Address by S.P.

Talwar Deputy Governor Reserve

Bank of India at Round Table on "The Role and
Regulation of NBFCs"

Address by S.P. Talwar Deputy Governor Reserve Bank of India at Round Table on "The Role
and Regulation of NBFCs" Organised by The Associated Chambers of Commerce & Industry of
India, New Delhi on August 20, 1997

"The Role and Regulation of NBFCs"

1. The Indian economy is going through a period of rapid `financial isation'. Today, the
`intermediation' is being conducted by a wide range of financial institution through
plethora of customer friendly financial products. The segment consisting of Non-Banking
Financial Companies (NBFCs), such as equipment leasing/hire purchase finance
companies, have made great strides in recent years and are meeting the diverse financial
needs of the economy. In this process, they have influenced the direction of savings and
investment. The resultant capital formation is important for our economic growth and
development. Thus, from both the macro economic perspective and the structure of the
Indian financial system, the role of NBFCs has become increasing ly important. It is
interesting to note that as at the end of March 1996 the regulated deposits (deposits
which RBI regulates) of 10194 NBFCs amounted to Rs.45,439 crore. The borrowing of
these companies stood at Rs.62,995 crore. One of the most impor tant component of
these deposits/ borrowings is deposits from public in which RBI is more concerned. Such
deposits stood at Rs.17,883 crore (excluding HFCs) which comes out to 4.25 per cent of
the total deposits of scheduled commercial banks.
2. The momentum of recent developments in non-banking financial sector has evinced
considerable debate. While there is a class in the industry strongly opposing the
strengthening of regulatory framework and focusing closer supervisory attention,
ostensibly in support of principle of free market, the another urging Reserve Bank to
intervene and enhance the image quotient of the industry so that a moderate level of
sustainable growth is as sured of. To appreciate and understand the present
predicament, it is better to look back to the history of the regulation of NBFCs.
3. To briefly recapitulate, the scheme of regulation of NBFCs originated in mid-sixties when
sudden upsurge in deposit mobilisation by Non-Banking Companies was noticed.
However, the focus of regulation was mainly intended to ensure that it serves as an
adjunct to monetary and credit policy and also provides an indirect protection to the
depositors. The focus continued to be the same till early 90s. Over a period of time,
especially during late 80s and early 90s, NBFCs have penetrated into the main stream of
financial sector and have established themselves as complements of banking industry.
4. At the dawn of liberalisation era, the Narasimham Committee (1991) had broadly touched
upon the role of NBFCs in the emerging financial sector and made certain valuable
recommendations for their healthy growth. The general tone of the committee was that
these companies should be encouraged to grow with corresponding reinforcement of
regulatory and supervisory frame work. As a sequel to Narasimham Committee, Reserve
Bank had appointed a Working Group on Financial Companies (Chairman, Dr. A.C.
Shah) to make an in-depth study of the role of NBFCs and suggest regulatory and control
measures to ensure healthy growth and operation of these companies. The Committee
had made several recommendations with far reaching implications. Accepting most of the
recommendations of the Committee, Reserve Bank had considered the Report as an
Approach Document for furtherance of the NBFCs sector.
 Some of the major recommendations of the Group were relating to shift of regulatory
approach from the liability to the asset side, introduction of scheme of registration and
entry point norm with minimum net owned fund (NOF) of Rs.50 lakhs for existing/new
NBFCs, issue of prudential norms for income recognition, provisioning, capital adequacy
etc., and amendments to RBI Act, 1934 giving enhanced power to RBI for better
regulation of NBFCs. The recommendations of the committee were implemented in a
phased manner. While the scheme of registration was introduced in April 1993 for all
NBFCs having NOF of Rs.50 lakhs and above, prudential norms/ guidelines were issued
in June 1994 for all registered NBFCs. These norms were more in the nature of guide
lines which were not mandatory in the absence of necessary statutory powers.
Subsequent to this, in April 1995, underscoring the importance of setting out a effective
supervisory frame work, an expert group under the Chairmanship of Shri P.R. Khanna,
Member of the Advisory Council for the Board for Financial Supervision was appointed to
design an effective and comprehensive supervisory framework for NBFC sector. Most of
the recommendations of the Committee have been accepted and a supervisory
framework comprising on-site inspection for bigger companies and off-site surveillance
system for other companies has been designed and the same is being implemented in a
phased manner.

5. As mentioned earlier, since mid 60s legislative frame work was structured mainly to
regulate the deposit acceptance activities of NBFCs. However, in the changed scenario
and in the light of the recommendation of the Shah Working Group so also the
observations of the Joint Parliamentary Committee a comprehensive draft legislation was
prepared in 1994 which however, required exten 73 sive discussion with Ministry of
Finance and Law. Finally, an Ordinance was promulgated by the Government in January
1997, effecting comprehensive changes in the provisions of RBI Act. The ordinance has
since been replaced by an Act in March 1997. The amended Act, among other things,
provide for entry point norm of a minimum NOF of Rs.25 lakhs (eventhough the
Ordinance provided for the minimum limit at Rs.50 lakhs) and mandatory registration for
new NBFCs for commencing business, maintenance of liquid asset ranging from 5 to 25
per cent of deposit liabilities, creation of reserve fund by transferring not less than 20 per
cent of the net profit every year, power to the Bank to issue directions relating to
prudential norms, capital adequacy, deployment of funds, etc. power to issue prohibitory
order and filing of winding-up petition for non-compliance of Directions/Act. The above
legislative changes would enable Reserve Bank to better regulate the NBFCs.
6. While the amendments have been mostly welcomed by the industry and the others
concerned, it was alleged by a section of people that the amendments are reflection of
RBI's expansionist attitude which would negate the true spirits of the current liberalisation
programme. For a more complete understanding, one should keep in mind that economic
liberalisation is about bringing market closer to the participants so that they have the
freedom to make econom ic decisions. Obviously, this means better regulatory
interference. A well functioning market does not suddenly emerge devoid of deliberate
acts of the Regulators. Many economic historians have noted a complex interaction
between State regulation and growth of the market as an institution. One of them, Karl
Polyani called it a `double-movement'. To simply state "every time the market widens its
scope of operation, new regulations by the State are needed to make the market function
well. Such double movement is a complex process of adaptive interaction where both
must learn to co-operate." Therefore, the legislative changes should be seen as a
conscientious act of regulatory response. In fact, this response emerged with an intention
to act as facilita tor for the industry which has established itself in the emerging market
and surely not as an overkill. Moreover, the changes have the following objectives;
i. to ensure healthy growth of NBFC sector;
ii. to ensure that they function on prudential lines;
iii. to quickly remove bad ones in the industry to avoid contamination effect through
regulatory intervention
7. Another dimension to the legislative changes is the presence of heterogeneous and
some time questionable accounting practices being followed by NBFCs and the
imperative need to bring uniform ity in the accounting practices which would enable inter-
firm and inter-industry comparison. It is beyond doubt that a well knit accounting practices
in conformity with international standards are a pre-requisite to repose faith in the
industry. There are several instances where NBFCs have capitalised from the absence or
inadequacies of the standard accounting practices. One such example is `Leasing'. It is
commonly noticed that `Leasing' route has been used mainly as a tool for deferring tax
liability. The sale and lease back transaction was rampant supposedly on the items of
100 per cent depreciable category, which has prompted Government to come out with
amendments to I.T. Act recently.
8. In the light of the amendments and also in the backdrop of recent developments relating
to CRB Capital Market Ltd, several policy changes have been introduced/being
contemplated. The major highlights of the changes are as follows :
a. In order to enhance financial soundness by ensuring a moder ate level of liquidity
in the companies' asset portfolio and also as a measure of in-built protection to
the depositors, the percentage of liquid assets has been increased in a phased
manner to 12.5 per cent and 15 per cent with effect from January 1, and April 1,
1998 for Equipment Leasing & Hire Purchase Finance Companies, Loan &
Investment Companies (registered under the earlier scheme). There were also
some disquieting practices among NBFCs e.g. creating encumbrance on the
SLR securities and thereby defaulting in meeting the liquidity requirement. As this
practice jeopardises the interest of depositors/investors, it has been decided that
NBFCs should entrust the securities to one of the scheduled commercial banks
at the place where the registered office of the company is located. These
securities are allowed to be withdrawn only for repayment of deposits or for
substitution or in case of reduction in the deposit.
b. After the issue of prudential norms in June 1994, it was observed that some of
the norms were subjected to various interpretation by different NBFCs leading to
non-compliance with the requirements. With a view to removing doubts as also to
rationalise the same in the light of recent developments, the prudential norms are
being reissued under the appropriate powers vested with Reserve Bank. Pending
registration, the norms are being made applicable to all NBFCs with NOF of
Rs.25 lakhs and above. Furthermore, having regard to risk profile of NBFCs, the
capital adequacy ratio is being proposed to be raised in a phased manner to 10
per cent and 12 per cent to be achieved by end March 1998 and 1999,
respectively.
c. It was also observed in the recent past that certain NBFCs were not disclosing
the provisioning made for non-performing assets and for diminution in the value
of investments in the financial statements prepared by the concerned NBFCs.
With a view to making NBFCs' financial statements more transparent, it is being
proposed that they have to disclose the provisions made in the financial
statement under appropriate heads.
d. In our perception, non-banking financial sector will be vibrant and shock proof
only if its constituents are sound, strong, agile and amenable to market discipline.
Accordingly it is only natural that a more liberal leveraging capacity can be
sustained only by well performing companies. Of course, a holistic view will be
taken on the level of performance of a company which normally would include
compliance with prudential norms with emphasis on capital adequacy and
exposure norms, other directions relating to deposit acceptance and obtention of
specified credit rating etc. Needless to mention that there will be continuous vigil
on the companies which enjoy the increased freedom, especially the bigger
NBFCs in terms of out-side liabilities, so as to minimise any systemic risk.
Afterall, freedom given should necessarily be utilised for the betterment of the
NBFC and the industry. Let it not be frittered away by the industry in their anxiety
to make quick profits.
 e. In the backdrop of recent legislative changes, several trade bodies have
represented to Reserve Bank to consider giving a separate dispensation for
closely-held investment companies. The principal reason adduced is that these
companies in essence are not doing any financial intermediation including trading
in stocks as such but only functioning as vehicle for holding shares of other group
companies for strategic reasons. They have also mentioned that such companies
are not accepting deposits from public. There appears to be some merit and the
issue is under active consideration of Reserve Bank. However, I urge the
industry to bring down the multiplicity of NBFCs belonging to same group through
the route of merger and acquisition. This would go a long way in enabling
regulators to read the pulse of the industry near to the perfection. Of course, this
also helps in arriving at the number of serious players in the market.
f. Norms for classification of NBFCs into various categories are also being revised
and accordingly only those NBFCs whose assets and income constitute 60 per
cent or more of their total assets and income will be recognised as EL/HP finance
companies. The existing EL/HP finance companies will be given time to meet this
new requirement. I may also mention that there were demands from certain
section to do away with the system of classification of NBFCs into various
categories. It should be appreciated that the classification is done on the basis of
principal business and it is very much necessary to differentiate NBFCs for
setting out discriminatory dispensation.
9. In pursuance of the requirements under recent legislative amendments, w.e.f. 9th
January, 1997, no NBFC shall commence or carry on financial activity without
obtaining/applying for a Certificate of Registration from/to the Reserve Bank. The industry
has promptly responded to the legal requirement and around 37,500 applications have
been received before the dead line. Out of this, from a preliminary quick scrutiny it is
found that only around 8300 NBFCs were having threshold limit of NOF of Rs. 25 lakhs
and above. The onerous task of issuing Certificate of Registration is being attended to on
war footing. In terms of the provisions of the Act, Reserve Bank among other things is
required to satisfy that ;
. the NBFC is in a position to pay its depositors when claim accrue;
i. the general character of the management of the NBFC is not prejudicial to the
interest of the depositors/public;
ii. it has adequate capital structure and earning prospects;
iii. any other condition specified by Reserve Bank.
10. Having regard to the huge number of applications to be processed, it is proposed to
utilise the services of Chartered Accountants as a one time exercise for conducting
special audit of applicant companies and to help RBI in determining the suitability for
issue of Certificate of Registration. I hasten to add that, those existing NBFCs which have
failed to submit their application for certificate should stop functioning as NBFCs forthwith
or else face the stringent penal provisions of the Act. Once the checks and balances are
put in place in pursuance to the amended provisions of the Act, we are sure that
companies with poor record of recovery, weak financials, large exposures to the group
companies and following unethical practices will find it hard to escape the rigours of
regulations.
11. With a view to setting out a foolproof disclosure standards by removing the shortcomings
in the existing reporting formats of Balance Sheet and Profit and Loss Account, as
prescribed under the Companies Act, 1956, an in-house study group has been
constituted with members from the Institute of Chartered Accountants of India. The
formats of the financial statements when reviewed, is expected to make the affairs of an
NBFC more transparent.
12. Another important point I wish to highlight is the role of Statutory Auditors in certification
of financial statements and other documents of NBFCs. Some instances have come to
our notice where the assets and investments shown in the Balance Sheet were not truely
reflective of the existence of actual assets. Obviously, in such cases, the concerned
statutory auditors should have qualified the Balance Sheet. Therefore, there is an urgent
 need for the accounting profession to be more responsible. We foresee that in the post
amendment period the `financial audit' should converge into a more broad based
`management audit'.
13. While Reserve Bank is gearing itself to take on the increased regulatory responsibility, at
the same time I urge upon the industry to appreciate the increasing need for promoting
Self Regulating Organizations(SROs) especially in the light of divergent nature and
heterogeneous practices of NBFCs. Such Organisation can effectively function as
channel of communication be tween the regulators and the industry. Besides, these
SROs can also bring in peer pressure on the members so that they adhere to fair
business practices.
14. In the recent past, the role of credit rating agencies in assessing the debt servicing
capacity of NBFCs has assumed much importance. The agencies which have since
come out of their infancy are required to establish themselves with more credible
assessment of their clients. This would go a long-way in enabling the investors and the
regulators to place more reliance on the credit rating.
15. Finally, I may also call upon the investors/depositors to be more cautious while placing
their deposits especially with those companies which offer very high rates of interest.
They should note that the dictum of high interest co-exist with high risk is equally true in
case of NBFCs also.