RBI order restricting 4 NBFC operations lacks clarity. It won’t help customers, companies

When the regulator clearly articulates the principles it has applied, other regulated entities in similar situations get informed on what is acceptable and what isn’t.

The Print
23 October 2024

The Reserve Bank of India issued directions to four non-banking finance companies not to disburse new loans after 21 October 2024. The directions suggest these companies were violating regulations and have now been asked to take remedial action. The press release, however, doesn’t provide adequate information on what exactly happened, and how customers and other regulated entities should read these actions.

What action did the RBI take and why?

The RBI does not release its orders in the public domain. Our inference, therefore, comes from the press release. The RBI finds the four NBFCs guilty on multiple counts: these entities levied interest rates that were excessive and did not follow RBI regulations; they were not following provisions laid down under the Fair Practices Code and regulations that required them to asses household income before giving a loan; they issued ever-greening loans; there were issues with conduct of gold loan portfolio, mandated disclosure requirements on interest rates and fees, outsourcing of core financial services, etc. The companies have been told not to give out fresh loans until they have fixed all the problems to the RBI’s satisfaction. However, they have been allowed to continue operations with existing customers.

Information for customers

Most of the complaints against the four companies seem to pertain to small loans, which presumably have to do with unsophisticated consumers. The regulations that the firms violated were put into place so that firms behave better with customers, and if they misbehave, customers would have recourse to the complaints mechanism and seek redress.

If you were a consumer of any of these NBFCs, what could you tell from the press release? There are many violations the NBFCs are charged with. The press release does not inform you what the entity is guilty of – one should probably presume that all were guilty of everything that is mentioned. This means that you were charged usurious interest rates and were a victim of unfair practices. The press release, though, does say that in the context of micro-finance loans, the firms were not assessing household income or existing repayment obligations before providing a loan. If you are a consumer desperate for the loan, this perhaps makes you feel better, because otherwise you may have been denied credit.

The regulatory actions offer existing customers no recourse. The NBFC can continue collecting repayments from you. If there were such egregious consumer protection violations, shouldn’t existing consumers be offered some recourse? Should the companies not be asked to evaluate which of their consumers have been wrongly charged? The companies were allowed to complete ongoing transactions between 17 and 21 October. What should consumers who were in the process of taking a loan during this period make of the press release? Are the companies expected to take suitable remedial actions for these loans? Clarity in the press release on what the charges against each NBFC are and what RBI means by suitable remedial actions might at least help consumers file complaints and decide their next course of action.

Information for other firms

The primary concern raised in the press release seems to be that of usurious interest rates. This is a bit of a puzzle because the RBI policy on interest rates has been fairly liberal. The board of the organisation is supposed to lay out the interest rate policy, and the firm has to adhere to it. The policies had to detail out ceilings on interest rates and all other charges.

The press release tells us that “the Weighted Average Lending Rate (WALR) and the Interest Spread charged over their cost of funds, which are found to be excessive and not in adherence with the regulations”. But the regulations place the responsibility on the board. Does this mean that the firms violated the policy set out by their board? Is this what is meant by “not in adherence with the regulations”? Or does the RBI mean that it has a view on what “excessive” is, and even if the interest rates were in adherence to what the board had set out, the RBI found them to be excessive. The implications to other regulated entities would significantly differ based on the answer to this question.

Similarly, the RBI is unhappy with how the companies have assessed household incomes. Other regulated entities might benefit from knowing how the RBI thinks of good methodology for calculating household incomes — especially because the NBFC has a clearer picture of the household it is dealing with than the regulator. The RBI may already have spelt out details in its circulars on how to do this, but those seem to not have been enough.

Some analysts have suggested that what is really going on is that the RBI is wary of the co-lending model adopted by two of the NBFCs, and these actions are a signal to the market to go slow on unsecured lending. The press release, however, provides no such indication. Had the press release been clearer, regulatory intentions would be better understood.

The importance of clarity

Regulatory actions serve important signals not just for the specific entity but the market too. When the regulator clearly articulates the principles it has applied, other regulated entities in similar situations get informed on what is acceptable and what isn’t. Perhaps there are informal channels in Mumbai where the rationale for regulatory actions is known and discussed, and one just has to be plugged into the network to know what is going on. However, that cannot be the basis of regulation in an aspirational economy.

Two railways privatisation models for India to learn from—UK & Japan

The experience of privatisation of railways across the world has been mixed. There have been some failures where the incentives did not play out and outcomes didn't match expectations.

Union railways minister Ashwini Vaishnav has categorically stated that the sector will not be privatised. Many Indians would have heaved a sigh of relief. Our anxiety may not be misplaced — railway privatisation has been fraught with difficulties in many parts of the world. However, it might be useful to analyse the different models for privatisation and consider the possibility that it may encompass many choices that eventually improve efficiency, safety and quality of service.

A railway train between point A and point B consists of different functions. At the very least, there are the railway lines, platforms, train coaches (or the rolling stock) itself, the signals that guide the coach and ensure no accidents, maintenance of the tracks, signals, coaches, ticket counters and reservation system, and the services within the trains such as food and other hospitality. Railway privatisation could mean handing over ownership of one or all components of the system to a private party. The handing of the full process in a region to a private entity is known as horizontal separation. It could equally mean handing over only the running of some parts of the system without giving up ownership. This is known as the vertical separation model.

Two examples

Let’s take the example of the United Kingdom. Its 1994 experiment of handing over infrastructure to the private sector did not work very well. In 2002, therefore, it established a public body, the Network Rail, which owns and manages a large chunk of the railway infrastructure such as tracks, bridges, tunnels, signaling systems and some of the stations. The trains, however, continue to be privately owned and run by train operating companies. These companies are largely based on a franchisee model where private firms bid to run rail services. The revenue risk in this model is borne by the private companies. This engendered incentives to cut costs by potentially lowering the quality of services or compromising on safety standards. Due to the inefficiencies of the franchisee model, the arrangement is also changing. In 2021, the Williams-Shapps Plan recommended the consolidation of various activities of Network Rail and other ancillary organisations into a new public body called the Great British Railways. The Plan has also proposed the end of the franchisee model. But it has not proposed the full return to government management either. The proposal is to set up a concession-based model, where private companies will be paid to run services and meet specific performance targets.

Another example is that of Japan. Unlike the UK, which undertook a vertical separation of the railways, Japan chose horizontal separation. It split the public sector entity, the Japan National Railways (JNR) into six passenger rail companies, operating in different regions of the country, and one freight company operating throughout. Each private company is responsible for the ownership, operation and maintenance of the infrastructure on its lines. The Japanese system also allows for "third-sector" railways where the government funds large projects but leaves the management to the private sector.

Lessons for India

Privatisation of railways need not mean complete ownership of the railway infrastructure or services. There are various models that could be considered, depending on what we want out of the rail system and what the current bottlenecks are. For example, we could continue to retain the ownership of the infrastructure as public utilities but allow the private sector to provide services, including the operation of train services. Alternatively, we could consider allowing for private companies to own rolling stock, which then lease it to private sector operators who run the trains.

The success of any model also depends on the surrounding legal and regulatory infrastructure required to make this work. For example, licensing and leasing require contracts that are fair and applied consistently. In both the UK and Japan, the regulator plays a pivotal role on issues such as licensing of private parties, safety standards, tariff setting, and consumer protection. In the UK, the Office of Road and Rail (ORR) oversees Network Rail, a public sector body, as well as other functions. In Japan, the Ministry of Land, Infrastructure, Transport and Tourism (MLIT) performs most regulatory functions. A liability regime and compensation framework in the event of accidents is another critical component to set the correct incentives for the private sector. In the UK and Japan, railway companies owe a duty of care to their passengers and in the event of an injury, the framework actually delivers compensation.

The experience of privatisation of railways across the world has been mixed. There have been some failures where the incentives did not play out and the outcomes did not match expectations. However, the efficiency, quality of service, and fiscal sustainability have been better than what would have ensued under fully nationalised railway systems. Most countries that went down this route are not walking back to a fully nationalised system. There are various models in which the three functions of ownership, operation, and maintenance are shared between the public and private sectors, each with their trade-offs. Even incremental reform to allow for private participation will bring in more investment and efficiency into the current operations of the railways.

This was published in the Print, 9 October 2024.