RBI’s has slashed Risk Weights on Bank Loans to NBFCs

Context: The Reserve Bank of India (RBI) has announced a 25 percentage point reduction in risk weights on bank loans to non-banking financial companies (NBFCs).

What are Risk Weights?

• Risk weights are a regulatory measure used by banks to assess the capital required to cover the risk of their loan exposures.
• The higher the risk weight, the more capital a bank needs to set aside, making lending more expensive.
• The lower the risk weight, the less capital a bank needs to hold, making loans cheaper and increasing credit flow.
• Risk Weights on NBFC Loans:
  • RBI has reduced the risk weights on bank loans to NBFCs by 25 percentage points, depending on their credit ratings.
• This move is expected to boost NBFCs’ credit flow, enabling them to lend more to retail borrowers and small businesses.

What Are NBFCs (Non Banking Financial Companies)?

• NBFCs are financial institutions that provide bank-like services but do not hold a banking license.
• They do not accept demand deposits (like savings accounts) but offer loans, asset financing, and investment services.

Types of NBFCs

• Based on Asset-Liability Structures: Deposit-taking NBFCs (NBFCs-D) and non-deposit-taking NBFCs (NBFCs-ND).
• Based on Systemic Importance: Among non-deposit-taking NBFCs, those with assets of Rs 500 crore or more are classified as non-deposit-taking systemically important NBFCs (NBFCs-ND-SI).

There are different types of NBFCs based on the activities they are engaged in. Here are some common types:

Difference between Banks & NBFCs

While both NBFCs and banks play crucial roles in the financial system, they have distinct characteristics, regulations, and functions that differentiate them from each other.

Functions of NBFCs

NBFCs play a significant role in diversifying the financial landscape by offering a wide range of services that complement traditional banking services. Here are the functions of Non-Banking Financial Companies (NBFCs):

• Financial Intermediation: NBFCs act as intermediaries between borrowers and lenders, providing various financial services without being full-fledged banks.
• Credit Provision: They offer loans and credit facilities to individuals, businesses, and sectors that might have limited access to traditional banking services.
• Investment Activities: NBFCs invest in various financial assets such as stocks, bonds, mutual funds, and other securities.
• Leasing and Hire-Purchase: They offer services like leasing and hire-purchase, allowing individuals and businesses to acquire assets without the immediate need for large upfront payments.
• Factoring and Bill Discounting: NBFCs provide factoring services where they purchase accounts receivable from businesses and provide immediate funds, helping with cash flow management.
• Insurance Services: Some NBFCs offer insurance-related services, especially in rural areas, to provide coverage to those who are underserved by traditional insurance companies.
• Foreign Exchange Services: Certain NBFCs offer forex services for individuals and businesses needing currency exchange and remittance facilities.
• Microfinance: NBFCs provide microfinance services to financially underserved sections of society, particularly in rural areas, by offering small loans and financial products.
• Advisory Services: Some NBFCs offer financial advisory services, helping clients with investment decisions, financial planning, and portfolio management.
• Mortgage Services: They provide mortgage loans, allowing individuals to buy or improve real estate properties.
• Vehicle Finance: NBFCs offer loans for purchasing vehicles, both for personal use and commercial purposes.
• Retail Financing: They provide financing for consumer goods, electronics, and other retail products through partnerships with retailers.

NBFC Registration Process

NBFC registration refers to the process by which a non-banking financial company (NBFC) obtains authorization and approval from the regulatory authority, typically the Reserve Bank of India (RBI) in India, to operate as a financial institution and provide certain financial services to the public.

The registration process involves fulfilling specific criteria, submitting required documents, meeting regulatory guidelines, and complying with financial and operational norms set by the regulatory authority. Once registered, an NBFC can legally engage in financial activities such as lending, investment, and other financial services, subject to the regulations and guidelines provided by the regulatory authority.

NBFC Regulations

NBFC regulations are a set of rules, guidelines, and norms established by regulatory authorities, such as the Reserve Bank of India (RBI) in India, to govern the functioning and operations of non-banking financial companies (NBFCs).

• Regulatory Authority: NBFC regulations are overseen by regulatory bodies like the Reserve Bank of India (RBI) in India.
• Licensing and Registration: NBFCs need to obtain proper licenses and registration from the regulatory authority to operate legally.
• Capital Adequacy: NBFCs are required to maintain a certain level of capital to ensure financial stability and solvency.
• Asset Classification: Regulations dictate how NBFCs categorize their assets and loans, ensuring transparency and risk assessment.
• Risk Management: NBFCs must have adequate risk management strategies in place to mitigate financial risks.
• Corporate Governance: Regulations focus on good governance practices, including board composition, transparency, and accountability.
• Prudential Norms: NBFCs have to follow specific norms related to lending practices, income recognition, and provisioning.
• Disclosure Requirements: NBFCs are required to disclose financial information regularly to provide transparency to investors and stakeholders.
• Interest Rates: Regulations often guide NBFCs on the maximum interest rates they can charge on loans.
• Anti-Money Laundering (AML) and KYC: NBFCs need to implement AML and Know Your Customer (KYC) policies to prevent illegal activities and ensure customer identification.

NBFC Crisis

The Infrastructure Leasing & Financial Services (IL&FS) crisis was a significant financial crisis that emerged in India in 2018. IL&FS was a major Non-Banking Financial Company (NBFC) conglomerate with involvement in various infrastructure projects and financial services. The crisis exposed weaknesses in the financial system and raised concerns about the functioning of NBFCs. The following points will demonstrate how this crisis unfolded.

• IL&FS was a conglomerate involved in financing and developing various infrastructure projects such as roads, ports, and energy. It also had subsidiaries engaged in financial services. IL&FS borrowed extensively to fund these projects, and over time, it faced difficulties in servicing its debt obligations.
• Default and Downgrade: IL&FS started defaulting on its debt repayments, triggering concerns among investors and lenders. Credit rating agencies downgraded its debt instruments, which had a cascading effect on investor confidence and liquidity.
• Contagion Effect: IL&FS had numerous subsidiaries and associate companies. As its financial troubles became apparent, worries spread to other financial institutions, including mutual funds and banks, that had exposure to IL&FS and its group entities.
• Liquidity Crunch: The crisis led to a liquidity crunch in the NBFC sector as well as in the broader financial markets. It revealed issues related to asset-liability mismatches in the NBFCs, where short-term liabilities were funded by longer-term and illiquid assets.

The Reserve Bank of India (RBI) and the government took swift action to address the crisis. The government superseded the IL&FS board and initiated an investigation into its affairs. The RBI introduced measures to provide liquidity support to the financial system, including the NBFC sector.

The crisis had implications for the broader economy, including a slowdown in credit availability, dampened investor sentiment, and concerns about the financial system’s health.

The IL&FS crisis underscored the need for regulatory reforms in the NBFC sector. The RBI introduced stricter norms for asset-liability management, governance, and risk assessment for NBFCs. It also revised the regulatory framework for rating agencies to enhance their accountability.

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