Introduction
The ecosystem of financial intermediation in India has seen a dramatic metamorphosis in the last ten years. Until the global financial crisis and a spate of defaults and bad loans between 2012 and 2014, public sector banks (PSBs) were the pillar of credit distribution in the country. The system began to crumble in the post-crisp period and because of a spate of defaults and bad loans between 2012 and 2014. By 2014, the asset quality issues of PSBs were piling up along with their non-performing asset (NPA) levels and pressure to decrease risk exposure. Consequently, their credit expansion took a perceptible hit, especially in risk pools and the underpenetrated segments of small and medium-sized enterprises, low-income housing finance, and rural consumers.
Into this void stepped the NBFCs, a financial institution class not permitted to take demand deposits like banks but capable of providing credit and pursuing other financial activities. The NBFCs rapidly became a necessary set of intermediaries in the financial system of India. Their models were marked by flexibility, sectoral specialization, and a fine knowledge of particular borrower requirements. While banks tended to rely on homogeneous credit evaluation and risk-averse practices, NBFCs took on innovative methods better attuned to the circumstances of small borrowers. They were thus best at lending to micro, small and medium-sized enterprises (MSMEs), affordable housing developments, and buyers of used vehicles sectors by and large ignored by traditional banks.[1]
NBFCs had a record boom between 2014 and 2018. They grew exponentially in loan book size, market share, and investor interest. But underlying the staggering boom were structural weaknesses like a high dependence on wholesale money and short-term borrowings to support long-duration assets. These vulnerabilities came to the fore in a in 2018 when IL&FS, a systemically important NBFC, collapsed. The crisis caused a liquidity squeeze and also busted investor confidence in the sector. Just as NBFCs were stabilizing in the wake of IL&FS, the impact of the COVID-19 pandemic hit the sector hard. It brought economic activity to a virtual standstill, disrupted cash flows, and had a heavy impact on borrower repayments subjecting NBFCs to fresh financial pressure.[2]
Emergence of NBFCs: Filling the Gap in Credit
NBFCs in India grew rapidly between 2014 and 2019. While public sector banks restricted lending activities to balance deteriorating balance sheets, NBFCs filled the credit gap. Between FY2014 and FY2019, NBFCs had a CAGR of 13.5% in credit disbursement, which compared favorably to the commercial banks’ 8.5% CAGR over the same period. This surge in growth saw NBFCs as serious players.
NBFCs stood out by having a keen eye on niche segments. Their credit products targeted segments usually neglected by large banks because of perceived increased risks or insufficient documentation. MSMEs, a segment commonly operating in an informal manner and without exposure to formal financial records, turned out to be a prime segment for NBFC lending. NBFCs created alternative methods to assess credit, like cash flows and psychometric scores, to assess risk. They also established a commanding share of the used vehicle financing market and loans to consumer durables, requiring niche knowledge of the behaviour of borrowers and local underwriting procedures.
Another prominent area of expansion came in real estate and housing financing. Housing Finance Companies (HFCs), which are NBFCs dealing in residential mortgages, aggressively funded developers as well as end-users on a large scale, especially in the affordable housing space. The Pradhan Mantri Awas Yojana (PMAY) and other government programs further increased the demand in the space.
NBFCs were bounded by a fundamental constraint: they
were unable to mobilize retail deposits like banks. Consequently, they had to rely on financing from banks, issuance of debentures, and drawing capital from mutual funds and institutional investors. The financing system was fine in a low-interest-rate regime with robust investor confidence. The drawback was that it exposed the NBFCs to liquidity shocks all the more when short-duration borrowings were utilized to finance long-duration assets a pure asset-liability mismatch.[3]
The IL&FS Crisis: Revealing Systemic vulnerabilities
The 2018 IL&FS collapse was a turning point for NBFCs. IL&FS, a large infrastructure financing NBFC with more than 300 subsidiaries, defaulted on its debt obligations and sent a shock wave through financial markets. IL&FS had outstanding debt of around ₹910 billion at the time it defaulted. The market was taken by surprise because IL&FS had a high credit rating and was viewed as a low-risk institution.
The benchmark caused a crisis of confidence in the NBFC sector as a whole. Mutual funds, key investors in NBFC debt, pulled back sharply on their exposure. The result was a liquidity freeze, especially affecting NBFCs that were heavily reliant on accessing short-term borrowings. As market access evaporated, many NBFCs found it difficult to roll over their liabilities and investor confidence took a hit.
The crisis brought out several systemic flaws in the NBFC model. To begin with, there was asset-liability mismatch. IL&FS had financed long-gestation infrastructure projects using short-term borrowings, which left it acutely exposed to liquidity shocks. Secondly, the crisis brought out weak corporate governance. Thirdly, rating agencies were sluggish in response. IL&FS had maintained high credit ratings until weeks before it had to default on payments, triggering concerns about the credibility. In all accounts, the crisis caused a loss of innocence to the NBFC segment. It dispelled the illusion of NBFCs expanding perpetually ignoring structural weaknesses and resulted in a call for urgent regulatory overhaul.
Regulatory Response: Firefighting or Structural Reform?
Post the IL&FS crisis, the Reserve Bank of India (RBI) and the central government made a range of responses to revive confidence in the NBFC sector. These responses could categorically be seen as short-term firefighting and long-term regulatory overhaul.
To overcome the near-term liquidity strain, the government launched the Partial Credit Guarantee Scheme (PCGS), enabling public sector banks to buy high-rated NBFC assets with a partially sovereign guarantee. The RBI also launched Targeted Long-Term Repo Operations (TLTROs), which pushed banks to borrow and on-lend to NBFCs at cheaper rates. The exposure limits in lending by banks to NBFCs were also temporarily loosened.
These relief measures benefited mostly large and better-rated NBFCs. Small and middle-sized operators continued to suffer. The risk aversion of investors was still high, and the costs of funding for weaker NBFCs increased.
Structural reform-wise, the RBI took firm action to intensify oversight. One important action was to bring Housing Finance Companies (HFCs) under the oversight of the RBI. This maintained uniformity and enhanced the coordination of oversight. The RBI also harmonized income recognition and asset classification standards of NBFCs with the standards prevailing in banks to bring in more transparency and accountability.
One of the most important reforms was the rollout of the scale-based regulatory system in 2021. It categorized NBFCs into tiers based on size, complexity, and systemic importance. Stringency of regulation was intended to rise progressively with the risk profile of the institution. Although such attempts were appreciable, others contend that they did not go far enough in resolving the core issues. Rao (2020), for example, opined that systemically relevant and functionally similar large NBFCs ought to be converted into full-service banks. S&P Global Ratings (2021) also mentioned that the days of consolidation were around the corner and would result in large and household-name NBFCs remaining afloat.[4]
The regulatory response thus walked a line between supporting in times of crisis and systemic change but more structural adjustment might now be required to build long-run resilience.
Redesigning the NBFC Model: The Path Forward
One of the key considerations in the process of rethinking is the diversity in the NBFC segment itself. NBFCs in India vary from local players operating in rural markets to behemoths controlling as much as a mid-sized bank does. A “one-size-fits-all” regulation is patently unsuitable. Consciously acknowledging this reality, the RBI’s scale-based regulation is a welcome development. In this methodology, larger and complicated NBFCs are subject to more onerous regulations and the others to proportionate regulation. This tiered structure permits focused regulation and reduces regulatory arbitrage.
Still, the case for transforming systemically important NBFCs large asset holders with high financial inter-linkages into banks remains compelling. Converting them into banks will increase their low-cost fund accessibility, subject them to stronger compliance standards, and decrease contagion concerns.
Another area of overhaul is liquidity access. NBFCs do not have direct access to the RBI’s lender-of-last-resort operations like the repo window as of now. Due to the absence of backstop financing, they are more exposed to liquidity shocks like in the case of the IL&FS crisis and the pandemic. To address this, solutions like a standing liquidity facility in favour of large NBFCs or structured co-lending models with banks have been suggested by experts. Encouragement of securitization and the creation of a stronger corporate bond market can also aid in NBFCs accessing diversified funding sources.
The IL&FS failure was as much a failure of internal controls and disclosure as it was a failure of liquidity. NBFCs have to up their governance standards especially in terms of risk management, disclosure and board accountability. Rating agencies got away by holding back downgrades on high-profile names as it appears now. They too have to overhaul their methods and increase their transparency.
Finally, a common perception is growing that industry consolidation is inevitable but also desirable. Only NBFCs with good governance practices, diversified funding sources, and healthy capital buffers will survive shocks in the future, according to CRISIL (2021). Weakened players or specialty NBFCs may have to merge or exit the industry or specialize in niche areas to maintain viability.[5] While it might limit the sheer number of NBFCs, it will also lead to a better capital- and professionally managed industry.
In brief, recasting the NBFC model has to be a delicate balancing act. India needs to retain the strengths of NBFCs innovation, agility, and outreach while correcting the vulnerabilities to systemic stability. A tiered regulatory structure, better access to liquidity, better governance, and consolidation in the sector will prove to be key to ensuring NBFCs continue to play their lifeblood role in the credit system in India.
Conclusion
Nonbanking Financial Companies have been a driving force in transforming the financial landscape in India in the past ten years. They have been instrumental in expanding credit to traditionally overlooked sectors like MSMEs, affordable housing, and rural businesses. The unregulated proliferation of NBFCs, coupled with reliance on unstable sources of financing and a lack of adequate regulation, brought grave vulnerabilities to the system. The IL&FS collapse of 2018 was a rude awakening and brought to light fundamental governance failures, financing structures, and risk evaluation.
The regulators’ and the RBI’s response has been proactive and considered. Liquidity support actions, the rollout of a scale-based framework of regulations, and the realignment of the oversight mechanisms have all been supportive of the sector’s stability. There are still additional structural reforms required. The sector has to now transition from firefighting to future-proofing.
At its core, the NBFC model has to change. It has to achieve a synergy of innovation and risk management, inclusiveness and accountability, and flexibility and resilience.
[1] Viral V. Acharya, Hemant Khandwala & Tanju S. Öncü, The Growth of a Shadow Banking System in Emerging Markets: Evidence from India, 39 J. INT’L MONEY & FIN. 207 (2013).
[2] Rajeswari Sengupta, Li L. Song & Harsh Vardhan, A Study of Nonbanking Financial Companies in India, ADB S. ASIA WORKING PAPER SERIES NO. 83 (2021), https://www.adb.org/publications/nonbanking-financial-companies-india.
[3] Rajeswari Sengupta & Harsh Vardhan, Don’t Ignore the Credit Risk in NBFCs, BLOOMBERGQUINT (2019), https://www.bloombergquint.com/opinion/dont-ignore-the-credit-risk-in-nbfcs.
[4] M. R. Rao, NBFC Regulation- Looking Ahead (National E-Summit, 2020) (unpublished conference presentation).
[5] CRISIL Ltd., Reports on NBFC Sector (2019–2021) (on file with author).
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