The Non-banking Financial Institutions (NBFI) sector in our country has been near-comatose after a series of scams that succeeded the heady days of 1996-97. The proportion of their deposits as a percentage of aggregate deposits and as a proportion of GDP has been declining. It is clear by now that a sophisticated financial system that contributes to economic growth requires a diversified and well-spread NBFI sector that can offer a range of products and services and act as a “shock absorber” or as a “spare tire” during systemic crises. While there is scope for improved regulatory regime, a revival of this vital sector requires an aspiration to grow and subject oneself to a self-regulatory mechanism.

Governor Dr. Bimal Jalan had, in his inaugural address at the ACG’s National Conference on “Non-Banking Financial Institutions – Rejuvenating through Corporate Governance” held on 18-19 October, 2002 suggested the formation of an SRO. The industry associations have since taken a step forward in this direction by requesting the Academy of Corporate Governance to guide and facilitate this process. The background to the issues before the NBFI sector in India has been covered in the thematic papers for the conference, which are part of this month’s issue.

"The price of freedom both for individuals and for enterprises seeking to be successful in creating prosperity is eternal vigilance, not eternal reporting"....... Eddie George, Governor, Bank of England.

"This leads one to wonder how severe East Asia’s problems would have been during the past 18 months had those economies not relied so heavily on banks as their means of financial intermediation".....The lack of a spare tire is of no concern if you do not get a flat......East Asia had no spare tires"........Alan Greenspan while addressing the World Bank/IMF Group 1999

Abstract
This note highlights (a) the importance of NBFIs in the financial system and economic development;
and (b) the corporate governance agenda before the NBFIs even as macro-institutional reforms are pressed for.

Corporate Governance and Macro-Environment:

6.0. Obviously there are two parts to the Corporate Governance framework that need attention separately but concurrently. The first is the aspect of macro-conditions of law, supervision and regulation. And the second is to do with board and management level aspects. Both are interrelated for a global investor - as he would like to invest in a good house in a good environment and not one that is in a slum! The contrary is also true.

7.0. It has been argued that the legal infrastructure has a significant bearing on financial development. Countries that have laws giving high priority to creditors; where contracts are rigorously enforced and where accounting standards are comprehensive and comparable, tend to create the conditions for good growth in financial system. The global rating firms (such as Standard & Poor, and Moodys) reportedly give specific weightage and rating to country conditions that include legal infrastructure, information infrastructure, regulation and market infrastructure.

8.0. In assessing the legal infrastructure, rating agencies may typically look at the over all law and order; consistency and effectiveness of the judiciary and law enforcement agencies, definitions of stakeholders, legal rights, the bankruptcy and pledge law and the company law provisions. Regulation, which is closely linked to the legal infrastructure is being examined by assessing the overall system of regulation including the self-regulating organisations; regulatory overlap; regulatory gaps; regulatory conflicts among agencies; effectiveness of regulation and their enforcement; availability of resources and tools for the regulators to achieve their objectives and examples of regulatory successes and failures.

9.0. Informational infrastructure relates to aspects such as accounting standards; quality and independence of auditors; basis of consolidation; segmental reporting; methods of asset valuations and quality; transfer pricing; sources and uses of funds etc., Market infrastructure evaluates conditions such as state ownership; privatisation; institutional investors; political environment; competition policy, banking structure and relationship with corporates and the like.

10.0. In assessing and addressing the macro-conditions, the 12 key standards for a sound financial system (as covered by the Financial Stability Forum’s Task Force Report) also become relevant. These standards comprise of monetary and financial policy transparency; fiscal policy transparency; data dissemination; insolvency; corporate governance; accounting; auditing; payment and settlement; market integrity; banking supervision; securities regulation and insurance supervision.

11.0. Basle Committee on Banking Supervision which is one of the standard setting bodies in the above, had issued a paper titled “Enhancing Corporate Governance for Banking Organisations” (1999) aimed at bank supervision which appear relevant in the regulation and supervision of NBFIs as well. While the BCBS recognizes, just as the CACG and the OECD, that the primary responsibility of good corporate governance rests with boards of directors and senior management, there are ways in which the environment can be made enabling. These include efforts by the government through laws; by securities regulators and stock exchanges through disclosure and listing environments; auditors - through audit standards on communications to Boards of directors, senior management and supervision; and industry associations – through initiatives related to voluntary industry principles and agreement on and publication of sound practices.

12.0. The guidelines on sound corporate governance practices issued by BCBS provide a template/framework for the regulators in assessing the quality of corporate governance. However, regulatory implementation being a wider aspect, four broad sets of tools are recognized to ensure soundness in the NBFIs (Jeffey Carmichael and Michael Ponerleano, 2002). These relate to (a) preconditions for entry into the market (comprising of licensing, ownership restrictions and capital requirements) (b) ongoing conditions for continued participation in the industry (market structure requirements, market conduct rules, disclosures, governance and fiduciary duties, balance sheet restrictions, associations among financial institutions, liquidity requirements, and accountability) (c) surveillance methods (complaints mechanisms, off-site monitoring and inspections); and (d) enforcement practices (prosecution, problem resolution and support schemes). The success of regulatory implementation will obviously depend both on institutional capabilities (which has never been in doubt in the Indian context) as well as (i) the overall regulatory structures including regulatory overlaps and gaps and (ii) the quality of regulatory backing including the legal and resource backing and the absence of political interference, if not active backing. (Reminding one of the criticality of “political will” that is being now raised by Kofi Annan in several contexts).

13.0. Regulation can be used effectively to stimulate growth and steer the development of this sector on a sustainable basis. A host of incentives and reddressal of anomalies raised by the NBFIs sector need consideration to stoke up the sector. While repressive regulation can undoubtedly retard growth of this sector, experience also shows that inappropriate regulation, especially at the licensing stage, leads to “irrational exuberance” and “infections greed” that was noticed as far back as in 1995-1997, further leading to distress in the entire sector, if not a systemic risk as such due to the relatively small size of the sector. Literature indicates that the lessons have been evident from worldwide experience from the 1970’s on the impact of inappropriate regulatory regimes.

Corporate Governance and the NBFIs

14.0. Sustainability of organisations and their growth is the primary responsibility of the owners, Boards of Directors and senior management. Case studies of failed NBFIs point out to laxity in corporate governance and ethical complacency that may have led to connected lending, false accounting, poor disclosures and reporting as also frauds. Though the listed companies require the first attention, increasingly the unlisted companies also are being assessed from the same viewpoint. Depositors, creditors, and important stakeholders wish to see both listed and unlisted NBFIs conforming to the broad principles that have now become a universal view. The recent move of the Department of Company Affairs, Government of India, to apply the accounting and disclosure standards to private limited companies is a pre-cursor to the increasing inclusiveness of the corporate governance principles.

15.0. The OECD principles as also the CACG guidelines emphasize the criticality of the Board in corporate governance - its composition, leadership, integrity and independence. International investing community is particularly concerned about the shareholder rights, their equitable treatment and evidence to show that the dominant shareholder is not the beneficiary of better information, insider trading and connected lending.

16.0. The NBFIs need to reform their boards and corporate governance processes to be able to revive the sector, evoke public confidence, gather financial resources and grow their business. Even as the regulatory systems and legal back up need reform, the initiative for revival of this sector lies mostly in the hands of the NBFIs themselves. They can do so by respecting shareholder and financial stakeholders rights (including depositors); meeting international standards in accounting and disclosures and Board restructuring to make it active and independent, as mentioned below.

17.0. Companies in the feudal and agrarian economies around the world suffer from the syndrome “your money but my property”. Entrepreneurship is mistaken for raising money quickly and spiriting away the funds, jeopardizing reputations and stability. The opening up of the NBFI sector attracted all and sundry to join the fray and it is only the crises that have separated the well governed ones that survive now from the adventurous had-been. Sustainable corporations are built on the basis of entrepreneurship – a desire to excel in the chosen business and its market segments. After the chastening by the market last few years, it may be worthwhile for companies to revisit and reposition personal values of the dominant shareholders as well as the corporate mission that will assure long-term viability and better relationship with all stakeholders. (Refer Criteria 1 , 9 of OECD working kit and Principles 1,3 and 8 of CACG). They may start encouraging debate and challenge in the boards and the general meetings as a necessary input to making better choices. Companies need to respect the rights of all shareholders and stake-holders for equitable treatment in access to information. (see OECD principles and Principles 6.7.9 of CACG). Reform of the Board and its processes is decidedly within the ambit of those in control and only requires the initiative and empowered action.

18.0. Disclosures of ownership structure, the people behind, the connectivities, the safety/fire walls etc., build public confidence. The most critical problem of NBFIs, the world over has been the extent of connected lending leading to unsustainable risk, asset-liability mismatches and liquidity crises. Measures must be evident as to how this scourge is being addressed by the company not merely through statements of compliance but by an activist policy. Accounting practices and the quality of auditing has always been in doubt. (George Bush’s statement that “sometimes things aren’t exactly black and white when it comes to accounting procedures” while defending his 1990 stock sale, has not been helpful either). Here again, there is a noticeable pattern of technical mismanagement (poor appraisals, poor risk portfolio, unsustainable rates of interest on deposits, indecent compensations etc) leading to cosmetic management (showing fictitious income/receivables, ever-greening of NPAs) leading to desperate management (quick fixing by collusion with suppliers, clients, auditors) eventually leading to fraud (outsight criminality). So much so that post-Enron, 72% of US public believes that corporate failures are not an aberration, but an epidemic with a pattern. All progressive companies have been trying to impress the reputation agents (research analysis, media, rating agencies) and the public by reaching international standards of accounting and reporting that goes beyond the statutory minimal. NBFIs may find such a move worthwhile to be able to raise resources and grow (CACG principles 5,7,10,15).

19.0. Boards need to be truly independent and each member must believe that his first duty is to the company, the artificial person. Not to the dominant shareholder, the CEO or the institution nominating him. Boards lose their meaning if they are only of executive directors and promoter directors. Independence arises through a sufficient number of thinking, guiding and inspiring directors who are truly independent and add value to the strategy of the company (a set of “fit, proper and competent” directors). Boards need to be assessed as they currently are, mapped for a desirable set of competencies and filled by a relevant group that makes board come alive and actively lead the company. This entails a shift in the locus of control - from the management or the dominant shareholder to the board. Concurrently, the quality of Board meetings would need a reform so as to set a vision, think strategically, constantly monitor risks and, continuously inspire strategic management. (4,6,7 of OECD working kit and CACG principles 1,2,4,9,11,12,14 and 15. The recommendations of the AS Ganguly Advisory Group on strengthening the Boards of Banks and Financial Institutions would also be useful).

20.0. In conclusion, NBFIs are too important to be let alone to their fate, as they provide the breadth, diversity and depth required for a sophisticated financial system. Such a financial system will not only cause economic growth but also provide the essential shock-absorption in what is threatening to be a risky future globally. Corporate Governance assumes critical importance in the revival and growth of this sector. There are two areas of attention in improving corporate governance. The first is that of creating an enabling environment through reform in the regulatory, legal, judicial and administrative mechanisms. The second is fully in the ambit of the companies themselves that would evoke public confidence directly or through reputation agents. A set of actions should be taken such as restructuring the Board structures and processes, improving the accounting, disclosures and reporting standards and respecting shareholder and stakeholder rights, which also reflect the critical principles stated by the OECD and the CACG.

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As elsewhere in the world, NBFCs in India have also had a long history and played a significant role in filling up the market gaps – they played a pioneering role in promoting leasing as alternate source of finance for the transport/automobile sector in India.  Over a period, some of the major companies diversified their financing activities and entered into areas which hitherto were confined to banking institutions. Often times, it is remarked that lines between ‘banks’ and ‘non-banks’ are getting blurred elsewhere in the world as well as in India and this perception, rightly or wrongly, led to replication of banking models of regulation & prudential standards to NBFCs. In the past (1971-2001) several Expert Committees constituted by RBI have deliberated upon the role & the regulatory measures needed and came out with their recommendations.

Currently, the NBFC sector in India is in a major transitional phase – a unique process of consolidation, and stabilization.  The CRB collapse in April, 1997 made the sector vulnerable; the loss of depositors’ monies in the CRB episode have raised issues of credibility and integrity of the promoters of some of the companies and the ‘black sheep’/ fly-by-night operators vitiated the climate and resulted in many people screaming that NBFCs should ‘shape or ship out’.  The major shake-out in the sector is the consequence of a massive regulatory reform and introduction of a new supervisory regime from January 1998.  In the process of reorganization of the sector, several companies closed their businesses, cut the size of their operations, shrunk their balance-sheets, which resulted in a major weed-out of number of companies and reduced the sector’s volumes of business.

After the CRB episode in 1997, NBFCs in India suffered a major setback.  Following position emerged as a sequel to the CRB phenomenon:

Introduction of a rigorous regulatory & supervision system

• A new system of registration
• Prudential norms – capital adequacy, creation of Reserve Fund, Liquidity Ratios, etc.
• Credit rating system
• RBI introduced a system of Investor education through press releases. 
  
• Major shakeout in the NBFC sector
• Recognition of the need for new structures & strategies with a clear vision & mission
• Realizing the need for a planned way of tackling emerging issues & challenges
• Industry Associations & Managements contemplating a new ‘Action Agenda’ for the sector’s survival, growth & development
• As on 30^th June 2002, 784 companies only are authorized by RBI, by way of a system of registration to hold or accept public deposits.  Applications for Certificates of Registration (COR) were received by RBI from 36,269 companies. COR was approved for 14,077 companies.  COR were registered/cancelled in the case of 19,109 companies. 

II.      It is clear from what is set out that the NBFCs in India are passing through a major transformation – the “Darwinian” theory of the “survival of the fittest” seems to be working.

However, it has been well recognized both in the GoI & RBI and in the financial market, that NBFCs have a significant role to play for the development of the real sector.  Some factors to be considered are:

(ii) They need to establish arrangements to raise liquidity in an “emergency” and ensure that there are no deferments/defaults in payment of interest & repayment of deposits on maturity.

(iii) A group/cluster of NBFCs should form into a “consortium” for bail out purposes. It is good to study models of such non-government ‘bail-out’ systems else where in the world, particularly some past cases in Germany where the market received institutions to maintain systemic stability & integrity.

(iv)   Put in place a Risk Management & Asset Liability management system, say by identifying first a good quality asset and raise a matching liability and also minimize maturity mismatches.

(v)  Establish good corporate governance systems and self-regulation. Establishment of a SRO is the need of the hour.

(vi) Reengineer their corporates/managements in such a way that they reorganize their business structures, portfolios, risk profiles and be able to cope with the strict regulatory & supervisory system.

3.       Emerging Challenges & Issues – Industry’s Perspectives & Perceptions:

4.     Prognosis

(i)     World Bank/IMF’s Perceptions

6.      Issues for Deliberation

ii. How is the new regulatory regime perceived?  If changes are needed, what are the recommendations?

iii.  Are the NPA norms and their tax treatment harsh and need to be revisited?

iv. In the light of CRB experience, should the selective entry, with high ‘start-up’ capital continue?

v. Is it preferable that NBFCs confine to their specialists/niche role and engage in activities where they have well defined strengths/core competence?

vi.  Is it possible and desirable to setup a Self-Regulatory Organization (SRO) – if so, what should be its broad functions and powers to ensure effective regulation? Can the NBFCs form into Groups/Consortia in order to ‘rescue’ a failing institution?

vii. If some of the large NBFCs wish to undertake a wide range of activities of a banking-model, is it better if they convert themselves into banks?

viii.In an emergency, what arrangements are possible for an NBFC to raise liquidity?

ix.  To establish good corporate governance systems and undertake Corporate & Management Reengineering, what measures are required in terms of Board composition, changes in business strategies, innovations in products, instruments & services, accounting standards, transparency and disclosures of transactions.

x. What arrangements are needed for developing/upgrading, on an on-going basis, professional expertise at the operational level in the institutions, and also ensure that Board Directors keep themselves abreast of all the emerging changes and developments in a dynamic market scenario with more intensive competition and incessant growth of innovations as a sequel to globalization and liberalization?

 

Annex

Need for Self-Regulation & Stronger Corporate Governance in NBFCs

The Reserve Bank of India’s (RBI) Governor, Bimal Jalan, in his inaugural address at the National Conference of NBFIs organized by the Academy of Corporate Governance on 18^th October, 2002 in Mumbai stressed on the need for a stronger corporate governance (CG) code specially in deposit taking non-banking finance companies (NBFCs) in order to safeguard interests of the depositors. The points emphasized by the Governor are:

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A unique experiment is being initiated in Kerala amongst the State Level Public Enterprises (SLPEs) as a part of the SLPE reform programme and post reform capacity building. It was conceptualized and suggested that a quarterly Operating and Financial Statement (OFS) be submitted by the management to the Boards of SLPEs which will include apart from the usual financial data:

a. A report on the (Key Performance Indicators) KPIs and an analysis of vacancies there of.

b. Qualitative statements on the progress made by the company.

c. Alerts on actual and potential material opportunities, risks and critical issues in business operations and

d. Statement of any instances of any corrupt practices by any employee or agent of the SLPE including any incidence of a demand for or offer of an inducement being made by or to a current or potential customer, client or contractor of the SLPE to gain a business opportunity.

While the first three are incidental aspects of good governance practices pursued by progressive companies, uniqueness arises from the fourth point. Conceptualised by Michael Gillibrand of the Commonwealth Secretariat during interactions with the SLPE managements and directors, the Public Sector Restructuring & Internal Audit Board (RIAB) is taking steps for introducing the Operating and Financial Statement (OFS) to the Boards of SLPEs for facilitating better governance.

According to Mr. Padmakumar, Secretary of RIAB, Government of Kerala, “this statement would make the CEO and top management introspect on the ethical considerations followed in business practices. This would also cause them (though not enforceable by law) to institute adequate internal control mechanisms to practice corporate ethics and a code of conduct being laid down for good Corporate Governance and not overlook them”.

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