CAFRAL Raises Concerns Over NBFC and Digital Lending Practices

• 13 Nov 2023

For Prelims: Reserve Bank of India, Non-Banking Finance Companies, Centre for Advanced Financial Research and Learning, Monetary policy, Companies Act, 1956, Deposit Insurance and Credit Guarantee Corporation

For Mains: Burning Issues Related to Banking Sector, Difference in NBFC and Banks. 

Source: IE

Why in News? 

The Centre for Advanced Financial Research and Learning (CAFRAL), a research body set up by the Reserve Bank of India (RBI), has highlighted a growing risk in bank financing for Non-Banking Finance Companies (NBFCs) and identifies potential dangers in the digital lending landscape. 

• Also, CAFRAL also warned about fake/illegitimate lending apps gathering personal data, posing potential misuse and safety risks for users.

What are the Major Concerns Raised by CAFRAL? 

• Interdependency Risks in NBFC Sector: 
  
  • CAFRAL observed that banks mostly lend to bigger NBFCs, leading to increased cross-lending within the NBFC sector. 
    • This creates a network of inter-dependencies and contagion channels that can amplify shocks and transmit them across the system.
  • For example, the default of IL&FS in 2018 and DHFL collapse in June 2019, triggered a liquidity crisis and a loss of confidence in the NBFC sector, affecting the asset quality and profitability of banks that had lent to them.
• Impact of Contractionary Monetary Policy on NBFCs:
  • CAFRAL also found that contractionary monetary policy leads to risk build-up in NBFCs’ portfolios. 
  • When the RBI tightens the policy rate, NBFCs face higher borrowing costs and lower profitability. 
    • To maintain their margins, they tend to shift their lending to riskier segments such as unsecured loans, subprime borrowers, etc. They also increase their exposure to capital markets by investing in equities and mutual funds. 
    • These strategies expose them to higher credit risk, market risk, and liquidity risk, which can affect their solvency and stability.
• Warnings About Illicit Lending Apps and Fintech Impact:
  • It also warns about fake/illegal digital lending apps, pretending to be legitimate and gathering personal data for potential misuse. 
  • Users can not easily verify the legality of these apps. There are concerns about potential losses from online lending affecting traditional banking if linkages between these sectors grow stronger. 
    • These apps often request extensive personal information, posing risks to consumer safety and privacy, although some data may be genuinely necessary.
    • FinTech has increased product diversity, with around 1100 lending apps available for Indian Android users across 80 app stores.

Note: Digital lending refers to the process of providing loans or credit to individuals or businesses through online platforms or digital channels without the need for traditional physical documentation or in-person interactions. 

What are NBFCs? 

• About: 
  • An NBFC, registered under the Companies Act, 1956, engages in various financial activities such as loans, investments in securities, leasing, insurance.
  • It excludes institutions whose primary business falls under agriculture, industry, goods trading, services, or immovable property trading.
• Criteria: 
  • When over 50% of a company's assets are financial assets and more than 50% of its income is derived from these financial assets, it indicates the company's primary involvement in financial activities. 
    • Companies meeting both criteria are registered as NBFCs by the RBI.
    • The Reserve Bank has been given the powers under the RBI Act 1934 to register, lay down policy, issue directions, inspect, regulate, supervise and exercise surveillance over these NBFCs.

Note: Companies primarily engaged in areas like agriculture, industry, goods trading, services, or real estate would not be regulated by the RBI, even if they conduct some financial activities. This exclusion is determined using the '50-50 test'.

• Exemptions From Registration with RBI: 
  • Under Section 45-IA of the RBI Act, 1934, an NBFC must obtain a registration certificate from the RBI and maintain Net Owned Funds of ₹25 lakhs (₹Two crore since April 1999) to operate as a non-banking financial institution. 
  • However, certain categories of NBFCs regulated by other authorities, such as SEBI-registered Venture Capital Funds, Merchant Banking, and Stock broking companies, are exempt from RBI registration. 
• Difference in NBFC and Banks: 
  • NBFCs are restricted from accepting demand deposits from the public, unlike banks, which commonly accept these types of deposits that can be withdrawn on demand without prior notice.
  • Unlike banks, NBFCs do not form part of the payment and settlement system. They are unable to issue cheques drawn on themselves, a standard practice offered by banks.
  • Unlike banks, the deposit insurance facility provided by institutions like the Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs. 
    • In case of bank failures, this insurance offers protection to depositors, but it does not extend to NBFC depositors.
• Funding: 
  • NBFCs primarily finance their operations through a mix of market borrowing and bank loans. 

Way Forward

• Monitoring the Inter-linkages and Spillovers: The RBI and other regulators need to strengthen monitoring the inter-linkages and spillovers between NBFCs and banks, as well as within the NBFC sector, using various tools such as network analysis, stress testing, early warning indicators, etc. 
  • They also need to coordinate and cooperate with each other to ensure effective information sharing and crisis management.
• Risk Management and Governance: Strengthening risk management practices to identify, assess, and mitigate potential risks in NBFCs effectively.
  • Enhancing corporate governance and regulatory oversight to ensure sound decision-making and transparency.
    
• Regulatory Surveillance of Digital Lending: Strengthening regulatory oversight over digital lending applications to ensure compliance with consumer protection laws and data privacy regulations.
  • Implementing clear guidelines to verify the legality and authenticity of lending apps.

UPSC Civil Services Examination, Previous Year Question (PYQ)

Prelims

Q. With reference to the Non-banking Financial Companies (NBFCs) in India, consider the following statements: (2010)

1. They cannot engage in the acquisition of securities issued by the government.
2. They cannot accept demand deposits like Savings Account.

Which of the statements given above is/are correct?

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

Ans: (b)