Context: The collapse of Non-Banking Financial Companies (NBFCs) has recently led to the formulation of regulatory guidelines by the Reserve Bank of India.

Issues with the NBFC Sector:

• Ailing sector: Leading NBFCs like IL&FS and Dewan Housing have gone under.
• Interconnectedness with the financial system:
  • Companies under the umbrella of NBFCs: include
    • Housing finance companies like HDFC.
    • Infrastructure finance companies and debt funds (those which pool investors’ money and lend to infrastructure projects).
    • Core investment companies (those investing in companies).
    • Stand-alone primary dealers (those who operate in financial markets on their own account).
  • Connections with banks: The NBFCs can get over 50% of their funding from banks.

Reserve Bank of India’s layered regulatory framework for NBFCs: based on - the smaller the size, the more minimal the regulation:

• Bottom base layer: it will have about a thousand companies.
• Middle layer: it includes both non-deposit and deposit-taking ‘systemically important’
• Upper layer: it will have around 25 to 30 ‘systemically significant’ companies and will face the same kind of regulation as banks.
• Top Layer: which is now empty; RBI plans to transfer individual NBFCs in trouble into this category having systemic spill-over of risks. (subjected to ‘prompt corrective action’)

Issues to be Addressed by the RBIs Regulatory Framework

• Regulatory arbitrage: prevent firms from using restructuring transactions and financial engineering strategies to take advantage of systemic loopholes in regulations.
• Fight geographical relocation: NBFC may decide to floats a firm in an overseas tax haven and does business which the domestic firm would not be able to do.
• Domino effect: If an NBFC with large borrowing from one or more banks gets into trouble and is unable to repay the bank(s) on time, then the banks can get into trouble.

Conclusion: Regulator has to keep in mind that regulation, as it evolves, must remain as minimal as possible while remaining effective.