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Concerns for Prudential Regulation in a Modular Financial System

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This post is part of our blog series on the Conference on Designing Regulations for a Rapidly Evolving Financial System hosted by Dvara Research.

In the previous blog post, we discussed about existing and new kinds of harms to consumers in a modular world, and consequently the need for consumer protection regulations to be strengthened in tandem with the trend of “Modularisation” in the financial system. This post deals with the concerns for prudential regulation in a similar environment.

Prudential regulation is commonly understood as capital regulation – regulation that requires firms to maintain adequate capital resources to ensure that there is no significant risk that its liabilities cannot be met. The primary function of a prudential regulatory framework, however, is to impose well-defined conditions for entry and propagation of activity by firms in the financial system. This should be done in such a way that there is a stable relationship between promoting competition and preserving consumer welfare and systemic stability. From the regulatory perspective, it is important that regulations are applied in a manner that is function-specific and institution-neutral in order to make sure competition in the market is sustained. Taking the example of credit intermediaries, several institution-types come to mind, that provide the function of credit intermediation, such as banks, NBFCs, and even Telecom companies through Direct Carrier Billing, and yet the manner in which some of the micro-prudential rules have been designed so far are inadvertently skewed against smaller institutions and certain institution-types.

Existing micro-prudential regulation design may provide an uneven playing field between incumbents and newer market players

Micro-prudential regulations typically concern with achieving a pre-defined target probability of default of regulated firms. The ‘probability of failure’ of firms is to be regulated, and the role of regulation is not to bring down the failure probability to zero but to make sure that the market is protected from unstable institutions while at the same time remaining competitive. Given that NBFCs are an early example of dis-intermediated institutions, it is important for us to consider the current regulatory landscape of NBFCs and understand anomalies if any. For example, Non deposit taking NBFCs (NBFCs-ND) provide credit intermediation functions similar to that of a bank without the acceptance of deposits. However, it has been the case that NBFCs have been prescribed capital requirements higher than those of banks. The design of these high capital requirements for NBFCs has been rationalised, for the most part, by the following:

  1. To protect the depositors of banks and the other creditors of the NBFC from the usually high levels of concentration risk.
  2. To compensate for the “lower touch”[1] regulations with regard to market conduct and consumer protection

In this case, the regulator should instead consider strengthening banks’ ability to assess the risk of lending to NBFCs and encourage risk-based pricing of funds as required. Stronger consumer protection and conduct regulations have to be developed and sufficient regulatory capacity should be created to enforce them instead of the ostensible use of micro-prudential regulations to solve a consumer protection problem. These high capital requirements have resulted in negative implications for the sector such as restricting credit growth and higher interest costs for consumers. It has also created an anti-competitive environment for NBFCs.

Existing regulatory frameworks may not completely capture new modular firms

Powerful tools such as licensing would need to be carefully applied as it can serve as the most critical barrier to entry. Regulatory framework should avoid taking a central planning approach while designing regulations for these newer entities with non-traditional business models. Regulatory design should consider whether the exact function of the modular firm justifies a need for regulatory oversight and if so, what the optimal channel to apply regulations is. Policy makers should not be considering details of or interfering with the kinds of business models as well as product-designs that should exist for the customers.

An instance of this is the regulation for Small Finance Banks (SFB) requiring them to originate 75% of their assets as Priority Sector Loans (PSL), a case of the regulator deciding the business models of regulated entities. The Revised Regulatory Framework for NBFCs[2] released by the RBI discusses the pre-conditions for the application of Prudential and Conduct Regulations. It is noted that prudential regulation, more specifically capital regulation, would apply to any NBFC that has access to public funds[3]. Conduct regulations would apply to any NBFC that has a consumer interface. This framework could be used as a base to identify the newer types of firms that would require prudential regulations. In many cases, the modularised entity providing an essential function while working with a bank or NBFC is covered by third party guidelines[4].

Measuring systemic risk becomes harder in the case of Modularisation

With the increasing number of participants in the financial services sector, and the increasing ease of manufacturing and delivering customised credit products for customer segments, it is likely that this could lead to a rapid expansion of credit in the economy. The increase in the availability of cost-effective delivery channels and better data-driven credit assessments might encourage lenders to concentrate on certain segments. It is likely that there is high concentration risk in particular customer segments such as urban salaried class who are currently experiencing the benefits of increased access to credit.

It could also be argued that the effects of Modularisation could bring down systemic risk as it would encourage lenders to diversify to segments that were traditionally neglected due to the lack of under-writable information. For example, better data driven credit assessments may be available on SMEs which may encourage banks and NBFCs to lend more to these segments. Hence, Modularisation could have an indirect positive or negative impact on systemic risk. It is important to now place special emphasis on employing tools to measure and understand systemic risks in the modular world.

It is thus evident that modularisation is going to have a significant impact on both micro and macro prudential risk in the financial system. Regulators would need to proactively anticipate these risks and design regulations accordingly.

In the concluding post of this series, we outline and briefly discuss the academic and policy research questions that emerged from the deliberations of the conference.

[1] Review of NBFC Regulatory Framework – Recommendations of the Working Group on Issues and Concerns in the NBFC Sector (

[2] Revised Regulatory Framework for NBFCs, 2014, Notification, Reserve Bank of India (

[3] ibid


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