

When an NBFC balance sheet exceeds about 1 per cent of GDP, its default can have systemic consequences.

There is a case for some micro-prudential regulation, and 'living wills' that will assist resolution for an NBFC the size of HDFC.

Resolution

Financial firms require a specialised bankruptcy code operated by a 'resolution corporation'.

Without this, we will have a messy default, as is playing out with IL&FS.

Micro-prudential regulation

We do not need micro-prudential regulation with NBFCs, as they make no promises to households.

Consumer protection

Some NBFCs have unsophisticated households as customers, and we need consumer protection there.

This involves issues such as sales practices and coercive collection practices.

We tend to jump to the notion that an NBFC is like a bank. But banks make a promise that deposits are liquid and have an assured return. NBFCs make no such promises.

IL&FS is more like Bhushan Steel, and less like a stressed bank.

The RBI should focus on just two things: The inflation target, and safe and sound banks.

Ajay Shah is a professor at the National Institute of Public Finance and Policy, New Delhi.

Ajay Shah
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