Economist Paul McCulley coined the term shadow banking in 2007 to explain the system of unregulated financial companies that operate outside the traditional banking system. “Unlike conventional regulated banks, unregulated shadow banks fund themselves with uninsured short-term funding, which may or may not be backstopped by liquidity lines from real banks.” Although at the time, he was specifically referring to the shadow banking system in the American economy, credit has existed and thrived outside the traditional banking system in most economies for centuries. Take informal money lending for example. In India, the rural economy has relied on informal money lending heavily for long. Although the risks associated with this sector are high, it is a more accessible and viable option of availing credit for many small businesses.
Shadow Banks (somewhat ominously termed), may not follow the same guidelines that govern the traditional banking system, but they include legitimate companies with a greater freedom of operation and less stringent rules. Shadow banking is a universal phenomenon and takes up various forms. It may take the form of high risk, short-term funding for long-term investments like infrastructure projects or peer to peer lending and high-risk investment products.
In developed economies, shadow banking focuses primarily on securitization of high-risk funds whereas in developing economies such as India, shadow banking is found to be actively supplementing the traditional banking system- providing a haven to individuals and corporations alike to park their liquid funds with easy access, less regulations and a comparatively lower cost of managing said funds.
In the Indian economy, this alternative system of credit can be bifurcated into two broad sectors- the informal sector which operates outside the radar of the banking regulations and legislations and the formal sector which is represented by NBFCs (Non-Banking Financial Companies).
NBFCs are companies incorporated under the Companies Act, 1956 and are regulated by the Reserve Bank of India (RBI). While the informal sector mainly caters to individuals and small/micro businesses which are financially excluded due to lack of collateral and lack of access to the formal banking system, the NBFCs, operate under the guidelines laid by the RBI and provide credit to governments, high net worth individuals and companies looking for liquid finances for investments and peer lending. As NBFCs are regulated by the RBI and operate under the RBI’s watch, they may not strictly be considered as shadow banks.
NBFCs IN THE INDIAN ECONOMY
Non-Banking Financial Companies play an important role in the Indian financial market. While the RBI regulates both NBFCs and banks, there are some significant differences in the regulatory treatment, with NBFCs being given greater flexibility in governance structures and operational matters, and being allowed to lend independent of priority sector targets and of statutory reserve requirements.
NBFCs play the role of a financial intermediary between investors and banks. While they do not hold banking license and may not accept deposits like a bank; their flexible structures help them to provide myriad services often tailor made to suit the needs of their clientele. NBFCs engage in many different categories of services including hire-purchase finance, construction finance, loans, housing finance, peer to peer lending among others. On a similar vein, NBFCs provide financial services in less developed states to small corporations and micro industries which may be excluded from the formal lending sector on account of low collateral or unstable credit history. Such NBFCs are usually micro-finance institutions which provide liquid funds to eager customers who are willing to pay higher interest rates on account of their inability to get funds from banks or non-availability of formal lending in their area. This has also substantially helped reduce the dependence on informal sector lending in such marginalised areas.
Categories of NBFCs-
NBFCs have been divided into several categories based on the services they offer and are governed by different authorities which are in turn governed by the RBI. These include-
- Housing Finance Companies – regulated by the National Housing Bank;
- Insurance Companies- regulated by the IRDA;
- Chit Fund Companies- regulated by the respective State Governments;
- Merchant Banking Companies, Venture Capital Fund Companies, Collective Investment Schemes- regulated by the SEBI.
NBFCs being financial intermediaries, are able to provide a more economical service due to the economies of scale and their ability to spread the risk of generating funds over a large number of units, hence, providing their customers with high liquidity and a higher return than traditional banks. Further, as NBFCs are not controlled or regulated to the same extent as commercial banks, they have a greater freedom in choosing their policies and clientele, which do not have to necessarily be in consonance with national objectives like priority sector lending etc.
NBFCs AND CURRENT CONCERNS
The prime concern at present is to protect the interests of the investors. The many levels of inter-connectedness of NBFCs through peer to peer lending and layered investments means that the financial/credit assessment of such NBFCs is difficult. The RBI has been working to streamline the operations of the NBFCs and bring about more transparency in their operations. The desired supervision should be more pragmatic, and genuinely risk-based, and which can be followed, much more in letter, than in spirit.
In furtherance of the same, the RBI has decided that lending to NBFCs would henceforth be based purely on the ratings given to such NBFCs by rating agencies accredited by the RBI. This makes the lending assessment similar to the one practised for lending to corporates and is a preventive for bad debts and NPAs. The RBI will be formalising the guidelines in this regard by the end of February, 2019.
Shadow Banks play an important role in every economy. In India, NBFCs are a more structured and regulated form of Shadow Banks and are function parallel to the traditional banking system. It is clear that NBFCs are an important and necessary alternative for corporations and individual investors alike.
In a growing economy like ours, the NBFCs need guidance from the RBI as has been proven during the IL&FS crisis in 2018. NBFCs are supplemental to the traditional banking system and also foster financial inclusion in the economy by giving access to micro industries. These qualities make it an imperative part of the economy.
 Paul A. McCulley, The Shadow Banking System and Hyman Minsky’s Economic Journey, Economic and Market Commentary (May, 2009), https://www.pimco.com/en-us/insights/economic-and-market-commentary/global-central-bank-focus/the-shadow-banking-system-and-hyman-minskys-economic-journey/
 ICRA’s Credit Rating Methodology for Non- Banking Finance Companies, ICRA Rating Feature, https://www.icra.in/Rating/ShowMethodologyReport/?id=395