Navigating the Perils of Over-Reliance: An advisory for NBFCs by RBI

In a recent address, RBI Deputy Governor Swaminathan, underscored the critical risks facing non-banking financial companies (NBFCs) due to their over-reliance on a limited range of funding sources and product types. Highlighting trends such as retail unsecured lending, top-up loans, and capital market funding, Swaminathan cautioned that these practices, while currently popular, might lead to significant difficulties in the future.

This comprehensive note delves into the key points raised by Swaminathan, exploring the implications for NBFCs and offering insights into sustainable risk management practices.

The Allure and Risks of Homogeneous Product Offerings:

Swaminathan observed a concerning trend among NBFCs- a proclivity to focus heavily on certain high-yield products like retail unsecured loans and top-up loans. While these products can be profitable, their homogeneity poses a significant risk. Concentration risk, where a company's portfolio is too heavily weighted in one area, can lead to catastrophic losses if market conditions change unfavorably.

“It is imperative that heads of risk functions at NBFCs closely monitor their business models and regularly scan their portfolio mix to prevent a build-up of concentration risk,” Swaminathan urged.

He noted that some entities have set risk limits for certain product categories, such as unsecured lending, at unsustainably high levels. This over-concentration makes NBFCs vulnerable to systemic shocks and economic downturns.

To mitigate these risks, Swaminathan recommended that heads of assurance functions include forward-looking risk management strategies in their board presentations. This proactive approach ensures that potential risks are identified and managed before they become critical issues.

Enhancing Risk Management and Compliance :

Swaminathan emphasized the need for NBFCs to invest in robust risk management frameworks. This includes developing early warning systems, conducting stress tests, performing vulnerability assessments, and monitoring cyber risk indicators. Additionally, targeted evaluations of compliance with KYC (know-your-customer) and AML (anti-money laundering) norms are essential.

One of the key recommendations was the implementation of comprehensive transaction monitoring capabilities.

By keeping a close watch on transactions, NBFCs can detect suspicious activities early and take appropriate action to prevent financial crimes.

The Pitfalls of Rule-Based Lending Models :

With the rise of automation, many NBFCs have turned to rule-based credit engines to expand their lending portfolios. While these models can enhance efficiency and scalability, Swaminathan warned that over-reliance on them could be detrimental. These engines are only as good as the data and criteria they use, and they can lead to inaccuracies in credit assessment, especially in dynamic market conditions.

“It is crucial to recognize that rule-based credit engines must be continuously monitored and validated to remain effective,” Swaminathan said. He advised NBFCs to maintain a clear perspective on the limitations of these models and to supplement them with human judgment and ongoing validation.

Swaminathan stressed the importance of periodic calibration of rule engines and models, taking into account real-time learnings and emerging scenarios. This approach ensures that the models stay relevant and accurate.

He called upon heads of risk and internal audit to pay special attention to this requirement, highlighting the need for internal or external validation of these models to maintain their efficacy.

Addressing Liquidity Risks:

Liquidity risk, arising from the concentration of funding sources and maturity mismatches between assets and liabilities, was another critical issue highlighted by Swaminathan.

“Reliance on a limited number of funding sources can amplify liquidity vulnerabilities, especially during periods of market stress or disruptions in funding channels,” he noted.

To mitigate liquidity risks, Swaminathan recommended several prudent practices:

1. Diversification of Funding Sources: Relying on a broader range of funding sources can reduce vulnerability to market stress.
2. Maintaining Adequate Liquidity Buffers: Holding sufficient liquidity reserves can help NBFCs navigate periods of financial strain.
3. Monitoring Maturity Profiles: Keeping a close watch on the alignment between asset and liability maturities can prevent liquidity squeezes.
4. Establishing Contingency Lines: Having backup funding arrangements in place can provide additional security during crises.

Additionally, Swaminathan highlighted the importance of stress testing and scenario analysis to assess resilience to adverse liquidity shocks. These tools can help NBFCs proactively manage liquidity risks and ensure uninterrupted operations.

The Role of Internal Audit and Assurance Functions :

Swaminathan pointed out that many NBFCs’ internal audit functions do not adequately audit the assumptions and inputs used in calculating liquidity risk management ratios. He emphasized the need for capacity building in mid-office and back-office functions to improve the assessment and monitoring of asset-liability management (ALM) and liquidity risks.

Moreover, Swaminathan expressed concern over the relatively low number of compliance staff in NBFCs compared to other sectors like commercial and cooperative banks. He observed that, despite regulatory measures aimed at ensuring the autonomy of compliance functions, there were instances where heads of assurance functions held junior positions within the organizational hierarchy or lacked direct access to the board.

“Such practices undermine the effectiveness and independence of assurance functions, potentially exposing NBFCs to heightened risks and attracting enhanced regulatory scrutiny,” Swaminathan warned. He also noted the problematic practice of dual-hatting, where heads of assurance functions take on additional roles, further compromising their effectiveness.

Moving Forward: Recommendations for NBFCs :

To navigate the complex landscape of financial risk and ensure sustainable growth, NBFCs should consider the following recommendations:

1. Diversify Funding Sources: Expanding the range of funding sources can reduce vulnerability to market disruptions and liquidity stress.
2. Develop Comprehensive Risk Management Frameworks: Investing in early warning systems, stress testing capabilities, and cyber risk monitoring can help identify and mitigate potential risks early.
3. Regularly Validate Rule-Based Lending Models: Continuous monitoring and periodic validation of automated credit assessment models are crucial to ensure their accuracy and relevance in dynamic market conditions.
4. Enhance Liquidity Management Practices: Maintaining adequate liquidity buffers, monitoring maturity profiles, and establishing contingency funding lines can help manage liquidity risks effectively.
5. Strengthen Internal Audit and Assurance Functions: Ensuring that these functions have sufficient autonomy, resources, and access to the board is essential for effective risk management and regulatory compliance.
6. Invest in Compliance Staff: Increasing the number of compliance staff relative to the size of the organization can enhance the effectiveness of KYC/AML compliance and transaction monitoring.

Conclusion

The insights provided by RBI Deputy Governor Swaminathan serve as a critical reminder for NBFCs to reassess their risk management strategies and business models. By addressing the issues of over-reliance on limited funding sources and product types, enhancing risk management frameworks, and strengthening internal audit and compliance functions, NBFCs can better navigate the challenges of a dynamic financial environment. These measures are not just regulatory requirements but are essential for the long-term sustainability and resilience of NBFCs in the face of evolving market conditions.