What's in a very name? lots, if you're a non-banking finance company (NBFC).

For one, though, you're nearly a bank, a minimum of as so much because the assets aspect of your balance-sheet worries, you play by a special set of rules compared to banks. You are not a part of the payments system; nor does one have access to the banking company of India's (RBI) lender-of-last-resort facility, a minimum of in some way. partially as a consequence of this, the RBI's oversight over NBFCs has additionally been marked by a lighter bit. prudent norms, whether or not in respect of plus classification, financial gain recognition, provisioning or capital adequacy ratios, are a lot of lax.

(http://articles.economictimes.indiatimes.com/2011-09-03/news/30110194_1_nbfc-sectorusha-thorat-bank-credit)

But all this would possibly change if the rbi acts on the recommendations of the working group on the problems and considerations within the NBFC Sector, headed by former deputy governor Usha Thorat. The underlying logic of the recommendations is indisputable: if you appear as if a duck and walk sort of a duck, you want to be nearly a duck, although you do not quack like one! So, there's no reason why the restrictive plan ought to be to any extent further lax for NBFCs than for banks. Consider: on the liabilities aspect, banks mobilise retail deposits, supply checking accounts and type the bulwark of the payment system. They conjointly access the wholesale marketplace for funds. Non-deposit-taking NBFCs (NBFCNDs), in distinction, get funds from the wholesale market or access the capital markets through commercial paper, nonconvertible debentures, inter-corporate deposits and bank borrowing. On the assets aspect, there's few distinction as each banks and NBFCs undertake disposal and investment activities. For all sensible functions, therefore, the road between banks and NBFCs is blurred. In such a state of affairs, there will be no case for a lighter bit once it involves control NBFCs. particularly once the steady increase in bank credit to NBFCs in recent years raises the terribly real chance of risks being transferred from the a lot of lightly-regulated NBFC sector to the banking sector. this can be the broad philosophy underlying the recommendations of the unit.

Following from this, the thrust of the recommendations is to bridge the bank-NBFC restrictive gap and, indeed, between deposit-taking and non-deposit-taking NBFCs. as an example, non-deposittaking NBFCs haven't any money reserve magnitude relation (CRR) demand, nor area unit they needed to keep up a statutory liquidity magnitude relation (SLR). There aren't any restrictions on branch growth or on finance activities. In distinction, banks area unit needed to keep up a CRR on that they earn no interest, associated an SLR of pure gold. They need run batted in approval for branch expansion; there area unit limits on their exposure to capital markets and, by and huge, they're not allowed to finance the acquisition of land or mergers and acquisitions. And tho' deposit-taking NBFCs area unit subject to some restrictions on branch growth, exposure to capital market and property, they like restrictive forbearance within the sort of a lower SLR: 15 August 1945 against pure gold for banks. The same forbearance is seen within the context of prudent laws. tho' the capital adequacy magnitude relation for NBFCs is higher at 15 August 1945 compared to 11th of September for banks, the amount for classifying loans as nonperforming assets (NPAs) just in case of NBFCs is higher at 180/360 days against ninety days for banks. There are variations within the provisioning framework likewise. The restrictive framework for possession and governance is additionally terribly completely different. The Banking Regulation Act, 1949, empowers the run batted in to stipulate the qualifications of administrators of a bank and to appoint and take away them. These powers don't seem to be available to the central bank under the rbi Act, 1934, in respect of the NBFCs. NBFCs vs. Conventional Banks: An NBFC cannot accept demand deposits, and therefore, cannot write a checking facility. It is not a part of payment and settlement system which is precisely the reason why it cannot issue cheques to its customers. Deposit insurance facility of DICGC is not available for NBFC depositors unlike in case of banks. SARFAESI Act provisions have not currently been extended to NBFCs. Besides the above, NBFCs pretty much do everything that banks do.

A table comparing the functions/limitations of Banks with NBFCs is as follows:

BANKS DEFINITION Definition : banking is acceptance of deposits withdrawable by cheque or demand; NBFC cannot accept demand deposit SCOPE OF BUSINESS Scope of business for banks is limited by section 6 (1) of the BR Act LICENSING Licensingrequirements

NBFC'S NBFC are companies carrying financial business

There is no bar on NBFC'S carrying activities other than financial activities

It is quite easy to form an NBFC. Acquisition of NBFC's is procedurally regulated but no approval required

REQUIREMENTS are quite stringent. Transfer of shareholding also controlled by RBI

MAJOR LIMITATIONS ON BUSINESS MAJOR PRIVILEGES

No non-banking activities can be carried

cannot provide checking facilities

Can exercise powers of recovery under SARFAESI and DRT law

Do not have powers under SARFAESI or DRT law

FOREIGN INVESTMENT REGULATIONS

Upto 74% allowed to private sector banks BR Act and RBI Act lay down stringent controls over banks

Upto 100 %

Controls over NBFC's are relatively much lesser

SLR/CRR

Banks are covered by

NBFC's have to maintain a certain ration of deposits in specified securities; no such requirement for nondepository companies

REQUIREMENTS SLR/CRR requirements

PRIORITY SECTOR LENDING REQUIREMTNS

Certain minimum exposure to priority sector required

Priority sector norms are not applicable to banks

Table depicting Banking V/S Non- Banking Financial Companies Regulatory Arbitrage In India

BANKS

NBFC's

FUNCTIONAL RESTRICTIONS

Carrying on checking accounts, remmitance functions and typical retail banking Acceptanceof term deposits trusteeship function,nominee

Permitted

Not permitted

Permitted

No express bar is there

Other functional limitations

Banking regulation act expressly bars any business other that permitted by the act [sec 6(1)]

a. For domestic NBFCs,no bar on nonfinancial business,except that on crossing of a certain barrier(50% of income or assets),NBFCs having international funding under automatic route,any activity included within the 19 permitted activities is possible.any other activity is possible only with the express FIPB approval

Leasing and hire purchase Operating lease

Banks are allowed to a limit of 10% of their assets Treated as a non -finnancial business ,not permitted

No limit

Permitted,though treated as a nonfinnancial business Permitted subject to capital norms and other limitations

Securitisation

Permitted subject to capital norms and other limitations

LICENSING RESTRICTIONS

Need for a license

Any new bank needs a license.licensing norms are tightly controlled and generally,it is perceived to be quite difficult to get a license for a bank

It is comparatively much easier to get registration as an NBFC.besides,there are some 30000 NBFCs currently registered,many of which may be available for sale

OWNERSHIP STRUCTURE/CHANGE IN OWNERSHIP

Indian ownership

Not noe than 10% of capital in a bank may be acquired without the approval of the RBI

While prior intimation of takeover is required in case of NBFCs,there is no need for express permission for a change in voting control.there is no limit as to the percentage holding permitted in case of NBFCs

Foreign ownership

Upto 74% capital in banking companies 100% capital may be held by foreign may be acquired for foreign owners owners subject to minimum under FDI norms

CAPITAL ADEQUACY REQUIREMENTS AND PROVISIONING

Basle norms

Present capital regulations are based on basle I. basle ll is proposed to be implemented effective 2007.Capital requirement generally 9% of riskweighted assets

Prudential regulations which lay down capital adequacy have been substituted in feb 2007,but they are based on basle l and not basle ll. Capital requirement generally 10% of risk-weighted assets. As much as 12 months overdue is permitted in case of lease and hire purchase transactions .6 months in case of loans and other exposures

Provisioning

90 days past due leads to NPA characterization and calls for provisioning as per international standards

CREDIT CONTROL AND SECTORAL ASSET RESTRICTION

SLR/CRR norms

Substantial part of assets of banks is blocked due to statutory liquidity ratio(SLR) and cash periodically changed to control the expansion of M3 in the economy

Only 15% of the deposits liabilities of NBFCs is to be held in certain permitted securities

Sectoral exposures

Periodic regulations place limits on the extent to which banks may invest in capital market and other specific segments.There are certain segments in which banks need to allocate minimium percentage of their assets

Very scanty limitations have been placed on assets of NBFCs. Investment in real estate and unquoted equity shares are controlled. Capital market exposure is not required to be reported

An asset becomes non-performing when it ceases to generate income for the bank. In India, a Non-Performing Asset (NPA) is broadly defined as one with interest or principal repayment instalment unpaid for more than 90 days. There exist defined mechanisms to deal with NPAs of banks and financial institutions today. However prior to 1993, banks had to take recourse to the long legal route against defaulting borrowers, beginning with the filing of claims in the courts. A lot of time was therefore spent in the judicial process before banks could have any chance of recovery on their loans. On average, a civil suit decision took anywhere between 5 to 7 years. Under the Recovery of Debts to Banks and Financial Institutions Act 1993, Debt Recovery Tribunals (DRTs) were set up for recovery of loans of banks and financial institutions. This led to speedy recovery of loans in about 1 years time as against the average time of 5 to 7 years required in civil suits. While initially the DRTs performed well, their progress suffered as they got overburdened with the huge volume of cases referred to them. To speed up the process of recovery from NPAs, The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI) Act was enacted in 2002 for regulation of securitization and reconstruction of financial assets and enforcement of security interest by secured creditors. The SARFAESI Act empowers Banks / Financial Institutions to recover their non-performing assets without the intervention of the Court. The Act provides three alternative methods for recovery of non-performing assets, namely:

Securitisation Asset Reconstruction Enforcement of Security without intervention of the court

Secured creditors are given the power to take possession of the securities in the event of default and sell such securities for the purpose of recovery of the loan. The Act provides for enforcement of Security interest by a secured creditor without intervention of the court, in cases of default in repayment of instalments and non-compliance with the notice period of 60 days after the declaration of the loan as a non-performing asset.

The Act also provides for setting up of Securitisation Companies/ Reconstruction Companies (SC/RC), which acquire the NPAs from banks and financial institutions by raising funds from Qualified Institutional Buyers (as defined by the Act) by issue of Security Receipts (As defined by the Act) representing undivided interest in such financial assets. The Act enables SC/RCs to take possession of secured assets of the borrowers including right to transfer and realize the secured assets. SC/RCs act as debt aggregators or agents of the banks or financial institutions focused in the resolution of NPAs. The SC/RCs buy the impaired assets from banks and financial institutions, thereby cleaning the balance sheets of the banks and permitting them to focus on their normal banking business. The promulgation of the SARFAESI Act has been a benchmark reform in the Indian banking sector. The progress under this Act had been significant, as evidenced by the fact that during 2002-03 when the Act came into effect, there was an overall reduction of non-performing loans to 9.4 per cent of gross advances from 14.0 per cent in 1999-20001. (Reserve Bank of India on Trend and Progress of Banking India 2002-2003)

Currently, three legal options are available to banks for resolution of NPAs- the SARFAESI Act, Debt Recovery Tribunals and Lok Adalats. The SARFAESI Act has been the most important means for recovery of NPAs. The amount of NPAs recovered under the SARFAESI Act formed over half of the total amount of NPAs recovered in 2009-10. Banks have referred as many as 78,366 loan default cases by end march 2010 under the SARFAESI Act involving a loan amount of Rs. 14, 249 crores. Against this, banks managed to recover Rs. 4,269 crores representing 30% of the loans2.( Reserve Bank of India on Trend and Progress of Banking India 2009-2010) Recently the Report of the Working Group on the Issues and Concerns in the NBFC Sector laid out recommendations to extend the coverage of SARFAESI to NBFCs as well. This move will benefit NBFCs, ensuring quicker recovery of their non-performing assets. This, in

turn, could encourage NBFCs to provide access to a wider range of financial products and serve better the cause of financial inclusion.

Introduction to the Factoring Regulation Act, 2011 The Factoring Regulation Act (hereinafter referred as Act), numbered as Bill No 24 C, 2011 was passed by the Parliament and which would to come into force as per notification(s) of the Central government from time to time. The Act deals with the following aspects:a. To provide and regulate assignment of receivable by making provision for registration of factors and assignment of receivables. b. To define the rights and obligations of parties to contract for assignment. c. Stating the penalties and offences for the Act.

ENFORCEMENT OF SECTIONS BY NOTIFICATION Certain Sections of the Act have been brought into force by The Central Government (herein after referred as Government) by NOTIFICATION NO.S.O. 711(E), dated2-4-2012 issued by Government which states that:In exercise of the powers conferred by sub-section (3) of section 3 of the Factoring Regulation Act, 2011 (12 of 2012), the Central Government hereby appoints the 2nd day of April, 2012, as the date on which the provisions of sections 19,20,21 and 32 of the said Act shall come into force. The Sections 19, 20, 21 and 32 of the Act which have been brought into force by the Government hereinafter have been referred as the Enforced Sections. The enforced sections shall come into force from 2nd April, 2012. Effect of the said notification:Factoring Regulation Act, 2011 throws obligation on NBFC A. Filing of assignment of receivables which are in the favour of factor for registration purpose

has been made compulsory. B. It has to be registered with the Central Registrar which has been set up under Section 20 of Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (here in after referred as SARFAESI) and Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (Central Registry) Rules, 2011 (hereinafter after referred as Central Registry Rules) made under SARFAESI mutatis mutandis, apply to the record of assignment of receivables in favour of a factor in the Central Register with the Central Registry. C. The filing for the assignment of receivables has to be done within 30 days from the date of assignment or the date of establishment of registry (which-ever is earlier) D. Non-filing of assignment for registration purpose would lead to penalty for the defaulting parties. E. On-realisation of the assigned receivables or settlement of claim against the debtor then the factor shall file for satisfaction of the assignment in the receivable in the favor of factor. F. The particulars of assignment of receivables entered in the Central Register of such transactions under section 19 are open for public inspection and Central Registrar shall be maintained in electronic form. G. Non-filing for registration purpose would lead to penalty for the company and every officer of the company responsible for the act and the fine imposed can extend to five thousand rupees each day the default continues. Brief Over-view of the Enforced Sections of the Act (Factoring Regulation Act, 2011) Section 19 of Act: - This section states that every factor before the Central Registry which has been set up under section 20 of SARFAESI, within:a. 30 days of assignment or b. Date of establishment of registry The factor shall register the particulars of every

assignment transaction receivable in the favour of the factor and receivables receivables may be described specifically or generally with reference to the debtor, or the period to which they relate or by any other general description by which such receivables can be identified and on realisation of receivables or settlement of the claim against the debtors the factor shall

file satisfaction of assignment of receivables in its favour. The provisions for registration of transactions contained in the SARFAESI and the rules made there under shall, mutatis mutandis, apply to the record of assignment of receivables in favour of a factor in the Central Register with the Central Registry. Section 20 of The Act Particulars of transaction of assignment of receivables entered in the central register shall be open during business hours for inspection by any person by payment of the prescribed fee. Section 21 of The Act If there is default in filing of particulars of assignment of receivables and realisation by a factor then the defaultee company and every officer of the defaultee company shall be punishable with fine which may extend to five thousand rupees for every day during which the default continues Section 32 of The Act gives the power to the Central Government to make rules. Enforced Sections of the Act brought into force would be applicable to whom all a. Non-Banking Financial Company (here in after referred as NBFC) as defined in clause (f) of section 45-I of the Reserve Bank of India Act, 1934 which has been granted a certificate of registration under sub-section (1) of section 3. b. Any corporate established under an Act of Parliament or any State Legislature or any company registered under the Companies Act, 1956 engaged in the factoring business. Process of Filing for Registration Process:a. Factor has to file every particulars of transaction of assignment with the Central Registry which is in his favour in Form -I within 30 days from the date of such assignment or from the date of establishment of such registry, as the case may be, in the manner and subject to payment of such fee as may be prescribed as per Registration Of Assignment Of Receivables Rules, 2012 (herein after referred to as Rule) but these Rule still have not been brought into force and section19(4) of the Act states that Central Registry Rules, 2011 shall apply whereever required, thus we can presume that Central Registry Rules, 2011 would apply at present for registration purpose.

b. The Form I would be filled by such form shall be authenticated by authorised representative of Assignee/ Factor using a valid digital signature. c. Not filing of information is punishable by the way of penalty and the company and the person of the company who is liable to file information would be the defaulters. d. On realisation of the assigned receivables or settlement of the claim against the debtors, the factor shall file satisfaction of the assignment of receivables in its favour in Form II which Factoring Regulation Act, 2011 throws obligation on NBFC shall be authenticated by a person specified in the form for such purpose by use of a valid digital signature. Test of Section 19 of the Act The take a look at of section nineteen is that the assignment of the receivables need to be within the favour of the factor because the section uses the words assignment of assets in his favour, that means that solely those assignments which might be within the favour of the issue would need to be filed with the central registry to be registered. Another take a look at of section nineteen factoring test of engaged within the business of factoring. Section 2(i) of the Act defines issue to be an authorized Non Banking money Company (herein when referred as NBFC) or body company established below associate Act of Parliament or any State legislature or any Bank or any company registered below the businesses Act, 1956 who all are engaged within the business of factoring. Liability below the enforced Sections It shall be the duty of the factor to file before the central registry for registration purpose for all those assignment transactions that square measure within the favour of the issue and it shall not be the duty of the party to file the data for registration. The issue shall even have to file for registration once the allotted assets are realized or the claim has been settled against the debtors because the language employed by section nineteen is that factor shall file satisfaction of the assignment of assets in its favour each issue is mandatorily prone to file the dealing of assignment for registration purpose before the central written account as section nineteen uses the words shall file, creating it obligatory on the a part of the factor to file the data for registration factoring Regulation Act, 2011 throws obligation on NBFC

On default of filing of the assignment of assets the parties accountable would be answerable for penalty obtain the approach of fine however the assignment wouldn't be cancelled for non-filing for registration process. Implication on Non Banking financial Companies:All those NBFC whose primary business is being engaged within the business of factoring shall be the paradigm of section nineteen of the Act, because the section nineteen uses the words factor shall file, for the needs of registration, the particulars of each dealing of assignment of assets in his favour and section 2(i) states issue would mean a NBFC that is engaged within the business of factorisation. therefore all those NBFC engaged within the business of factorisation would need to file for registration the dealing of assignment that is within their favour Filing of knowledge for registration of assignment of any sort of assets that is due in the favour of the issue and once the due has been realized has been created obligatory on the a part of NBFC. The assignment of assets doesn't become in-valid as a result of the explanation of non-filing for registration before the Central Registrar as Section twenty one of the Act of imposes penalty by the approach of fine on non-filing . The registration method has been created obligatory as section nineteen uses the word shall file and any default in filing shall be punishable not just for the corporate except for each officer of the company is in default. therefore creating not solely the NBFC however each officer of the NBFC UN agency is liable for filing of the data for registration would be created liable for default of non-filing and therefore the default of non-filing is punishable by the approach of fine which can be 5 thousand rupees for each day the default continues The information relating to the assignment of assets has got to be filed for registration as per the Registration of Assignment of assets Rules, 2012 (rules) and rule four states that

assignment for assets would be registered within the manner a interest is registered and same rules would apply because it applies for interest.If we analyse the form by which the filing of information is to be made, i.e. Form I, we would see that the authority is asking for the:a. Financial details of the assignment. b. Is the assignment absolute without recourse to the assignor?

c. The description of document by which the receivables are assigned d. Particulars of the principal terms and conditions of the assignment agreement Thus the central registry is trying to keep a check on as to what are and how the assignment is being done and thus by this process the central authority is keeping a check on the way the assignment of receivables is done and it also gives the power to persons to go and check the details of the assignment and thus Act is trying to bring a process of truth and fairness in the process which would give the companies a chance to see whether the details are true or not and it is also putting the information of assignment in public domain. Thus NBFC have to now file the information and register making the information open for tested. Banks Exposure to NBFCs In the context of the recent global crisis, it was observed that undue reliance on borrowed funds can be a source of risk and a more stable retail base of deposits are good for both the bottom line and resilience of the financial institutions. In that context, analysis of liabilities side of the balance sheets of NBFCs14(14 NBFC-NDs do not raise public deposits.) revealed that the major sources of finance are public deposits, debentures, borrowings, commercial papers and inter-corporate loans. Liabilities of the consolidated balance sheets of NBFCs revealed that borrowings constitute the largest size of liabilities, even for the deposit taking NBFCs; corresponding to this, the size of public deposits are very miniscule as pointed out earlier. The consolidated balance sheets of NBFCs (both the categories i.e., deposit taking and nondeposit taking and systemically important companies) revealed that more than 68 per cent of the consolidated balance sheet constitutes borrowings. Out of which, 30 per cent resources are borrowed from banks and financial institutions as at the end of March 2011. These borrowings are in the forms of direct advances and loans (both secured and unsecured). These apart, borrowings by way of debentures issued by the NBFCs constituted around 33 per cent and of which a sizable portion is subscribed by the banking system. Both of these are on the rise over a period (Chart 3). It is intriguing to note that the total size of the balance sheet of NBFCs-ND-SI reached to Rs. 7,30,366 crore as at the end of March 2011, from Rs.1,70,957 crore as at the end of March scrutiny and to be

2005 growing more than four fold. It is even more interesting to note that the NBFCs-D which is a better regulated segment vis--vis NBFC-ND-SI makes up to just around 14 per cent of the latter. In other words, the systemically important non-deposit taking NBFCs have grown faster by nearly 7 fold as at the end of March 2011 when compared with the size of deposit taking NBFCs. As NBFC-ND-SI companies are not permitted to raise public deposits, borrowings constitute the major component of their liabilities at around 74 per cent by end of March 2005. This proportion got mellowed down to around 65 per cent by endMarch 2009 reflecting subtle effect of the global crisis and the aftermath, as there was no direct impact on the Indian financial system. However, this proportion gone up to 69 per cent by end of March 2011. From the point of view of systemic interconnectedness, it is important to examine the proportion of loans and advances from the banks and financial institutions to total borrowings, accordingly it constituted 25 per cent of the total borrowings (both secured and unsecured) of NBFCs-ND-SI by end-June 2010 (Chart 5) which increased to 30 per cent by end-March 2011. These are direct borrowings in the form of loans and advances from the banks and FIs. Besides, indirectly, even assuming that major portion of the debentures, securitised debts and CPs issued by NBFCs are subscribed by the banking system, this portion alone forms another 30 to 35 per cent of the total borrowings. Thus in any case, the large chunks of resources are coming from the banking system to NBFCs. The argument therefore, is to put more checks and balances on the banking systems exposures to NBFCs. To be precise, this is aimed to avoid any serious systemic consequences if either side of the institutions show some symptoms of trouble. To put more specific question; is there a corrective mechanism before it builds up a system level crisis. If there are any trouble among the NBFCs-ND-SI, there is a possibility to spill over to the banking system and also the mutual funds and thereby to the rest of the financial system, especially as the banks are largely based with the short term deposits, while the NBFCs, in general, are known for the medium to long term financing and high risk taking activities. Ceteris Paribus, it has the implications for mis-matches in the assets-liabilities of NBFCs, though this is subject to more detailed analysis of the maturity pattern of the assets and liabilities buckets18(18 The detailed analysis of ALM statement is beyond the scope of this study due to paucity of disaggregated data.). Further, it may be cited that it is possible for an NBFC to conduct some other non financial activity by deploying funds in non-financial assets (RBI, 2011). Similar views have also been expressed by the Report of the recent Working Group on Issues and Concerns in the NBFCs Sector (Chairperson: Usha Thorat, 2011). Therefore, it calls for introspection for the regulators whether it is sufficient to fix a ceiling from the banks level. As a long term

remedy, efforts need to be in the development of private bond market as that would serve better for diversifying the sources of funds for NBFCs.

It has to be underlined that higher dependency of NBFCs on the banking system for his or her resources won't solely strain banks at the time of crisis however additionally place NBFCs themselves into vulnerable state of affairs. For, there area unit potentialities that banks will become over sensitive to a economic condition or impending crisis and that they will either become too reluctant to lend to NBFCs or at the intense case, they'll fully refrain from lending to NBFCs which might any precipitate the situation, particularly once NBFCs area unit in dire want of funds. The recent international crisis may be a pointer during this direction. Further, this kind of state of affairs would compel NBFCs to show to securities industry with higher prices to wade over the tight liquidity conditions impacting the cash market likewise. it should even be noticed that a major portion of their funds are being funded by the mutual funds (RBI, 2010A). Even here similar things area unit possible: NBFCs were stressed as bank loans to them had dried up and interest rates had inflated in cash markets, resulting in higher costs of borrowing (RBI, 2010). It may be noticed that NBFCs are having exposures to industry as they keep their funds within the style of fastened deposits, albeit it constitutes comparatively a smaller proportion of say eleven to twelve per cent of their total assets.It may be pointed out that NBFCs are also having exposures to banking system as they keep their funds in the form of fixed

deposits, albeit it constitutes relatively a smaller proportion of say 11 to 12 per cent of their total assets. Even if NBFCs are not deposit taking and therefore, the question of repayment commitment of the depositors money does not arise, any failure of even such institutions will result in the losses that will ultimately have a cascading effect on the entire system, therefore all the institutions should come under closer scrutiny. The underlying principle to regulate these NBFCs are to regulate similar risks in a similar manner irrespective of whether they take public deposits or otherwise. Presently, the definition of systemically important is predicated solely on the dimensions of assets of NBFCs and this appears to be inadequate and extremely simple. the dimensions of liabilities/assets alone isn't a enough condition for the general importance. this needs refinement by taking under consideration the complex inter-connectedness (both organically and financially) with the remainder of the establishments at intervals the economic system and conjointly abroad, since complex connectedness will increase the general risk. for example, a recent report from money Stability Board got wind that besides the dimensions, the degree of inter-connectedness, the degree of substitutability of the activities undertaken by the establishment ar to be taken under consideration to benchmark an establishment as systemically important. the kinds of endeavor similarly because the quality of the activity of the establishments also are necessary for redefining the systemic importance. Thomson (2009) suggested for regulatory attention to deal with the four Cs (Contagion, Concentration, Correlation and Context or Condition) to identify the institutions which are systemically important. According to him, contagion refers to failure of institution which has the potential of transmitting to other institutions/ market. Concentration refers to the size and substitutability aspects of a particular institution in the system. Correlation refers to (i) institution take on risks that are highly correlated with other institutions and (ii) potential for largely uncorrelated risk exposures to become highly correlated in periods of financial stress. It is also known as the too many to fail problem. Condition/ context, of course, refer to the judgment of a particular context or situation in which an institution becomes systemically important. It also refers to the probability that economic or financial conditions if materialise that produce the state of nature where a firm becomes systemically important.

Although banks and NBFCs compete for similar kinds of business on the assets side, NBFCs distinguish themselves by offering wide range of products/ services such as leasing and hirepurchase, financing of used commercial vehicles, corporate loans, investment in nonconvertible debentures, IPO funding, margin funding, small ticket loans, venture capital, equity and debt investments, etc. In most of these areas either banks are reluctant to finance or finance to a very limited extent. Since the regulatory and cost-incentive structures are not identical for banks and NBFCs and that NBFCs borrow funds from banks to on-lend, it is necessary to establish adequate checks and balances to ensure that the banks depositors are not indirectly exposed to the risks of a different cost-incentive structure. Moreover, as NBFCs are well known to venture into the areas not permitted for the banks and in such cases, large scale exposures to NBFCs tantamount to banks entering into those areas in an indirect route. There was a substantial change in the risk perception in 1990s, world over, about the nonbanking financial activities. This was one of the strong reasons for the passage of Graham Leach Bliley (GLB) Act in the US which till then separated the traditional banking from the modern day financial activities under the erstwhile Glass Steagall Act. With the passage of GLB Act, banks were permitted to pursue financial activities in the form of universal banking framework. Accordingly, the non-banking financial activities also amplified multi-fold in the US during the post GLB Act. However, the global financial crisis has proved the fact that greater risks to banks particularly came in newer forms of non-banking activities such as sponsoring of securitisation SPVs and private pools of capitals (RBI, 2011). In that context, the banking sector will be affected with growing interconnectedness with non-banking business, in case NBFCs continued to have less than par regulation and supervision with that of banks. This is not to advocate that NBFCs borrowings from banks per se will result in crisis, it is only intended to caution that excess dependency on banking sector will only exasperate if a crisis like situation arises. In view of the above, the work is also underway on structural methodologies to identify systemic importance at the IMF, the BIS and the national central banks and academia based on inputs capturing size, probabilities of failure, similarities in exposures and interconnectedness (FSB, 2011). Experiences of Select Countries: Banks Exposures to NBFCs

It is significant to note that the practice of NBFCs borrowing from banking system is not uncommon in many countries. A survey of select countries experience revealed that the NBFCs in general are relying on the banking system for their source of funds to a great extent. In Bangladesh, for instance, NBFCs collect funds from a wide range of sources including borrowings from banks, financial institutions, insurance companies and international agencies as well as deposits from other institutions and the public. Incidentally, line of credit from banks constitutes the major portion of total funds for NBFCs in that country. Deposit from public is another important source of fund for NBFIs, which is stated to be increasing over the years. NBFIs are allowed to take deposits directly from the public as well as institutions. Just as the case of India, there are regulatory restrictions for the NBFIs to collect public deposits with less than one year. In Bangladesh, a study by Ahmed et al. (2007) (Ahmed Md. Nehal and Mainul Islam Chowdhury (2007): Non-bank Financial Institutions in Bangladesh: An Analytical Review,Working Paper Series No 0709, Policy Analysis Unit, Dhaka, Bangladesh.)pointed out that there is evident that loan from bank and deposit base are the key sources for NBFIs fund and account for nearly 75 per cent of the total. At the same time over the period bank loans as the main source of funds is decreasing, while the importance deposit base is gaining momentum. NBFIs have to offer higher rates on deposits due to competition from banks to attract deposits and such high cost of fund for NBFIs compel them to operate on a relatively low profit margin. Similarly it was observed from the analysis that in several other countries such as Indonesia, Thailand etc. similar kind of interconnectivity between banks and NBFCs were found with higher exposures to NBFCs.

Banks Exposure to Deposit taking NBFCs-D For the deposit taking NBFCs, it is significant to note that, the proportion of public deposits outstanding is reduced to just around 3.8 per cent of their total liabilities as at the end of March 2011 from 20.9 per cent as at the end-March 2001. With tightening of the prudential regulatory norms in respect of deposit taking companies, NBFCs zest to raise public deposits seems to be fading, and the public deposit is increasingly being substituted with their reliance on other forms of sources, viz., mainly borrowings. A closer analysis of the sources of funds revealed that their total borrowings as at the end of March 2009 constituted as much as 72.5 per cent of their total liabilities (which increased from 31.8 per cent as at the end of March 2001), which came down to 66.2 per cent by end-March 2011. Understandably, borrowings are mainly from within the financial system, viz., banks and financial institutions (nearly half of the total borrowings), which besides showing the close financial inter-connectedness within the financial system, also underscores higher systemic risks of the financial system in certain extreme circumstances (Table 3 and Chart 4). Table 3 : Key Liabilities of Deposit taking NBFCs@ (end-March) (per cent to total) Liabilities Paid up Capital Reserves & Surplus 2001 4.18 2002 2003 5.46 7.58 2004 7.11 2005 2006 6.22 4.83 2007 4.67 2008 4.38 2009 2010 4.95 4.13 2011p 3.46 12.81

11.79 10.48 12.58 13.48 11.39 14.87 12.07 11.66 12.20 12.93

Public Deposit Borrowings Other Liabilities Total Liabilities(Rs.crore)

20.90 15.06 13.35 13.18 10.77

6.47

4.28

2.74

2.56

3.00

3.90 66.22 13.70

31.85 45.23 58.54 63.66 64.01 65.94 66.84 67.83 72.47 68.00 31.27 23.76 1.56 2.58 7.07 7.90 12.14 13.39 7.82 11.92

25,604 29,895 26,355 32,754 36,003 37,828 48,554 74,562 77,128 94,212 1,05,431

P: Provisional @: Excluding Residuary Non-Banking Financial Companies (RNBCs) Source: Authors calculation based on Data from Report on Trend and Progress of Banking in India, various volumes, RBI It is clear that the banking system is the major source of funding for NBFCs, both directly and indirectly, though banks have been prescribed with prudential ceiling on their exposures to the NBFCs. Till recently, banks had the incentive for lending to NBFCs as such loans were permitted to be classified as priority sector lending by the banks15(15 Recently, the regulator had clarified that bank loans to NBFCs, other than to such MFIs which fulfilled certain recently introduced eligibility conditions, would not be eligible to be classified as priority sector loans.). Incidentally, NBFCs are the major issuers in CPs segment which was as high as 62 per cent of the market size of Rs. 44,171 crore at end-March 2009 this share, however, came down to around 48 per cent in a market size of Rs. 1,23,400 crore by end-June 201116
16

Relates to the outstanding position by mid-June 2011.).

This kind of high dependability of NBFCs on the banking system would mean systemic vulnerability in the context that NBFCs are involved in higher risk activities vis--vis the banking system. For instance, NBFCs do not have any exposure limit on their capital market related activities unlike the banking system. Moreover compared with regulation of banking sector, NBFCs in general, are less stringently regulated as pointed out by various Committees and Working Groups. However, it needs to be underlined that there has been substantial progress over the period towards bringing the regulatory norms relating to NBFCs on par with the banking system. Nevertheless, it needs to be underlined that, the protective cover available for the depositors of banks through the Deposit Insurance and Credit Guarantee Corporation (DICGC) are also absent for the depositors of NBFCs-D. The seriousness of high financial interconnectedness/ interdependencies was also highlighted by the Financial Stability Report of RBI (2010). The report stated that immediately after the

Lehman Brothers collapse, NBFCs faced with the pressure of withdrawal from the mutual funds which subscribed to the short term NBFC debt were unable to either rollover or extend further credit and this created a liquidity crisis. This type of situation would have thrown the system out of gear had not the Reserve Bank of India, being the lender of last resort, and the Government taken appropriate liquidity support measures.

The higher borrowings of NBFCs, especially from the banking system raise some concerns about their liquidity position. More so, if such reliance happens to increase further. Incidentally, as can be seen from the Chart 4, the banking systems exposure to NBFCs-D has considerably increased over the years. These concerns will be further accentuated in case the banks own liquidity position becomes tight at the time of crisis or even at crisis like situation. Analysing the sectoral deployment of credit by the banking system also revealed the fact that their lending to NBFCs have been on the consistent increase from 2007 to 2011 from around 2.75 per cent in May 2007 to 4.80 per cent by March 2011 confirming NBFCs reliance on the banking system for their major chunk of funds. Though this percentage is apparently smaller, any failure or crisis at few NBFCs can still have its implications. Incidentally, it may be worth being pointed out that the mutual funds also have a sizable exposures to NBFCs by subscribing to instruments, viz., debentures, CPs and securitised debts issued by the NBFCs. Accordingly, at the end of October 2010 mutual funds exposure

accounted around 16.6 per cent of the total exposures to debt related instruments and it came down to 11.8 per cent by end-March 2011. Non-Deposit taking Systemically Important NBFCs (NBFCs-ND-SI) In India, as pointed out earlier, among the non-deposit taking NBFCs, the large NBFCs with Rs. 100 crore and above assets size17(17 Till September 2005 these NBFCs were classified with an asset size of Rs.500 crore and above.) have been classified as systemically important financial institutions (NBFC-ND-SI). As these NBFCs are not raising resources by way of public deposits, they are regulated with fewer rigors compared with NBFCs-D. Even this type of reclassification of NBFC-ND-SI came into existence since mid-2006 although, the Reserve Bank has initiated measures effective 2000 to reduce the scope of regulatory arbitrage between banks, NBFCs-D and NBFCs-ND (RBI, 2008) recognising their importance, essentially from the systemic stability point of view. With the recent happening of global financial crisis and aftermath, the regulators attention world over has received increased attention towards the systemically important financial institutions (SIFIs). Even in the case of India, the extant prudential regulation of NBFCs-NDSI are endeavoured to bring convergence with that of the deposit taking NBFCs. Accordingly, it is advisable to introduce the return relating to balance sheets on a monthly basis and a more detailed returns encompassing the whole operations of the companies on completion of their annual accounts, as against the quarterly, half yearly annual returns to be filed by the deposit taking NBFCs. It is also worth being pointed out that there are also NBFCs-ND with assets size of less than Rs. 100 crore which are further classified into NBFCs-ND with asset size of Rs 50 crore and above but less than Rs. 100 crore, in respect of which monitoring is done only with respect to their assets size. The other smaller NBFCs are outside the purview of the Reserve Banks regulatory and supervisory ambit.