View: The RBI needs to cut the Gordian knot that threatens financial stability in India

Economy


At the heart of Reserve Bank of India’s (RBI) discussion paper, ‘
Revised Regulatory Framework for NBFCs’, released last Friday, is its concern that the problems of non-banking financial companies (NBFCs) should not result in systemic risk and endanger financial stability. Not only because financial instability can threaten economic stability (as seen after the Lehman Brothers collapse in 2008), but also because any spillover of problems from NBFCs to banks impacts the health of banks with far reaching consequences. Most importantly, the failure of a large enough bank represents a potential claim on taxpayer money.

The reason is simple. World over, taxpayer money is used to bail out banks, as the downside risk of allowing a large enough bank to go under is far worse. Hence the term ‘moral hazard’. Hence also why banking alone remains a licensed and highly regulated activity even in free-market economies.

RBI is cognisant of this. So, the logic of continuing with light-touch regulation for NBFCs at the base of the pyramid, that account for the overwhelming majority of NBFCs with asset size of more than Rs 1,000 crore while dividing the rest into three categories in a pyramid-like structure with more stringent regulation reserved for NBFCs higher up the pyramid, is sound.

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But where it errs is in assuming more regulation of NBFCs will automatically mean greater safety. This is not true, as we saw in the context of the spectacular collapse of Yes Bank and Lakshmi Vilas Bank. Regulation that is not backed by adequate and effective supervision merely adds to compliance costs for the regulated entity without serving the objective of financial sector stability.

So, if more regulation alone will not serve the goal of financial stability, what will? To answer that one needs to examine three key issues: regulatory arbitrage, inter-connectedness between banks and NBFCs, and following from that, risk to financial stability.

Ability of Stability

Take regulatory arbitrage. Even with the higher dose of regulation proposed in the discussion paper, there will still be large differences in the regulatory framework governing NBFCs and banks. Even the largest and most-tightly regulated NBFC will be less regulated than the smallest commercial bank. Banks, for instance, maintain cash reserve ratio and statutory liquidity ratio, are licensed by RBI with promoters subject to a ‘fit-and-proper’ test, etc. There are also strictures regarding what they can and cannot do. Most importantly, banks have a much higher capacity to cause systemic risk and endanger financial stability.

Here, let me digress a little. What do we mean by “systemic risk” and financial stability? Remember, a key difference between banks and NBFCs is that banks alone are licensed to take deposits repayable on demand. If one bank fails, there is a risk that the public at large may lose faith in the banking system and rush to withdraw their deposits in other banks, too, resulting in a ‘run on banks’. Since bank deposits are withdrawable on demand, banks will have no choice but to pay.

But under the fractional reserve system that is the basis of modern banking, banks keep only a fraction of their deposits in cash/ liquid form and lend out the rest. Therefore, banks cannot possibly pay their depositors, if all of them rush to withdraw their money at the same time.

Performance Anxiety

In contrast, NBFCs (even those allowed by RBI to take public deposits) cannot take deposits repayable on demand. The minimum maturity is one year. Hence the failure of an NBFC cannot result in a run on other NBFCs. It can shake the confidence of the public in other NBFCs, but can’t lead to a run as in the case of banks.

So, does this mean no NBFC should be allowed to fail? No. There is no inherent systemic risk in the failure of an NBFC. Badly run NBFCs must be allowed to fail. But the failure of an NBFC could give rise to ‘systemic’ risk, and have repercussions for the stability of the financial system, if the NBFC in question is so closely connected with banks that failure could potentially endanger the bank’s balance sheet.

Hence the root cause for systemic risk from failure of NBFCs lies in the interconnectedness between banks and NBFCs. If banks have an excessively large exposure to an NBFC, it could compromise the safety of banks and financial stability. This is where the danger lies. According to the RBI paper, NBFCs now obtain more than 50% of their funding from banks.

This is what we need to guard against. Sure, NBFCs perform a vital role in the economy, and as their number and size increases, scale-based regulation is good. But in any market-driven economy, however well-regulated, it is a given that NBFCs will fail periodically. Unfortunately, the remedy suggested in the discussion paper — more regulation — does not address the root cause of a potentially much more dangerous disease.

This is the risk to financial stability arising from excessive interconnectedness that results in the problems of NBFCs ending up on the balance sheets of banks, potentially constituting a drain on taxpayer money. It is this excessive interconnectedness that RBI needs to nip in the bud, even as it plugs some of the more egregious regulatory gaps.



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