The NBFC sector in India is facing a confluence of challenges in 2024, creating a perfect storm that includes consolidation efforts, intensified capital raising endeavors, and mounting profitability pressures. This turbulent environment can be traced back to the IL&FS crisis of 2018, which exposed vulnerabilities in major NBFCs.

Concerned about potential spillover effects on the financial services industry, the Reserve Bank of India (RBI) has taken proactive measures by tightening regulations and intensifying scrutiny of NBFCs in recent years. These measures aim to address governance issues, strengthen risk management practices, and enhance overall supervision.

A recent RBI report highlights the Department of Supervision’s focus on examining licensing requirements for NBFCs and initiating supervisory actions against non-compliant entities in the fiscal year 2023-24. The regulatory landscape for NBFCs has undergone significant changes in the last few years, setting the stage for ongoing challenges in 2024.

New Four-Layer Regulatory Structure

The RBI has implemented a new four-layer regulatory structure for NBFCs based on their size, activity, and perceived riskiness. This structure aims to provide a more nuanced approach to regulation.

  • NBFC-Base Layer: This layer will include new-age NBFCs, especially those involved in peer-to-peer lending and account aggregation. It will also include non-deposit taking NBFCs with asset sizes below ₹ 1,000 crore and those that do not raise public funds or have direct customer interaction. The RBI intends to maintain a “light-touch” regulatory approach for this layer, focusing on transparency and good governance rather than strict financial regulations.
  • NBFC-Middle Layer: This layer will encompass important NBFCs like deposit-taking NBFCs, housing finance companies, and infrastructure financing companies. It will also include all deposit-taking NBFCs regardless of asset size and non-deposit taking NBFCs with asset sizes of ₹ 1,000 crore and above. The RBI aims to address potential areas of arbitrage between banks and NBFCs in this layer.
  • NBFC-Upper Layer: The Upper Layer will consist of NBFCs specifically identified by the RBI as warranting enhanced regulatory requirements. These NBFCs will be identified based on a scoring methodology that considers factors like size, interconnectedness, complexity, and supervisory oversight. The goal is to implement stricter regulations and more intensive supervision for these systemically important NBFCs. Additionally, mandatory stock exchange listing may be required within a specific timeframe to enhance transparency.
  • NBFC-Top Layer (Ideally Empty): This layer is intended to remain empty. However, the RBI may move specific NBFCs from the Upper Layer to the Top Layer if they are deemed to pose a significant risk to the financial system. NBFCs in the Top Layer would face the most stringent regulatory and supervisory requirements.

The implementation of this new structure began in October 2022 and is expected to bring more stability and order to the NBFC sector.

The Remaining Challenges

One notable change involves the tightening of norms related to unsecured lending portfolios of banks and NBFCs. This adjustment, prompted by indiscriminate growth in unsecured loan portfolios, particularly in personal loans and credit cards, raises risk weights by 25 basis points to 125 percent on retail loans. The implications for NBFCs are substantial, leading to higher capital allocation for underwriting unsecured loans and subsequently pressuring capital levels. Raising capital under these circumstances may impact valuations, with investors exercising caution due to the high growth in the unsecured portfolio. The potential hindrance of anticipated interest rate softening in 2024, especially in the face of geopolitical shocks, adds another layer of complexity.

Experts’ Outlook

Experts believe that NBFCs with strong risk management and good corporate governance will be best positioned for success. Technology adoption and responsible lending practices are seen as key differentiators. While the short-term may be difficult, the NBFC sector is expected to see continued growth as credit demand recovers and interest rates stabilize.