Explained | Non-Banking Financial Company

What’s in today’s article?

• Background
• What is a Non-Banking Financial Company (NBFC)?
• Financial Activities & Services Performed by NBFCs
• News Summary
• What are the RBI’s Gold Loan Norms?
• Need for Reinforcing These Norms
• How Will the RBI’s Scrutiny Affect NBFCs?

Background

• The Reserve Bank of India (RBI) earlier this month asked gold loan lenders to stick to regulatory norms while lending.
• This has been decided in a bid to tighten its grip over Non-Banking Financial Companies (NBFCs).
• The RBI has recently increased its scrutiny of NBFCs after it found certain NBFCs to be flouting regulatory norms.
• Recently, the RBI banned IIFL Finance from issuing fresh gold loans after the firm was found violating lending norms.

What is a Non-Banking Financial Company (NBFC)?

• Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956.
• It is engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority.
• Difference Between NBFCs and Banks:
  • NBFC cannot accept demand deposits;
  • NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself;
  • Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.
• Systematically Important NBFCs:
  • NBFCs whose asset size is of ₹500 crore or more are considered as systemically important NBFCs.
  • The rationale for such classification is that the activities of such NBFCs will have a bearing on the financial stability of the overall economy.

Financial Activities & Services Performed by NBFCs

• Financial Services: NBFCs offer a variety of financial services, including loans and credit facilities, asset financing, leasing, hire-purchase, investment in securities, and managing portfolios of stocks and shares.
• Credit Provision: They play a significant role in providing credit to different sectors, especially underserved markets and small-to-medium enterprises (SMEs) that might not have easy access to traditional banking services.
• Investment: NBFCs are involved in investment activities such as acquiring shares, stocks, bonds, debentures, and securities issued by the government or other market players.
• Specialized Financing: Many NBFCs focus on niche markets and specific financial products, such as microfinance, infrastructure finance, housing finance, and insurance services.
• Regulation: In India, NBFCs are regulated by the Reserve Bank of India (RBI), which sets guidelines for their operations, including capital adequacy, risk management, and governance practices.
• Role in Economy: NBFCs complement the banking sector by providing financial services to segments that are not fully served by banks. They help in deepening the financial markets and increasing financial inclusion.

News Summary

• The RBI has increased its scrutiny of NBFCs after it found certain NBFCs to be flouting regulatory norms.
• In March, the RBI banned IIFL Finance from issuing fresh gold loans after the firm was found violating lending norms.

What are the RBI’s Gold Loan Norms?

• The RBI stipulates lenders to comply with certain norms while lending money in lieu of gold.
• For instance, lenders are not allowed to lend any amount of money that is greater than 75% of the value of the gold that is submitted as collateral by the borrower.
• This is to ensure that banks have sufficient cushion to absorb any losses by selling the gold in case the borrower defaults on the loan.
• The RBI also mandates that when a loan is disbursed to a borrower, no more than ₹20,000 can be disbursed in the form of cash. The remaining loan amount needs to be deposited in the borrower’s bank account.
• It also instructs lenders to conduct the auction of any gold (in case a borrower defaults) in a fair and transparent manner in locations that are accessible to the borrowers.

Need for Reinforcing These Norms

• The gold loan portfolio of NBFCs has increased at an aggressive pace since the pandemic. It is growing over four-fold from about ₹35,000 crore at the end of financial year 2020 to about ₹1,31,000 crore by the end of FY 2023.
• The RBI may fear that such aggressive lending by NBFCs is happening in widespread violation of lending norms.
• This could potentially cause systemic trouble in the future as the gold loan industry grows in size rapidly.

How Will the RBI’s Scrutiny Affect NBFCs?

• The NBFCs expect the RBI’s scrutiny of their lending practices to affect their growth and profitability.
• The RBI’s insistence that no more than ₹20,000 shall be disbursed as cash when a loan is approved, for instance, is expected to make NBFC gold loans less attractive.
• Many NBFCs might also have to become less aggressive in their lending practices as the RBI enforces the loan-to-value rules more strictly.
• Also, measures to make the auction process more transparent and accessible to borrowers could increase the cost of doing business for NBFCs and lead to higher borrowing rates for lenders.
• On the other hand, the RBI believes that its lending norms will make the gold loan business more sustainable and help avoid systemic risks in the long run.

Q1. What is an Overdraft facility?

An overdraft facility allows account holders to withdraw funds exceeding their account balance, up to a predetermined limit set by the bank. It acts as a short-term loan, offering flexibility and quick access to additional funds.

Q2. What is a Residuary NBFC?

Residuary Non-Banking Company is a class of NBFCs whose 'principal business' is to receive deposits, under any scheme or arrangement or in any other manner.

Source: Why is RBI keeping an eye on gold loans? | Explained