After the IL&FS debacle, NBFCs have come under the microscope of regulators, investors, analysts and the wider public. Predictably, there are calls for further tightening of regulations in the belief that it will somehow improve matters.

To get to the crux of the issue, let’s begin by asking, why do NBFCs exist? After all, it should theoretically be possible for banks to take over this space. But then, the banking system’s coverage has well-known gaps that exclude large sections, precisely the failing that has allowed non-banks to thrive.

A case in point is loans against second-hand trucks, by logic a troublesome asset to finance. It depreciates rapidly and you cannot pinpoint the location of the asset for sure. A regulator evaluating this business would see red flags everywhere. And yet, Shriram Transport Finance plunged headlong and triumphed by learning the nitty-gritty of the trade and building an entire eco-system around it.

Regulations are a product of rational thought, whereas innovations emerge from out-of-the-box thinking. Innovations cannot thrive under a heavy hand; they require a higher tolerance for failure.

In banking, failures come at a high cost, and so there is a need for rigorous regulations to prevent downsides. That’s why NBFCs have been at the forefront of innovations in financial services, which banks go on to adopt later. Any attempt to prevent downside risks by tighter regulations will stifle innovation.

Besides, regulators also have a fiduciary responsibility to facilitate NBFC growth. After all, NBFCs have led the way in innovations. Lending against gold was for long ignored by banks, pushing borrowers to moneylenders and pawnbrokers. The entry of NBFCs redefined the category with innovations that brought millions into the ambit of institutional credit.

Regulations must evolve with the times. For example, in the era of digital lending, making gold-loan NBFCs seek prior approval before opening new branches serves little purpose. There’s a need to strike a balance between preventing downside risks and allowing businesses to grow to their potential. Surely, the time is right for introducing risk-weighted capital requirements for NBFCs at par with banks.

Existing rules prescribe a uniform 100 per cent risk-weight across all assets irrespective of the tenor. If lenders taking on excessive risk is the worry, risk-based capital norms are the way to go. Only those who understand the risks and have the capital to bear the consequences will remain in the fray.

Likewise, moving away from blanket caps on loan-to-value (LTV) ratios towards risk-weighted capital will catalyse innovations in the risk underwriting process. As loans go further above a base LTV, regulators may prescribe higher capital. The current LTV cap of 75 per cent on gold loan amounts to a one-size-fits-all approach. It pushes small borrowers back towards informal sources and constricts product innovations by withdrawing the lender’s incentive. Also, it is an anomaly that one can borrow any amount without security under personal loans, but not when furnishing liquid security.

Does the case against tighter regulations and for greater tolerance of failure mean we should resign ourselves to more fiascos like IL&FS? Not necessarily. IL&FS had drastic repercussions because India’s financial markets are still a work-in-progress and there’s a dearth of alternatives to bank funding, especially for the long term.

Our bond markets are still undeveloped, compelling NBFCs to borrow more from the banking system. Therefore, a good start will be to have on-tap public issue of bonds directly to investors, enabling NBFCs to raise funds regularly at lower issuance cost.

The writer is MD and CEO of Manappuram Finance Ltd. Views are personal