India’s NBFCs, wrongly called shadow banks, need the government’s backing

Out of the shadows.
Out of the shadows.
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India’s non-banking financial companies have been under intense scrutiny lately.

There has been a chain of defaults and downgrades following the crisis at the Mumbai-based Infrastructure Leasing & Financial Services (IL&FS), stoking fears of a contagion in the financial sector.

The situation has been exacerbated by similar tidings in the fortunes of the housing finance company DHFL and Reliance Capital. What followed these episodes is a public outcry in the business press and social media, deriding NBFCs as “shadow banks.” Consequently, retail investors have started shying away from the sector.

In the wake of such incidents and the union budget tomorrow (July 5), there is a need for finance minister Nirmala Sitharaman to restore the lost faith in the sector. After all, NBFCs have played a catalysing role in financing economic growth, and are not really shadow banks in the Indian context.

Unfair comparison

It is important to understand the term “shadow banking,” to see why India’s NBFCs cannot be equated to the true shadow banks in the US or China.

Shadows banking generally refers to financial intermediaries that are in the business of credit, but not subject to regulatory oversight.

In the US, the 2010 Dodd-Frank Act, which was introduced in the aftermath of the global financial crisis, focused primarily on the banking industry. It left the shadow banking sector largely intact despite them controlling around half of the $1 trillion (Rs68 lakh crore) US annual mortgage market.

The US Federal Reserve chief Jerome Powell once famously characterised non-bank lenders as imprudent and a potential problem for the credit markets and the broader financial system.

China began issuing directives to shadow banks in 2017 calling them out for their risky financial practices, such as excessive borrowing and speculation in equities. The bulk of shadow banking in the country revolves around mid-tier banks and regional lenders looking to compete with banking behemoths.

Thanks to shoddy practices, millions of small-time investors have lost their life savings as they were fooled into investing in plans like online peer-to-peer (P2P) lending platforms.

Tightly regulated

The highly-regulated NBFC ecosystem in India presents a different picture.

Any NBFC managing assets over Rs500 crore should stick to an array of regulations such as capital adequacy, disclosure norms, and fair practice code, among other things, which prevents mis-selling of products.

Of course, there is still room for improvement by tightening regulations like making the office of a credit risk officer (CRO) mandatory for NBFCs with assets over Rs5,000 crore, and more stringent asset liability management (ALM) norms.

NBFCs in India have been playing a key role in providing bottom of the pyramid financing. Shriram Transport Finance and Cholamandalam Investment and Finance Company, for instance, pioneered used vehicle financing. Likewise, Muthoot Finance broke new grounds in gold financing.

A new crop of specialised NBFCs such as Vistaar, U GRO Capital and Five Star Business are trying to fix the credit fault lines of India’s micro, small, and medium enterprises (MSMEs).

Suffice it to say that the recent challenges faced by a few NBFCs are classic examples of how a few badly run enterprises with poor corporate governance could tarnish the entire sector.

While it is true that there is general tightness in finances available to NBFCs post the IL&FS fiasco, it, however, does not warrant a fundamental relook at the business models of all the NBFCs.

Budget hopes

Considering the seminal role played by NBFCs in India, it may be in order for the finance minister to provide the much-needed succour to this vital sector, by announcing measures to inject liquidity and bridge the trust deficit the sector is facing by reclaiming the public confidence back.

Opening a liquidity window will be helpful as NBFCs are facing crunch time.

Of greater importance is the resumption of lending by banks and mutual funds to the segment. It is equally important to create a vibrant and liquid secondary bond market that will go a long way to improve liquidity for NBFCs. Such measures will not only help improve the prospects of the sector but also of the economy at the aggregate level.

Such steps would help send out a clear message to the broader investment community that NBFCs are no shadow banks.

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