The Reserve Bank of India (RBI) has been proactively taking action against non-banking financial companies (NBFCs) and banks for regulatory lapses and non-compliance with the RBI directives. The RBI recently prohibited 4 NBFCs from sanctioning and disbursing new loans. This article discusses the RBI’s approach towards principles-based regulations and the steps that the RBI can take to encourage innovation while ensuring that such regulatory lapses are reduced.  

RBI bans NBFCs from lending

Recently, the RBI prohibited 4 NBFCs from sanctioning and disbursing new loans, because of unfair and usurious practices adopted by these NBFCs. As per the RBI’s press release, this action was taken in furtherance to the RBI’s warnings to the 4 NBFCs and was based on concerns arising out of their pricing policies, particularly related to weighted average lending rate and interest spread. Reportedly, the said NBFCs had an interest spread over 14 percent. This action taken by the RBI is one of a series of supervisory actions taken by the regulator against regulated entities for circumventing regulations.

Earlier this year, RBI took strict action against various regulated entities like Kotak Mahindra Bank, IIFL Finance, and Paytm Payments Bank, for circumventing regulations, including KYC norms, outsourcing norms, and loan-to-value-based norms.

These regulatory actions taken by the RBI have created a sense of uncertainty amongst the regulated entities around the RBI’s regulatory approach. The RBI is gradually transitioning from a traditional rule-based approach to a modern principles-based approach for framing regulations, in order to adapt to the constantly evolving market and foster innovation in the banking sector.

Shift in approach

The RBI traditionally adopted a rule-based approach in which regulations were prescriptive and detailed specific penal consequences for their violations. For instance, prior to 2014, the RBI permitted microfinance institutions that were incorporated as NBFCs to charge a maximum interest rate of  26 percent on the loans provided by them. Subsequently, the RBI removed this quantitative limit and iterated that the interest rate will be either the cost of funds plus margin, or the average base rate of the five largest commercial banks, whichever was lower. Thus, rule-based regulations provided quantitative regulatory targets and responsibilities for regulated entities that could be easily monitored and enforced.

However, most market players felt rule-based regulations discouraged innovation and did not keep up with the constantly evolving market. Further, it was observed the regulated entities did not follow the law to its spirit and it led to a practice of “box ticking” compliance.

For instance, in the master directions on peer-to-peer lending platforms (P2P Platforms), the RBI had taken a rule-based approach for regulating the operation of P2P Platforms. As per the master directions, individual lenders were required to approve the borrower before the disbursal of each loan. To circumvent this requirement, the lenders executed contracts with the P2P Platforms that had an auto-invest clause under which the lenders permitted the P2P Platforms to invest and loan their monies as per the lending criteria prescribed without any manual approval. In this case even though the regulated entities adhered to the master directions in letter, they did not adhere to the spirit of the master directions.

Due to such issues with rule-based regulations, the RBI is gradually shifting towards principles-based regulations to allow entities flexibility to adapt to evolving circumstances and encourage innovation. For instance, presently, the RBI does not prescribe any way to determine interest on the loans provided by the NBFCs. The RBI only provides that the rates of interest beyond a certain level will be seen as excessive, not sustainable or conforming to normal financial practice.

Additionally, the scale-based regulations mandate NBFCs to internally adopt an interest rate model to determine the rate of interest to be charged for loans and advances based on relevant factors such as cost of funds, margin, and risk premium. NBFCs are also required to adopt appropriate internal principles and procedures to determine processing and other charges.

Scope for improving approach to regime

While principles-based regulations encourage innovation and development in the rapidly changing landscape, some NBFCs have taken advantage of the lack of pre-defined rules or limits. For example, it has been observed that in the absence of any upper limit or prescribed method for calculating the interest that can be charged by the NBFCs on loans, some NBFCs exploit their borrowers and charge interest rates as high as 60 percent.

Contrary to the claims by the proponents of principles-based regulations, it must be taken into consideration that they are prone to ambiguity and arbitrariness. Adopting principles-based regulation often results in the market players only maintaining the minimum level of conduct required to comply with any principles-based regulations, rather than following the spirit of the law.

Historically, in the United States of America, it was observed that principles-based regulations were introduced to facilitate innovation by financial institutions in the domain of financial products and services. However, these products eventually resulted in substantive losses to these financial institutions and impacted the soundness of the financial system. For instance, as per various experts, innovative mortgage products developed by financial institutions during the principles-based regulatory resulted in the 2008 financial crisis, which threatened the stability of the American banking system.

In light of the increased violations of principles-based regulations, it is recommended that the RBI should adopt a hybrid approach while regulating interest rates and framing other regulations. The RBI may take the following factors into consideration while deciding to adopt a rule-based approach or principles-based approach. Taking these factors into consideration will help in striking a balance between fostering innovation and ensuring safety and consistency in the financial sector.

Objective of the regulations

The desired outcome of the regulations must be taken into consideration while deciding the approach the regulator should adopt in framing the regulations. For instance, if the regulator aims to target behavior that is malum in se, prescriptive rules prohibiting such behavior would be preferable to prescribing general principles. Similarly, if the regulator is of the opinion that there are multiple ways of achieving the desired regulatory outcome, principles-based regulation would provide flexibility in their conduct for achieving the desired outcome. On the other hand, rule-based approach can be adopted in situations where there is only one way of complying with a requirement.

Nature of the subject matter

It is recommended to consider the subject matter while deciding the approach to adopt for drafting the regulations. For instance, if the subject matter involves rapidly changing technology or is required to be updated frequently then it is recommended to adopt a principles-based approach. Whereas, if the subject matter involves standard forms or disclosures, it is recommended that a rule-based approach must be taken, since it makes it easier for regulators to analyze information and compare institutions. The RBI could consider setting interest rates and, or, other financial parameters for NBFCs and keep updating it periodically.

Market participants

Attributes of market participants must be considered while deciding the approach that is to be adopted. A principles-based approach is more appropriate to regulate entities that are more sophisticated or institutional, whereas a rule-based approach is more appropriate for regulation aimed at safeguarding the consumers. Additionally, it must be taken into consideration that principles-based regulations are best suited where there is no information asymmetry among the market participants. On the other hand, a rule-based approach is required in markets where one party has an advantage over another.

Collaboration with the regulator

Another factor to take into consideration is trust and the interaction between the regulator and the regulated entity. Principles-based regulations require a level of collaboration between the regulator and the regulated entities. Engagement between the senior management and the regulator for the regulatory process is required for the proper implementation of the regulations.

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Bharucha & Partners – Vivek Mishra, Vatsal Srivastava and Palak Nangru