Is shadow banking system legal in India

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This article is written by Mahima Sharma, Pursuing LLB from Symbiosis Law School Pune. This article analyses the concept of shadow banking in India and governing regulations, following which, the article depicts how the government has planned to overcome the credit crunch due to the outbreak of COVID-19.

Introduction

While the evolution of shadow banking could be followed from the 1970s, after the horrible experience of the great financial crisis of 2008, the world has become anxious and serious about the important contributions and the risk involved with the Shadow banking system. According to the financial stability board, the shadow banking system has continued to grow in the sixth consecutive year in 2017 to $184.3 trillion which accounts for almost half of the global financial assets. In the recent decades, the developing countries have had massive growth in the shadow banking system, India is one of the fastest developing countries of the world, has also shown tremendous growth in the system until the collapse of IL&FS Group in 2018, a major shadow bank of the country, which disturbed the credit cycle, slowed down the investment and even influenced the growth of GDP. Hence, it has become more important to keep analyzing the shadow banking system because they are susceptible to fundamental danger and crisis, and also due to the fact that this works outside the scope of the regulated banking system, and there is less transparency in work than the conventional banking system.

This article begins with defining the shadow banking system, and the risk associated with it. Following which the author has delved into the recent contributions made in the shadow banking system in India. 

What is the shadow banking system?

In basic terms, shadow banking refers to the non-banking financial intermediaries which perform activities like credit intermediation, liquidity transformation, and maturity transformation like those of the traditional commercial bank. The term shadow banking was first used in 2007 by Paul McCulley of PIMCO, which specifically referred to the American financial institution, which uses short term deposits to finance long term loans. Since then the term has been used more elastically to include all the financial companies which provide services like any bank but without any regulation. Activities of shadow banks include a group of specialized financial institutions that channel the funds from savers to investors through securitization and secured funding techniques.

In India, shadow banking is generally known as Non-banking financial intermediation and market-based finance, which not only means finance-based company but also includes the group of companies that are engaged in activities like an investment, insurance, chit fund, stockbroking and other alternatives of investments. In India, where a commercial bank cannot provide required services by the customer due to legal issues, the NBFCs play the role of a supplementary bank by providing what is required by the customer.

Entities that comprise the system

Some of the important Complex legal entities which comprise of the shadow banking system are:

Hedge fund

A hedge fund is an investment fund that invests in fairly stable securities and is willing to allow effective use of sophisticated investing, portfolio creation, and risk control strategies to boost efficiency, such as short selling, leveraging, and derivatives. Due to its use of advanced analyses, regulatory authorities generally do not permit hedge funds to be commercialized or made available to anybody except institutional investors, wealthy individuals, and other investment firms who are regarded to be sufficiently advanced.

Structured investment vehicle

A Structured Investment Fund (SIV) is a non-bank financial entity set up to gain a credit premium between some of the longer-term assets retained in its portfolio and the shorter-term liabilities it holds. They are easy credit and liquidity lenders, often “borrowing” by investing in securitization, but also by making an investment in corporate bonds and financing by issuing commercial paper, not in the short term.

Money market 

Money Market is a segment of the financial market in India where borrowing and lending of short-term funds take place. The maturity of money market instruments is from one day to one year.

The role played by the shadow banking system

Like standard banks, shadow banks offer loans and typically raise the liquidity of the financial system. However, unlike their more regulated competitors, they do not have access to central bank financing or government programs such as deposit insurance and debt guarantees. The International Monetary Fund‘s headline report describes the two main roles of the shadow banking system as securitization – the production of protected assets and collateral intermediation – to both mitigate counterparty risks and promote secured transactions.

NBFCs (Non-Banking-Financial Companies) play a significant role in implementing sustainable growth in the country by addressing the diverse financial requirements of clients. Furthermore, NBFCs also play a leading role in delivering creative financial services to micro, small, and medium-sized enterprises ( SMEs) best tailored to their market needs. NBFCs are investment banks involved in the business of cash flow deposits and it plays a key role in channeling limited resources to capital accumulation. They complement the role of the banking sector to meet the growing financial requirements of the business sector, providing credit to the unorganized sector and to small local borrowers.

However, it does not include aspects relating to agriculture, industrial activity, sale, purchase, or construction of immovable property. The shadow banking system is very diverse, and some components of it play crucial roles in the credit intermediation process, especially under present circumstances when the traditional banking system is restricted by its lineage of non-performing loans, as well as by a progressively invasive and complicated legal regime.

Regulations under the system

In November 2010 Seoul summit, which was the fifth meeting of G20 heads of government or heads of the state to discuss the global financial system and world economy, where the leaders also requested the FSA (Financial stability Board) to collaborate with other international bodies to strengthen the system of shadow banking by suggesting the possible regulatory guideline. In February 2013 the working group called financial stability board regional consultative group for Asia (RCGA) was constituted to conduct the study on Asia’s shadow banking system. The group conducted the survey and reported the NBFCs profile and risk associated with respect to Asia’s banking system.

In India, it was certainly Identified that the Constitution of NBFCs acted as a shadow bank in the country. However Major Numbers of NBFCs have been under the regulation of the Reserve Bank of India from the last 50 years. Thus it can be considered as the shadow banks in India are of different genres and the dangers posed by them are of different kinds.

Certain categories of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI, examples- Venture Capital Fund/Merchant Banking companies/Stockbroking companies registered with SEBI, Insurance Company holding a valid Certificate of Registration issued by IRDA, Nidhi companies as notified under Section 620A of the Companies Act, 1956, Chit companies as defined in clause (b) of Section 2 of the Chit Funds Act, 1982, Housing Finance Companies regulated by National Housing Bank, Stock Exchange or a Mutual Benefit company.

However, for the NBFCs which are registered under Section 45IA of the RBI Act 1934, are regulated under the basic regulatory framework of the following Act- 

  1. RBI Act of 1934
  2. NBFC (acceptance of public deposit) direction,1988
  3. NBFC ( deposit accepting and holding of Prudential direction) 2007
  4. NBFCs auditors direction 2008
  5. Prevention of Money Laundry Act 2002

And other Circular and press notes issued By RBI.

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Importance of the shadow banking system

Even though NBFCs are small players, the services provided by them are still important for developing countries like India. In the present system of economies, the NBFCs are providing affordable financial services that contribute to boosting the economy. 

Long term credit

NBFCs play an important role in providing long term funds to the trade and commerce industry which is ultimately used for the development of infrastructure in the country. Long term credit allows sustainable growth and development of the economic sector.

Mobilization of assets 

NBFCs help in mobilizing the fund and rotation of resources by converting investments into the most useful form which makes a wide and strong contribution to economic development without expecting anything in return.

Increasing growth of the financial market

The money related market depends intensely on Non-banking monetary establishments for raising capital. The new businesses and little measured organizations are subject to reserves offered by NBFCs and furthermore so as to look after liquidity. For a successful working and parity in the budgetary market, NBFCs assume a noteworthy job.

Standard of living and employment

These companies widely attract funds from foreign endowments for industrial and other sectors which ultimately signifies the increased opportunity for employment and standard of living.

Increase in National Income

NBFCs aim to construct capital for a few industries like private and otherwise, which results in collecting a capital stock for the nation. This straightforwardly includes the national income and results in the movement of Gross Domestic Product (GDP).

Risk associated with the shadow banking system

  1. Shadow institutions are not liable to the same policies as the depository banks, which are required to maintain and hold large financial balances as they are in public positions. NBFCs thus have a very significant influence on financial leverage, with a high debt ratio relative to the financial cash available for immediate claims to be paid. High leverage increases profits during boom periods and losses during downturns. This high leverage will also not be immediately evident to investors, and shadow institutions will thus be able to create the appearance of higher performance during economic booms simply by taking greater countercyclical risks. 
  2. As these entities continue to remain outside of the regulative sphere, there is an absence of a coherent image of the level of their activities and their participation in the financial system. These non-bank financial mediators consequently act as an obstacle to the successful conduct of monetary policy, as they remain resistant to direct control by the central bank.
  3. Shadow banking activities are scattered across borders. Distinct regulatory regimes across geographical areas of law pose a hurdle in their containment. For example, high taxation in some countries may lead to the adoption of tax evasion strategies by financial firms. Tax haven countries keep taxes small in order to draw international investments and build employment.
  4. Shadow Banking involves the procedure of avoiding government regulation. In many cases, the banks themselves formed part of the shadow banking system by circulating a specialized subsidiary to carry out shadow bank transactions.
  5. Banks can also invest in financial products provided by other shadow banking institutions. And, as shadow banks do not have access to central bank financing or any other support system, they remain susceptible to external shocks. Such sub-linkages and the enormous size of shadow banking activities give rise to systemic risk concerns, as a seemingly minor issue affecting one entity may amplify and send shocks.

Recent contributions

After the Crisis faced by Indian NBFCs because of the bankruptcy of the IL&FS group and Dewan housing Company, NBFCs are going through fresh turmoil of halted manufacturing and wiped out consumption due to the outbreak of Coronavirus. Officials have been trying to sustain India’s shadow banking system following the fall of the big infrastructure financing company IL&FS in 2018. Companies are the pillar of Asia’s third-largest economy as they lend to everyone, including small merchants to business titans. In just ten days of the outbreak of COVID-19, the capstone shadow lender lost 350,000 customers and nearly 50 billion rupees ($651 million) in assets.

To help cash-starved shadow lenders cope with the coronavirus-fueled slowdown and encourage banks to invest in bonds of these financiers, the government in the month of May announced new measures after the steps taken by the central bank last month on buying debt of shadow lenders met a lukewarm response. Finance Minister Nirmala Sitharam said that the government will open a 300 billion rupee ($4 billion) credit line for non-bank firms, and will fully guarantee investment-grade securities issued under the plan. To further help the lower-rated financiers, the government will also provide a partial guarantee to bonds rated AA and below, injecting another 450 billion rupees.

Conclusion

The growing size and interconnection of NBFCs are to be concerned about. RBI has been working continuously to streamline the regulation for the working of these shadow banks to secure the customer’s interest. A lot needs to be done to change and implement the law to prevent a situation of bankruptcy like the IL&FS group. However, The NBFCs are Important as they play a supplementary role and also provide depth to the financial market.

References

  • Concept of shadow banking in India- research paper.

https://www.worldwidejournals.com/global-journal-for-research-analysis-GJRA/special_issues_pdf/November_2014_1476528396__41.pdf

  • The growth of the shadow banking system in emerging market-evidence from India.

https://www.cafral.org.in/sfControl/content/DocumentFile/1212201353512PM_the_growth_of_shadow_banking_system_in_emerging_markets_evidence_from_india(1).pdf


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