NBFCs must manage operational risks – The Hindu BusinessLine

lipped from: https://www.thehindubusinessline.com/opinion/management-of-operational-risks-by-nbfcs/article64822290.ece

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They gradually erode the efficiency of the organisation drawing attention of stakeholders only after substantial damage is done

K. Srinivasa Rao

The gradual autonomy in business operations and digital thrust has empowered non-banking financial companies (NBFCs) significantly. When NBFCs, driven on fintech proliferation and onset of innovative products were bracing for higher role in financial intermediation, the impact of pandemic set new opportunities for growth.

In a strategic move, well before the pandemic, the RBI allowed co-origination of loans by banks and NBFCs for creation of priority sector assets. The Co-lending Model (CLM) is a permitted arrangement for banks to lend through the use of NBFCs by sharing risks and rewards. NBFCs will absorb 20 per cent risk while banks will bear the rest. The purpose is to use the synergy of banks and NBFCs to deliver speedy credit under priority sector that is targeted to reach vulnerable sectors of the economy.

Accordingly, many leading public sector banks (PSBs) and even private sector banks have entered into risk sharing to increase the credit outgo. For example, SBI had tied up with Adani Capital, PNB with Paisalo and Vedika Credit Capital, Bank of Baroda with U GRO Capital, Bank of India with MAS Financial Services, Union Bank with Capri Global Capital Ltd (CGCL), Central Bank of India with IIFL Home Finance, and so on. In its bi-monthly monetary policy in April 2021, the RBI made it mandatory for all prepaid payment instruments (PPIs) to move to a fully KYC-compliant framework from March 2022 and increased the limit of outstanding balance from ₹1 lakh to ₹2 lakh, potentially increasing the scope of float funds.

As result of such increased autonomy, the contribution of NBFCs towards supporting real economic activity and their role as a supplemental channel of credit intermediation alongside banks is well recognised and is further poised to grow. Over the years, the sector has undergone considerable evolution in terms of size, complexity, and interconnectedness within the financial sector. Many entities have grown and become systemically significant and hence there has been an imminent need to upgrade the regulatory framework for NBFCs keeping in view their growth and corresponding change in the risk profile.

Performance of NBFCs

While many of the potential increase in scope of NBFCs are yet to manifest, they have been growing well despite shocks of collateral damages in the financial markets on account of IL&FS fiasco and its domino impact. A look at some of the data points on their performance track record will affirm the trends (Table 1).

The data clearly indicates the uptick in the share of NBFC assets moving from 12.25 per cent in March 2017 to 15.06 per cent by March 2021. Amid the stiff competition when the financial entities are struggling to contain their market share, a rise of asset base from ₹19.8 trillion to ₹34.75 trillion is a robust growth. With more freedom and diversity, the trend will further catch on significantly by 2025. Similarly, the data on credit volumes also show a good rise (Table 2).

The volume of credit of the NBFC sector increased from ₹17.64 trillion in March 2017 to reach close to ₹27 trillion by March 2021 with its share increasing from 18 to 20 percent during the period despite the downfall of many NBFCs. While the rise in asset size and credit growth of the sector could be important for the revival of the economy, managing corresponding risks are equally significant. Realising so, the RBI swiftly moved to upgrade regulatory norms by aligning them close to the banking standards.

Stronger regulations

Treading the path of regulatory reforms for NBFCs, among many changes to macro/micro prudential norms, significant upgradation of regulations come from RBI through roll out of:

(i) scale-based regulations (SBR) to be made effective from October 1, 2022, to realise its sustained vision to develop a strong, robust and vibrant NBFC sector complementing the banking sector.

(ii) The prompt corrective action (PCA) framework is also extended to NFBCs, effective from October 2022.

(iii) Earlier, in May 2019, it made institutionalisation of chief risk officer (CRO) mandatory for NBFCs having asset size of ₹5,000 crore or more to ensure that better and systematic risk management in integrated in leading them.

(iv) New asset classification and provisioning norms were introduced in November 2021 calling for identification of special mention accounts (SMA) as part of NPAs on a day-end position basis and upgrade from the NPA to standard category only after clearance of all outstanding overdues. In other words, NBFCs can upgrade NPAs to standard category only after the entire arrears are cleared.

Risk management in NBFCs

In the backdrop of obvious rise in the scope of business and increased regulatory rigour, what remains challenging is the implementation of risk-management strategies in the sector to ensure that the business models remain viable, adequately ring-fenced and sustainable. In the realm of risk management, the asset quality norms will bring to focus any gaps in credit risk management due to SMA framework while the trends of risk adjusted yields on investment, treasury earnings and ‘mark to market’ obligations can reveal the shortcomings in market risk.

But any slackness in operational risk management (ORM), latent in the business, cannot come to fore quickly leading to accumulation of its adversity. ORM is inherent in people competency, inefficiency of technology and systemic failures that does not measure up immediately and cannot be quantified. They gradually erode the efficiency of the organisation drawing attention of stakeholders only after substantial damage is done.

Experiences of PNB mega fraud, YES Bank fiasco, PMC bank failure, exit of Lakshmi Vilas Bank and many other instances causing immense collateral damage haunts the financial sector and its consumers. Incipient indifference towards ORM escapes even the regulators. Sometimes weak corporate governance can even shield it from the board and its subcommittees much to the detriment of the entity. Development of people competency to handle the nuances of ORM and sensitization of the line management should be integrated with the learning culture.

Appropriate ORM strategies should transcend the whole entity from bottom to top and vice versa. NBFCs should be able to carve out rigid standard operating procedures — the first line of defence and made capable to de-risk the entity in the long-term interest. Getting certification of standardisation of ORM practices can also be helpful in mitigating risks.

Failing to tame the operational risks can have serious consequences threatening the sustainability of the organisations. A tough task awaits NBFCs to rein in operational risk much beyond going successful in scaling up business. A right risk prioritisation can be a recipe to thrive in the vibrant economy poised to unfold in post-pandemic regime.

The writer is Adjunct Professor, Institute of Insurance Risk Management, Hyderabad. Views are personalPublished on January 13, 2022

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