On May 10, India’s Supreme Court (SC) has given the verdict that non-banking finance companies (NBFCs) cannot be regulated by the State-enacted moneylending legislation. This brought a respite to NBFCs bothered by the 13-year-long cases in Kerala and Gujarat, which tried to regulate the business of NBFCs, including the level of interest rates charged by them to borrowers.
The Case
In 2009, several NBFCs filed applications in the Kerala High Court (HC) after the State government asked them to obtain licenses under the Kerala Money Lenders Act, 1958, failing which penal consequences were threatened. However, Kerala HC ruled in favour of the State government in November same year causing non-bank lenders to move the SC for resolution.
A similar crisis struck in Gujarat around the same time but there was a different outcome. The office of the Prevention of Money Lenders in Gujarat asked NBFCs to register under the Bombay Money Lenders Act. Opposing the move, the NBFCs filed pleas at the Gujarat HC, which had ruled in favour of the lenders in 2010. Again, in 2011, the State asked NBFCs to register under the Gujarat Money Lenders Act but failed after the HC ruled in favour of lenders in the same year. This led the Gujarat government to file an appeal against NBFCs before the SC.
What is moneylending legislation and how it’s different from NBFC regulation?
In India, moneylending legislation was introduced to curb non-regulated indigenous lenders from charging exorbitant interest rates to borrowers. It requires licensing of moneylenders, imposing a ceiling on the rate of interest (which, in the Kerala Act, was a maximum 2% above the maximum interest charged by commercial banks), mandating moneylenders to keep books of accounts and give receipts, etc. One of the earliest moneylending regulations in India is the Bengal Moneylenders Act, which was enacted before Independence, in 1940.
As per the scheme of the Constitution, there are three Lists with respect to the allocation of powers between the Union and the States. List 1 is the Union list, where only the central government is competent to make laws, List 2 is the State List, where state governments are allowed to make laws, and List 3 or the Concurrent List, where both Centre and States are competent to make laws. While giving the verdict, SC has stressed that comprehensive regulations with respect to NBFCs fall in List 1 while moneylending legislations fall in List 2.
The conflict between the two regulations arose because many of the moneylending legislations were imposed at a time when there was no clarity with respect to the regulation of NBFCs by RBI. The Reserve Bank of India Act, 1934 was enacted initially to regulate banks, and the regulation for NBFCs was included at a much later date in the act. However, during the time when the clarity is yet to come state governments faced issues like farmers’ suicide or there could be some political imperative that led them to take action against NBFCs as per the moneylending act.
The NBFCs were anguished by the state government’s attempts to bring them under the moneylender act due to the adverse effect of a dual and disparate regulation on economic efficiency in doing business. Secondly, making NBFC subject to state regulation took away their flexibility of doing business and exposed them to several risks, for example, a decision of moratorium on loans taken by the state government as political imperative would need them to comply with.
Microfinance crisis
Around the same time, in 2010, the microfinance (MFI) sector in Andhra Pradesh (AP) struck with a similar crisis. MFIs operate like NBFCs and provide credit to the underprivileged sector. They started emerging in 1990s, mainly in AP. Due to this, the State is deemed as the motherland of the MFI industry in India. The crisis happened right after the successful listing of a major MFI player in the state, SKS Microfinance (which later renamed as Bharat Financial in 2016 and merged with IndusInd Bank in 2019).
In Oct 2010, the AP government passed The Andhra Pradesh Microfinance Institutions (Regulation of Moneylending), Act following an ordinance to curb the activities of MFIs, which include specifying the area of their operation, rate of interest, and recovery practices. The legislation was passed after a spate of suicide by rural borrowers due to alleged coercive loan recovery methods followed by MFIs. The AP government barred SKS and other MFIs as well as some NBFCs from giving loans causing the MFI sector to collapse and shutdown of many smaller companies.
In 2011, SKS filed a plea in SC challenging the AP MFI Act and sought scrapping of the legislation. In 2013, SC has provided interim relief to SKS to operate in the State until the case is resolved. However, it directed SKS to adhere to the Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Act. In 2017, the SC did not give any immediate relief to SKS and asked the company to plead its case before the AP HC only.
The latest SC Verdict
The bench of Justices at the SC held that NBFCs do not fall under the jurisdictions of moneylenders acts of State governments when the financiers are already regulated by the Reserve Bank of India Act, 1934. The top court identified the conflict between the RBI Act and the Moneylenders Act. It implied that Chapter IIIB of the RBI Act covers the cradle to the grave of NBFCs. “As a consequence, the single aspect of taking care of the interest of the borrowers which is sought to be achieved by the State enactments gets subsumed in the provisions of Chapter IIIB,” the bench said.
Expected impact
The latest ruling expects to favorably impact NBFCs in the following ways:
Smooth functioning: It expects to enable smooth functioning of NBFCs due to reduced levels of intervention. State governments have often attempted to take steps against NBFCs under their moneylending acts even though the issue was still being subjudice.
No dual regulation: The issue gave rise to the possibility of dual regulation of NBFCs, which is not new in the Indian market though. Previously, some regulatory aspects of Cooperative banks were divided between state governments and RBI. However, it gave rise to lapses and the Centre had to revise such regulations in Sep 2020 and gave RBI more regulatory control. Dual regulations in the NBFC space due to the presence of a State enactment and RBI regulation created a lot of uncertainties, mainly in Gujarat and Kerala, which are expected to go away with the latest ruling.
Lower pressure on NIM: The cost of borrowing of most NBFCs expects to increase in a rising interest rate environment. The latest ruling expects to help lenders lower pressure on their net interest margin (NIM) due to a lack of intervention from state governments while passing on the rate hike to borrowers.
Disclaimer:
The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.
