Pre-empt Regulatory Arbitrage

The Reserve Bank of India’s reputation as a regulator is rock-solid in the global financial system. It now has to ensure that its regulation on NBFCs has the life span of a turtle

SOMEONE once gave regulation one-fifth the life span of a chimpanzee. India has seen numerous examples where the regulator tries to erect walls around a particular sector, only to find that business has found a way around. Some of these sidesteps can be labelled as criminal, but most of these instances can be clubbed into what is now known as “regulatory arbitrage”, which means utilising gaps in the existing regulatory framework without violating the law of the land. There is a regulatory arbitrage occurring right now, which has the Reserve Bank scrambling to plug the loopholes. This involves nonbanking finance companies (NBFCs), especially those promoted by foreign banks or even those sired by international financial giants. The central bank is now planning to come out with regulation that endeavours to eliminate the NBFC-spawned arbitrage.  

Foreign banks are keen to expand their footprint, and given India’s growth rate, they want it all done now! India is currently the hot new thing on the global investment block and everybody desperately wants in. Even foreign banks that once found business in India only marginally engaging now suddenly want to hitch their wagons to this emerging economic powerhouse. For example, certain European banks, which, in an exemplary display of foresight, had deliberately shrunk their Indian businesses in the ’90s, are today jostling to catch a piece of the action. And, this requires branch expansion of an unprecedented scale. 

But then the RBI thinks otherwise. The central bank has been deliberately going slow in granting new branch licences, driven by larger apprehensions of systemic risk. As an alternative, some foreign banks have been expanding their presence through finance companies, or NBFCs. These NBFCs don’t need to approach the RBI for opening branches. Most of them don’t even accept deposits in order to escape the RBI’s gimlet gaze. As a result, foreign banks have been opening NBFC branches furiously. These branches are, for all practical purposes, like bank branches with only one crucial difference — these can grant loans for buying houses, cars or two-wheelers, but cannot issue cheque books. According to a report of an RBI internal group on ‘Level playing field, regulatory convergence and regulatory arbitrage in the financial sector’, banks are likely to set up NBFCs to benefit from regulatory arbitrage: “A bank’s NBFC subsidiary which grants retail loans such as consumer loans, vehicle loans, housing loans, etc., coupled with a bank ATM can circumvent the branch authorisation restrictions imposed on the bank by extending its outreach substantially. The customer can deposit or withdraw cash at the bank ATM, obtain a loan from the NBFC and make repayments into the loan account by using the bank ATM. Thus, the bank together with its NBFC subsidiary can perform more or less all the functions which a bank branch undertakes.”

The trend has now taken a curious twist. The RBI has now stopped a few banks from opening or operating NBFCs, without doing anything about the existing ones. Barclays, Deutsche Bank and HSBC find their applications for NBFCs lost in a black hole. Interestingly, NBFCs launched by non-banks have sailed through — in addition to GE Money, US insurance giant AIG recently got the nod to launch and operate an NBFC. So did Singapore’s Temasek, which bought over an existing NBFC (something reportedly done by Goldman Sachs). In the midyear review of its 2006-07 credit and monetary policy, the RBI has even allowed these NBFCs to issue co-branded credit cards and sell MF products. This puts them somewhat on par with banks.

The RBI’s concern with bank-run NBFCs is not totally out of place. Many of these NBFCs extend risky loans, including loans to speculate in the capital markets. This is risky on two counts — first, any default can lead to an impairment of the parent bank’s capital. But the riskier proposition is the contagion effect it may have on the system as a whole. Most of these NBFCs are heavily leveraged, which means they borrow in multiples of their capital (can be 10-15 times) from the market to finance their lending operations. So, any slight slippage might affect even the lenders, who in turn might knock over another chain of financial agents in the system. 

In all likelihood, the RBI might opt for stricter regulation of the banks that have promoted NBFCs. For instance, it might choose to treat a bank and its family of NBFCs as a conglomerate, inviting consolidated supervision, including imposition of ceilings on the conglomerate’s lending to industrial groups. There might even be stricter norms introduced for bank financing of NBFCs against shares, debentures and PSU bonds, in addition to finding ways that staunch the flow of bank funds to the capital market through NBFCs. Another alternative would be closer coordination with Sebi for regulating finance companies that are engaged exclusively in the stock markets. The overall purport of the new NBFC policy will be to make a distinction between bank-sponsored NBFCs and independent ones, against the current difference of deposit-accepting and nondeposit accepting NBFCs.

All that’s fair enough. But there’s another problem here: if the RBI shuts the door now, it presents a new kind of hazard. It provides the existing foreign banks with an unfair advantage over the others, which might then induce the excluded lot to indulge in an extreme form of regulatory arbitrage. The top five foreign banks already account for 82% of the total profit reported by all the 30 MNC banks in the country. Any form of prospective selection through regulatory fiat might only enhance this discrimination. The Institute of Chartered Accountants of India shut the door on foreign accounting firms some years ago, but only after it had allowed in a couple of the foreign firms. However, the ones left standing outside the gates still managed to sneak in through cracks in the wall. MNC banks, deprived of either branches or NBFCs, might be also tempted to attempt something extreme, thereby putting the entire system to even a greater risk. The RBI’s reputation as a regulator is rock-solid in the global financial system; it now has to ensure that its regulation on NBFCs has the life span of a turtle.

Published as an Op-Ed in The Economic Times (November 1, 2006)