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‘Strict bank-type rules on NBFCs may either shut off capital or shift systemic risk to another part of system’

Principal Economic Adviser Sanjeev Sanyal said an unintended consequence of ever-increasing bank regulations is that it shifts market activity to shadow banks from main lenders.

By: ENS Economic Bureau | New Delhi |
Updated: February 21, 2020 4:37:25 am
IL&FS, IL&FS crisis, PMC Bank, PMC Bank fraud, Reserve Bank of India, RBI, NBFC, indian express Principal Economic Adviser Sanjeev Sanyal

In light of the recent failures at IL&FS and PMC Bank, the Reserve Bank of India (RBI) is in the process of improving supervision, including risk management and governance, at non-banking financial companies (NBFCs), and harmonising the regulations for housing finance companies with the NBFC regulations, according to a Finance Ministry discussion paper released Thursday.

However, it cautioned that imposing stringent bank-type regulations on NBFCs could either shut off capital to a significant part of the economy or shift systemic risk to yet another part of the financial system. Only a nuanced regulatory trade-off with active and flexible supervision can be made to work in such a scenario, said Sanjeev Sanyal, Principal Economic Adviser in the finance ministry, while releasing the paper. The discussion paper is part of fresh initiative by the Finance Ministry to encourage debates on various issues.

Sanyal said an unintended consequence of ever-increasing bank regulations is that it shifts market activity to shadow banks from main lenders as the latter become more averse to lend to high risk borrowers. But since banks are also lenders to NBFCs, there are inter linkages in the system which can pose challenges even for the better regulated entity.

For instance, the share of bank borrowings in NBFCs’ funding has increased from 21.2 per cent in March 2017 to 29.2 per cent as of March 2019 as banks compensated for reduced capital market access for NBFCs. In addition, the top 10 NBFCs (of 9,659 NBFCs) accounted for more than 50 per cent of the total bank lending to NBFCs as of March 2019, as per the paper.

Sanyal said part of the reasons behind the recent failures at NBFCs such as IL&FS and cooperative lender PMC Bank can be attributed to lack of effective supervision. Even the 2008 global financial crisis has revealed that the institutions that went belly up were not lightly regulated, rather they were properly regulated, but imposing uniform regulations and risk weights can cause problems for the entire financial system, he said, while trying to ignite a debate on what should be appropriate balance between regulation and effective supervision.

“The regulation versus supervision trade- off requires a mindset change such that the first order of policy should be to ensure that legitimate entities, i.e., the “compliants”, can carry out business activity without any encumbrance. This requires simpler regulations combined with greater emphasis on supervision to detect improper activity, determine the extent of the problem, and penalize the “non-compliants”. This applies to all fields of policymaking and concerned ministries and regulators need to invest in supervisory capacity,” he wrote in the paper.

However, the problem with supervision is that it requires active monitoring and accountability from the government department of regulatory body, which pushes them to keep adding top-down regulations regardless of their effectiveness.

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