By Mukta Malhotra

Too many regulations and many of them micro. That is the refrain of the nation's NBFCs. These finance companies have been around for long, but attempts to regulate them began only during the Sixties. The Banking Laws (Miscellaneous Provisions) Act 1963 was the first formal statute enacted to regulate the NBFCs. This was followed by several committees which looked into the functioning of NBFCs and made recommendations for fostering healthy growth within a regulatory framework. Later, the NBFCs were almost set free in July 1996.

But, that freedom was short lived. With the CRB scam exploding on the face of the regulator, the Reserve Bank of India (RBI) tightened its noose around the nation's teeming NBFCs and erected a tough regulatory framework. Perhaps, in a rush of anxiety the RBI went a bit overboard. Says Mahesh Thakkar, executive director of the Mumbai-based Association of Leasing and Financial Service companies (AL&FS): "RBI has been tinkering with regulations. It took two and a half years to complete licensing of NBFCs. This resulted in investors getting confused and they preferred to wait."

The moot point here however is this: why should the RBI resort to micro management of NBFCs? Micro regulations can surely be done away with. Nowhere in the world can one see such micro mangement in a critical sector of the economy. One, NBFCs cannot raise deposit unless they are rated. Two, their total borrowings are determined by RBI. Three, NBFCs can gain access to bank finance only for the purposes of hire-purchase and leasing activities.

Uneven playing field
Not surprising that NBFCs have been clamouring for a level playing field. Says Thakkar of AL&FS: "Now that the RBI has brought NBFCs under stringent control, it should give them the same benefits as enjoyed by banks and financial institutions." As far as policy direction and broad regulations are concerned, NBFCs and banks are regulated at par. Both banks and NBFCs are supervised by the RBI under the RBI Act. With a minor differnce: banks come under RBI's department of banking supervision while NBFCs come under its department of non-banking supervision.

There is an anomaly here though. Prudential norms governing NBFCs' capital adequacy and asset concentration are more stringent than those pertaining to banks. The minimum capital adequacy ratio for NBFCs is 12 per cent, while it is eight per cent for banks. Moreover, NBFCs cannot accept deposits unless they have a minimum credit rating. Higher NPA provision requirements rein NBFCs in further.

There are other areas where NBFCs are at a disadvantage vis-a-vis banks. Consider this example: s.194A of the Indian Income Tax Act provides for a limit of Rs 10,000 up to which a bank need not deduct tax at source on interest payments. The corresponding limit for NBFCs is Rs 2,500. Under the RBI Act s.36(1)(viii), NBFCs are required to compulsorily transfer at least 20 per cent of their profits to reserves, which can be utilised only for purposes specified by the RBI. And what more, unlike banks this mandatory transfer to reserves is not allowed as a deduction against income.

Harsh regulations
Here is a taste of how harsh the NBFC regulations are. The latest balance sheets of most leasing and hire-purchase companies indicate that they cannot increase their statutory liquidity reserve (SLR) ratio as proposed by the Vasudev Committee Report from the current level of 12.5 per cent to 25 per cent in a phased manner. The expected result: most leasing and hire-purchase companies could turn into unviable ventures.

Not without reason. Since this regulation would mean a loss of four to five per cent in the SLR investments of leasing and hire-purchase companies whose cost of fund is between 14 and 16 per cent, it would ring a death knell for these NBFCs. Banks, on the other hand, could even earn profit to the extent of four to five per cent on their SLR investments, as their average cost of funds is pegged between seven and eight per cent, thanks to their ability to access current and savings deposits.

Here is another NBFC regulation that is too harsh. The RBI has prescribed a higher capital adequacy ratio of 15 per cent for unrated NBFCs against just 12 per cent for rated companies in the small and medium sector. This is NBFC-unfriendly. Reason: with margins under pressure, an NBFC is able to recover a 12 per cent return only if its debt-equity ratio is at least four to one. However, thanks to the deposit acceptance ceiling of 1.5 times the net-owned funds, small and medium hire purchase and leasing companies would be able to recover only a nine per cent return on their capital. That means these NBFCs will have to manage with a three per cent higher capital adequacy ratio which itself regulates NBFCs’ total borrowings.

Mishaps possible
There is yet another fly in the NBFC ointment. RBI has recently announced the need for introduction of NBFC depositors. Since NBFCs mobilise deposits from places not serviced by banks, proper introduction is needed as far as NBFC depositors are concerned. Absence of proper introduction is sure to cause delays in accepting deposits from the public. The implication: interest loss to NBFC depositors.

Tax authorities permit cash transactions up to certain limits and since deposit transactions of NBFCs are no different, this cash transaction limit should be applicable to deposit transactions as well. Usually, NBFCs pay interest and matured deposits through cheques or warrants. This practice presupposes that depositors have already established their identities. The main objective of introduction is to avoid incidence of frauds by account-holders through cheque issues. Since NBFCs are not a part of the payment system, such mishaps are not ruled out.

There are some other regulations too which are hazy at best and need clarification. Moreover, tax treatment of securitisation is not clear. The stand taken by the Central Board of Direct Taxes (CBDT) on "true leases" too is unclear. CBDT has not even defined the characteristics of a tax-admissible true lease and it is left to the discretion of the appellate and assessing authorities to decide what constitutes a tax-admissible true lease. Worse, there is no clarity whatsoever on situations wherein a lease may not be regarded as a genuine lease from the taxation point of view. Clarification is also needed on the rate of depreciation applicable in such deals.

Restructuring needed
All these arguments only tell one thing: regulations and income-tax provisions relating to NBFCs need to be restructured. One such instance of much-needed restructuring is this: s.43B of the Indian Income Tax Act, under which individuals are allowed a tax-deduction on payments made to banks and financial institutions on cash basis only. If this provision is extended to payments made to NBFCs, it would bring relief to all those NBFCs whose non-performing assets are mounting. For, such a provision can not only discourage defaults, but offer tax relief to NBFCs too.

Loan Recovery Tribunals (LRTs) also require to be rehauled, LTRs are constituted under a separate law to expedite settlement of delinquent loans of banks and financial institutions. NBFCs should also be brought under the LRTs . The argument: a quasi-judicial system such as LRTs should not only bring relief to the already over-burdened judicial system, but also create a specialised agency for handling recovery claims of NBFCs.

Tax and depreciation
LRTs apart, result-oriented tax and depreciation laws need to be put in place. Lease and hire-purchase transactions, where the assets concerned have been already taxed either locally or during the course of an inter-state trade deal, should be fully exempted from sales tax. Not just that, an uniform rate of sales tax should be levied where this is not the case. Sales tax on financial lease and hire-purchase transactions is essentially an additional levy on goods. For, sales tax must have been levied on such goods purchased by a finance company when they were sold by the supplier. Besides, there is no uniformity among the states as far as sales tax rates and principles are concerned. This adds to the cost of finance transactions distorting the competitiveness of NBFCs. This has been happening for very long now, with the states levying sales tax on financial lease and hire-purchase transactions for the last 15 years.

The depreciation rates for infrastructural assets also need to be revised. Depreciation rates for infrastructural assets such as earth-moving equipment, material handling equipment and railway wagons should be rasied. If this is done, it will not only help the NBFCs, but also boost investments in technology and infrastructure.

Plan of action
True, the NBFC sector regulations in India are more stringent. Such stringency is needed considering the fact that NBFCs are allowed to access public deposits. However, regulations should have certain clear objectives, long-term goals and a vision.

Regulations are not an end in themselves. It is counter-productive to micro-manage any sector. And regulations should not be there just for the heck of it.

Any NBFC regulation should aim at fostering healthy development of the industry. Says KVS Manian, chief operating officer of the Mumbai-based Kotak Mahindra Finance: "RBI needs to loosen its grip on NBFCs steadily."