Regulatory arbitrage cannot continue
The Reserve Bank of India’s (RBI) attempt to plug regulatory gaps between banks and non-banking finance companies (NBFCs) is part of the ongoing process to bring greater convergence in regulatory standards between the two. Following the spate of NBFCs defrauding investors in the late 90s, the regulatory framework, especially for deposit-taking NBFCs, was tightened. Non-deposit taking NBFCs were, however, kept out on the grounds that they were not taking deposits from the public.
However, as recent events show, there is no end to human ingenuity. With the bull market in stocks triggering a huge demand for funds and banks constrained from lending beyond certain limits, non-deposit taking NBFCs have stepped into the breach. Their modus operandi: raise money through commercial paper (CP) and loans to buy stocks. But since most of these CPs and loans are raised from banks, the effect has been to increase the exposure of banks to the stock market beyond the prudent limits set by RBI. Currently, banks’ exposure to the capital market cannot exceed 20% of their net worth (or 40% where all entities are taken together). Additionally, banks are not allowed to lend beyond Rs 20 lakh to an individual for buying stocks. There is also a related issue, that while Indian banks are not allowed to set up NBFCs, foreign banks are. The result is that some foreign banks, particularly Citigroup under its subsidiary, Citi Financials, have been very aggressive in the capital market.
Given that any exposure of banks to the capital market beyond prudent limits could pose a risk to the system as a whole, the RBI is understandably concerned. Among the options examined by the expert group are treating commercial paper as public deposits; introducing capital adequacy requirements for non-deposit-taking NBFCs to limit the leverage of capital funds; and stipulating a gearing ratio, i.e. borrowing as a multiple of capital funds. Alternatively, the RBI could consider imposing a limit on the extent of bank finance that can be extended to such NBFCs. Whichever route the RBI finally adopts, there can be no two opinions on the need to end regulatory arbitrage wherever it exists.