NBFC, Banks and Digital Banks: Viewing the IWG recommendations through a post-fintech lens

November 30, 2020

Shivashish Chatterjee, Co-Founder and Joint Managing Director, DMI Finance Private Limited

The RBI Internal Working Group has issued its recommendations for ownership guidelines and corporate structures for Indian private sector banks. Much has been written already about the report, with a focus on the suggestion that corporate and industrial companies be permitted to become promoters of banks. The second part of the ownership recommendation, that NBFCs with over INR 50k crores should also be considered for universal banking licenses, has received far less attention. There is a risk that the casual reader understands this observation to mean that NBFCs that are successful at acquiring a large asset base need to become banks in order to continue.

A healthy and functioning economy needs strong banks. It also needs strong financial intermediaries that are not banks. As the IWG notes in the report, Indian banks have become less relevant in financial intermediation since the early days of liberalization. That role has, on the margin, been taken up by non-bank players including NBFC's and an increasingly important capital market. These different intermediaries play distinct roles in the allocation of capital from savings to investment. Banks occupy a special place in any modern financial system, owing to their function as stewards of low-duration capital from depositors who seek relatively risk-free returns. Equity capital markets are at the other extreme, where savers go to seek out excess return by assuming long-term risk. NBFC's help to channel debt capital to those parts of the economy that are underserved by the banks. India has a long history of highly successful NBFCs that have created new classes of investments, such as vehicle financing and consumer durables financing. In short, it would be a gross oversimplification to treat NBFC's as merely an intermediate step to universal banks. The success of NBFC's should not be measured by their ability to grow their assets and conversion to a bank should not be considered the goal of successful NBFC's. Many large NBFC's would struggle as banks and there are probably several smaller NBFC's that would make excellent banks. The size of an NBFC’s assets may well be uncorrelated to its suitability for a universal banking license.

In considering this recommendation, the RBI should make a distinction between deposit-taking and non-deposit-taking NBFC's. Deposit-taking NBFC's are much closer to banks since they put depositor capital at risk. It makes sense to view these NBCF's through a banking lens and avoid regulatory-arbitrage by supervising them as banks. However, there is a very large and vibrant ecosystem of non-deposit-taking NBFC's, which is essential to realizing the lofty ambitions of the Indian economy. These NBFC's need a different regulatory framework in order to succeed and innovate. Bank-style supervision of such entities would be inappropriate no matter how large they get. NBCF's that are innovating on credit products, bringing financing to underserved segments, experimenting with technology to improve the credit experience, and bringing credit to those who have been shut out of the formal credit systems need to be recognized by the regulator for the essential role that they are playing and supervised appropriately. 

In recent years the RBI has been quite proactive in promoting financial innovation through initiatives like the regulatory sandbox. A regulatory sandbox allows for controlled innovation by fintechs and capital providers to bring a new financial idea to life and test it out before it is rolled out to a broad audience. NBFCs can be a critical piece of the success of such initiatives as many of them are more nimble and have a greater affinity for technology than banks. They are a natural part of the growing ecosystem of fintech and have played a meaningful role in whatever success this burgeoning sector has achieved in the area of financial inclusion. For a thriving economy, India needs a thriving NBFC sector. While the collapse of IL&FS has left a bad taste in our collective mouths about large NBFCs, we must recognize the difference between bad governance and core function. Banks are as prone to bad governance as NBFCs, while performing a different, yet critical, function. 

One idea that was likely outside the purview of this IWG and hence not addressed in this report is the idea of a new type of banking license, one that differentiates between banks, not just on the basis of what they do, but also on the basis of how they do it. The time for a separate category of digital bank is likely coming soon, and the entire NBFC and fintech industry is hoping that the RBI will be as farsighted about adopting this new category of bank as it has been in creating new categories of NBCFs such as P2P and Account Aggregator.