NBFC Regulation turned sixty

Vinod Kothari, finserv@vinodkothari.com

Not sure if any cake was cut[1], but NBFC regulation turned 60, on 1^st Feb., 2024. It was on 1^st Feb., 1964 that the insertion of Chapter IIIB in the RBI Act was made effective. This is the chapter that gave the RBI statutory powers to register and regulate NBFCs.

1964: Insertion of regulatory power

What was the background to insertion of this regulatory power? Chapter IIIB was inserted by the Banking Law (Miscellaneous Provisions) Act, 1963. The text of the relevant Bill, 1963  gives the object of the amendment: “The existing enactments relating to banks do not provide for any control over companies or institutions, which, although they are not treated as banks, accept deposits from the general public or carry other business which is allied to banking. For ensuring more effective supervision and management of the monetary and credit system by the Reserve Bank, it is desirable that the Reserve Bank should be enabled to regulate the conditions on which deposits may be accepted by these non-banking companies or institutions. The Reserve Bank should also be empowered to give to any financial institution or institutions directions in respect of matters, in which the Reserve Bank, as the central banking institution of the country, may be interested from the point of view of the control of credit policy.”

Therefore, there were 2 major objectives – regulation of deposit-taking companies, and giving credit-creation connected directions, as these entities were engaged in quasi-banking activities.

As for deposit-taking by companies, Indian laws permitted companies, including non-financial companies, to accept deposits. For non-financial companies, this power was limited to short-term deposits (36 months) and only for a small part of the long-term funding requirements. But finance companies (mainly hire purchase companies) always had a very strong lobby, and they were able to convince regulators to permit deposit acceptance upto 1000% of their net worth, and for time going upto 10 years.

As for the types of NBFIs., the 1963 amendment talked mainly about 3 – lending companies, investment companies, and hire-purchase companies. The other 3 activities still found in sec. 45IC (c), viz., insurance, chits and money circulation schemes, were added in 1974, possibly as a result of the Bhabatosh Datta Study Group report of 1971.

Thus, pursuant to this power, in 1966, the RBI issued  Non-Banking Financial Companies (Reserve Bank) Directions, 1966. Simultaneously, similar directions were issued for non-banking non-financial companies, by way of Non-Banking Non-Financial Companies (Reserve Bank) Directions, 1966. RBI’s regulatory domain on non-financial companies was taken away, with the insertion of sec. 58A in the Companies Act, 1956 and promulgation of Companies (Acceptance of Deposits) Rules, 1975.

The spurt in NBFCs  before 1980s

What were the commercial reasons for spurt in NBFC business till early 1980s (the early 1980s gave a new impetus as we discuss below). Major banks had been nationalised in 1969. There were major gaps in the savings and financial system of the country. First, savings institutions flourished, mainly in the southern part of the country and in the east. Chit funds, mutual savings bodies such as Nidhis, and small savings-oriented companies (which were later called Residual Non-banking companies) developed during this period.

As for the gaps in lending, consumer durables companies such as Singer Sewing Machines and Murphy radio had brought the English pattern of instalment supply. Hire-purchase, once again with its roots in the UK law, became quite popular for funding of commercial vehicles. Major hire purchase companies developed in Madras, other parts of southern India[2], as also in Delhi.

Not only were these hire purchase companies able to charge high rates of interest from borrowers owing to the practice of disclosing a “flat rate” of interest[3], they were able to attract deposits offering rates of interest higher than banks. Banks were subjected to liquidity ratio requirements, which were not applicable to NBFCs, giving them an edge[4]. Historically, even the restriction on rates of interest that could be offered was not there, too. On top of this, the companies, which were now registered with the RBI under Chapter IIIB could contend that their deposit-taking activity was under RBI supervision – see para 3.9 on page 13-14 of the Bhabatosh Datta Study Group report.

The James Raj Study Group (1974) was engaged on the question whether deposit taking by NBFCs should be banned – it recommended against it. At the same time, it recommended banning of chit funds. Chit funds and money circulation schemes were accordingly banned in 1978; states continue their right to regulate permitted chit funds.

Advent of equipment leasing and equity market boom

Equipment leasing made its debut in 1973, and within a short time, the performance of early entrants became public. In the meantime, the possibility of creating tax shelters with depreciation claim, based on a tax ruling in favour of the First Leasing, caught attention, and overnight, most of the hire purchase companies of yesteryears turned into leasing companies.

The 1985 to 1990 was also a notable public issue boom. There was no SEBI then – public issues were approved by the Controller of Capital Issues. Whole lot of leasing companies came out with public issues, which received substantial public response.

Deposit-taking and asset-liability mismatches continued to bulge as the number of NBFCs continued to grow[5].

Until 1997, NBFCs were projected as the ones that needed support.  For example, Dr A C Shah study group said that  a “ well diversified and healthy NBFC sector would impart further depth to the financial system”, and therefore, it suggested that “regulators have to resist the temptation of over-regulation which will stifle the growth of the non-bank financial sector but have, in fact, to encourage a healthy and orderly growth of these intermediaries so as to ensure the solvency and safety of the financial system of which these companies form an integral part.”

The balloon bursts; a new phase of NBFC regulation begins

The balloon burst in 1997. There is always some casualty that causes it to burst – in this case, it was CRB Capital Markets. The company buckled under deposit redemption pressure. Rating agencies downgraded NBFCs by the dozen. With the CRB case turning queer, there was a massive run on NBFCs across the country, and soon, hundreds of companies downed their shutters, and lakhs of depositors had nowhere to get their hard-earned money from.

The country-wide furore brought regulators under flak, and as a result, RBI Act was amended in 1997.

From 1998, the RBI started a new process of registration of NBFCs[6], stipulating a minimum net worth requirement of Rs 25 lacs. A Standing Committee of Parliament report notes that over 36000 applications were received by the RBI, out of which nearly 20000 applications were rejected.

Usha Thorat recommendations: focusing on systemic importance

The scenario post 1998 has been a consistent evolution of the regulatory framework. The distinction between systemically important (SI) and other NBFCs was based on Usha Thorat panel report, resulting into dissection of NBFC regulations into two: those for deposit-taking companies were contained in separate regulations, whereas the rest of the NBFCs were classed into those with asset size of Rs 500 crores and above, and the remaining. This development is well captured in one of our write ups of 2012.

Scale-based regulatory system

While there have been several developments intermittently, but the next major step in the evolution has been the recent scale-based regulatory system, instead of the erstwhile functional classification, whereby NBFCs have been classed into middle and upper layer (regulatory arbitrage is minimal in such cases), and base layer NBFCs. An article by our colleagues explains the new regime.

60 years is a long journey! Whether it is due to or despite the regulation, NBFCs have continued to evolve and grow.  Many of the NBFCs of today are larger than several banks. Many provisions of the Income-tax law treat NBFCs at par with banks. Provisions of SARFAESI Act also provide NBFCs powers akin to those with banks, though with some differences. Government schemes for credit to small businesses, such as CGTMSE, recognise lending by NBFCs at par with those by banks. In short, NBFCs are today a very significant player in the financial system. Of course, the number of deposit-taking NBFCs has consistently come down, as it should.

At this stage of regulatory evolution, the RBI should seriously look at shedding a lot of its burden by (a) de-registering companies which are purely into investment business; and (b) simplifying the conditions for qualifying as core investment companies, to take pure holding companies out of the regulatory ambit. 

---

[1] And the right place to cut the cake should have been Kolkata, where the first Department of Non-banking Companies, was set up within the RBI.

[2] Bhabatosh Dutta reports about 500 financiers in the 4 southern states, of which 3 were limited companies.

[3] A flat rate of 10% for 3 years will result into an IRR of nearly 18%.

[4] Some of the established names, particularly in Madras, had so much of depositor faith and depositors queued up outside their offices to place their life’s savings with the finance company. Ironically, the same depositor also took a loan from the same company, paying a higher interest rate!

[5] A bit of a personalised note is apt here. With a book on leasing to my credit, I was easily accepted as a leasing trainer and consultant. The early 1990s was a boom period for the NBFCs. There wasn’t any major business house that did not venture out into leasing. The prospect of getting tax shelter on account of the-then existing 25% investment allowance, on top of depreciation, and setting it off against business income, was compelling enough. This easily led to several malpractices. On business front, there were transactions with overvalued sale-and-leaseback assets, small value items (as per the-then rule, items costing Rs 5000 or less could be fully depreciated in the year of purchase), etc. On liability side, NBFCs could continue to accept 12 months’ deposits, mobilising broker-networks with high incentives, and hope to keep the fire burning. As a trainer, I went frantically over the country. In 1995, I would have done some 40 workshops in a single year, mostly of 2 day duration each, and some longer.

[6] Personally, I recall addressing a huge gathering of chartered accountants in Kolkata. I recall that some 30000 applications for NBFC registrations were filed from Kolkata alone. Kolkata has ever remained the hub, at least from the viewpoint of sheer number of registered NBFCs.