The Usha Thorat Committee has recommended far-reaching changes in the regulation of NBFC sector based on perception of increased risk. Some of these changes will strengthen the sector and prepare it for long-term sustained growth.

As the guidelines for provisioning and income classification tighten, tax deductibility for the provision a la banks was a must and has been recommended. Along with increased tier-I capital adequacy requirement, it has been recommended that NBFCs be given benefit under the SARFAESI Act, which will help superior recovery.

Many a time there is a debate that veers towards banks vs NBFCs. The point missed is that they compete as well as complement. I would draw an analogy with railways and roadways that compete sometimes for freight and complement at other times and constructively co-exist. The roads provide for the last-mile connectivity that may not be viable for the rails. The road transport can also deliver a lot more innovation which may not be feasible for rails, given their requirement of scale.

While there is merit in tightening of regulations, I do not agree with the same being justified for reason of use of public funds. Also, as per the report itself, between 2005-06 and 2010-011, NBFCs have strengthened their own funds and reduced aggregate borrowings.

From RBI"s point of view, encouraging growth of NBFCs will reduce systemic risk considerably, as broadly NBFCs can leverage only up to 6.6 times (to meet total capital adequacy of 15%). In fact, NBFCs are leveraged less than three times. NBFCs financing 25.9% of their total assets with owned funds represent a degree of safety. In contrast, bank-owned funds, as a percentage of total assets, are only about 6-7%. Further, banks have refinancing facility and RBI stands as the lender of last resort.

A bank in trouble has to be bailed out. Therefore, sensitive sectors lent through NBFCs will have a huge cushion of NBFC equity capital. Even if the end user of capital defaults, banks will have the safety net to the extent of NBFC"s net worth, which is quite substantial. Therefore, it is not exactly a regulatory arbitrage or indirect transfer of risk.

The world over, equity markets have liquidity as risk takers are financed with ease. Without liquidity, the markets will become unattractive even for genuine investors.

For a growing economy like ours, mobilising equity is pre-requisite for raising debt and, therefore, capital formation which, in turn, is key to meet the growing demands of goods, services and generate employment.

To sum up, while tightening provisioning, income recognition and capital adequacy along with SARFAESI, tax deductibility of provisions are welcome proactive measures, NBFCs are not at par with banks in terms of risk to the system, nor benefit from subsidised public funds. Therefore, provisions like prior approval for transfer of equity, powers to supersede board, liquidity norms etc can be reconsidered.

The above column appeared in The Economic Times on August 30, 2011