In 2021, the Reserve Bank of India (RBI), through several consultative documents, indicated that the non-banking financial company (NBFC) sector may undergo significant regulatory changes. While some proposed changes enable easier lending for NBFCs, others lead to additional costs. One such proposal, made in the RBI Discussion Paper on Revised Regulatory Framework for NBFCs- A Scale-Based Approach, is to mandate a Core Banking Solution (CBS) for all NBFCs with more than 10 branches.
A CBS, at the core of the proposal, is a comprehensive, off-the-shelf product, catering to all back-office operations of commercial banks. Such a “bank-in-a-box” product integrates several modules covering deposits, loans, clearing, payments, guarantees, treasury operations, teller features, and ATM integration, among others. Keeping this in mind, to understand this proposal’s implications, we present our arguments across three aspects— relevance, cost, and applicability.
Figure 1: The Components of a CBS
On Relevance, evident from the definition, CBSs cater to the wide-ranging requirements of banks. However, they tend to be rigid in most aspects and the complexities involved often make customisations difficult. Business processes, flexible schedule definition, repayment frequency, interest accrual method, moratorium changes, among others, are a few examples where undertaking changes in CBSs are complex. In contrast, other systems, like Loan Management Systems (LMSs), offer more flexibility, without burdening the lender with unnecessary modules.
This difference in features becomes very significant for NBFCs since they are restricted from offering demand deposit accounts, accessing Payments and Settlement Systems (PSS), among others. Consequently, NBFCs need and tend to opt for specialised systems that meet their requirements. For instance, they have customised systems to suit their business for various stages of the lending journey such as loan origination, credit underwriting, loan servicing, collections, monitoring, etc. These systems not only offer customised functionality but also provide flexibility to make changes as the business evolves Thus, a rigid “bank-in-a-box” product is ill-suited for NBFCs’ needs.
Costs associated with a CBS are another major hurdle. NBFCs are highly specialised lenders, often focusing on select product segments. They generally need more customised LMSs with integrated sophisticated Loan Origination Systems (LOSs). Thus, the RBI’s decision to mandate CBSs for NBFCs is at best redundant, and at worst counterproductive, as NBFCs will be forced to onboard expensive CBSs while retaining their customised LMSs.
Further, the Total Cost of Ownership (TCO) of a CBS ranges from 0.50% of AUM for a typical bank to about 3% of the AUM for NBFCs (with INR 100 crores (Cr) in AUM). In contrast, the cost of feature-rich, customised LOS and LMS modules tends to hover between 0.20% to 0.30% of NBFCs’ AUM. Thus, without the RBI monitoring, or controlling the CBSs’ costs, a small NBFC with INR 100 Cr in assets, across 10 branches must spend an astronomical INR 3 Cr to own a CBS, vis-à-vis onboarding LOSs and LMSs at one-fifth of the cost.
Essential & Good-To-Have Features Of LMS
For Loan Account Management:
|Essential||Flexible Product Definition: Flexible product definition is a key requirement, and the following are essential to offer this flexibility:
1. Computation methods (30/360, actual/actual, etc)
|Essential||Complete life cycle handling — Disbursement, Collection, Accrual, Penalty, Provisioning, Write-off, NPA, etc.
1. Loan Accounting- Automated handling of all accounting arising from various life cycle events
|Non-Essential||1. Co-Lending Capabilities
2. Digital Collections
3. E-Sign, E-NACH and E-Stamping capabilities
For Branch Management:
|Essential||1. Cash Management capabilities
2. All branch cash transactions to be recorded, tracked, and accounted immediately
3. Cash Control measures like tallying physical cash
4. Inventory Management
5. Document Management
For MIS, Analytical and Internal Audit functions:
|Essential||1. Standard Reports on PAR, POS, Disbursement, Submission to credit bureaus, and Collections
2. Potential integration of Data Warehouses (essential if the volume increases)
3. Basic analytical capabilities on demography PAR/POS
|Non-Essential||1. AI/ML-based modelling and credit decisioning
2. Automation/Digitisation of the entire audit process
For Customer Self-Service Modules (depending on nature of business)
|As Required||1. Multi-channel origination
2. Digital collections and Loan Servicing
The natural next question is, “why cannot an NBFC choose the desired functionalities from the CBS offering?”. To answer this, current market practices must be discussed. Presently, most manufacturers of CBSs offer them as a baseline product, akin to a minimum viable product. Technically, CBS providers can deactivate certain unnecessary features, but this does not proportionally reduce costs. Further, if one thinks semantically, deactivation of a CBS’s features no longer renders it a “bank-in-a-box” product but increases its similarity to an LMS.
This does not mean that the RBI should instead mandate an LMS. Rather, the RBI could outline broad guidelines on minimum functionalities for the IT systems of NBFCs. This is in sync with the RBI’s past approach, where it had issued the “Information Security (IS) Framework for NBFCs” in 2017, which unfortunately applies only to NBFCs with more than INR 500 Cr in assets. Smaller NBFCs, serving several thousands of clients, are not mandated to have any IT systems. This leads to an absence or deprioritisation of features like integrated loan management, automated reporting, Maker-Checker for all transactions, integrated accounting, and integrated grievance redressal systems.
In such cases, NBFCs lack the adequate technical capacity to ensure customer protection and seamless regulatory reporting.
The final aspect is applicability. Does the 10-branch criterion hold? We think not. In the Fintech era powered by technology-driven startups, NBFCs can operate exclusively through online channels, serving thousands of customers without any brick-and-mortar “branch”. Therefore, the RBI should mandate all NBFCs with lending operations to adopt appropriate IT systems.
However, significant scope for interpretation results given the RBI has mandated a specific type of system instead of mandating a set of minimum functionalities. As a result, there can be a divergence between what the RBI sets out to achieve, and the outcomes realised by it and the NBFCs.To conclude, NBFCs must adopt robust IT systems to enhance efficiencies and improve controls. Most well-run NBFCs have already adopted sophisticated IT systems rivalling many banks. Now, whether such systems are called CBS, or LMS, or any such acronym, is less important.
The more important questions are whether such systems aid in the NBFC’s business operations, help serve customers better and whether they enable the RBI to discharge its regulatory mandate seamlessly. In light of these concerns, we propose that the RBI reconsider its decision and instead consider mandating the minimum technical features that it wants to see in any of NBFC’s IT systems, rather than specific products.
The article is co-authored by Arun Kumar D is the Head of Business Development at Dvara Solutions.