Beyond universal banks: differentiated banks, NBFCs and shadow banking

Detail

1. Why go beyond universal banks?

• A universal bank (a full-service commercial bank) takes all kinds of deposits and gives all kinds of loans. Its deposits create new loans, and this is how credit creation happens (Class 12, Money and Banking).
• Nationalisation (1969) and the 1991 financial sector reforms (Class 11, LPG chapter) spread bank branches widely. Even so, many poor households, migrant workers and micro firms still had:
• no easy place to save small amounts,
• no cheap way to send money home,

• no small loans without collateral.

• The answer came in two forms:

• specialised (differentiated) banks, and

• non-bank lenders (NBFCs), which sit outside normal banking.

• This led to a new risk: shadow banking, meaning bank-like activity with lighter rules.

2. Differentiated banks

• Differentiated banking: the RBI gives licences to specialised banks. Each one may do only a limited set of activities, to meet a particular need.
• Origin: the Nachiket Mor Committee (2013), which looked at financial services for small businesses and low-income households.
• Timeline:
• 2014: guidelines issued
• 2015: first licences given
• 2019: on-tap licensing for SFBs (anyone who qualifies can apply at any time, with no fixed licensing window)

	Payments bank	Small finance bank (SFB)
Purpose	Deposits and remittances (sending money) for migrants and low-income users	Savings and credit for small farmers, micro firms and the unorganised sector
Deposits	Capped at Rs 2 lakh per customer (raised from Rs 1 lakh in 2021)	No cap
Lending	None; no credit cards (debit cards allowed)	Yes. At least 50% of loans must be up to Rs 25 lakh [2][3]
Asset rule	At least 75% of demand deposits in SLR government securities	PSL target 75% of ANBC [2] (NCERT: cut to 60% from 2025-26, verify current)
Minimum capital	Rs 100 crore	Rs 200 crore
Path	—	Can become a universal bank

Key terms

• SLR (Statutory Liquidity Ratio): the share of deposits that a bank must keep in safe, liquid assets such as government securities.
• PSL (Priority Sector Lending): loans that the RBI requires banks to give to chosen sectors, such as agriculture, micro and small enterprises and weaker sections.
• ANBC (Adjusted Net Bank Credit): the base loan figure against which PSL targets are measured.

How the SFB PSL target is split

• 40% of ANBC must go to the PSL sub-sectors that the RBI names.
• The other 35% can go to any one or more PSL sub-sectors [2].

Why a payments bank cannot fail through bad loans

• It gives no loans at all. So it has almost no credit risk (the risk that borrowers do not repay).
• It must park at least 75% of demand deposits in government securities.
• Its main risks are:
• operational risk (failures in systems or processes)
• compliance risk (breaking rules, such as KYC)

Worked example: payments bank asset rule

• A payments bank holds demand deposits of Rs 1,000 crore.
• It must keep at least 0.75 × 1,000 = Rs 750 crore in SLR government securities.
• It may keep at most Rs 250 crore as current and time deposits with scheduled commercial banks.

Worked example: SFB small-loan rule

• An SFB has a loan book of Rs 10,000 crore.
• At least Rs 5,000 crore must be in loans of up to Rs 25 lakh each [2][3].
• This keeps the SFB focused on small borrowers.

Case: Paytm Payments Bank (January 2024)

• The RBI stopped it from taking fresh deposits and top-ups, because of KYC (Know Your Customer) and other compliance failures.
• Lesson: in a bank that gives no loans, the main supervisory worry is governance and compliance, not NPAs.

Neobank

• A neobank is a digital-only financial provider with no branches.
• In India a neobank has no banking licence of its own. It works through a partner bank that holds a licence.
• So deposits sit with the partner bank. The regulator holds the licensed partner bank responsible.

3. NBFCs: definition and legal base

• NBFC (Non-Banking Financial Company): a company registered under the Companies Act whose main business is lending, investing or financing assets.
• Legal base:
• It is regulated under Chapter IIIB of the RBI Act, 1934.

• It must register under Section 45-IA.

• Principal-business (50-50) test: a company is an NBFC only if both conditions hold:

• financial assets are more than 50% of total assets, and
• income from financial assets is more than 50% of gross income.

Worked example: 50-50 test

• Company A has total assets of Rs 500 crore, of which Rs 300 crore are loans and investments. That is 60%, so condition 1 is met.
• Its gross income is Rs 80 crore, of which Rs 44 crore comes from interest and dividends. That is 55%, so condition 2 is met.
• Result: Company A is an NBFC and must register with the RBI.
• If financial income were only Rs 36 crore (45%), it would fail the test, even with 60% financial assets.

How an NBFC differs from a bank (a common exam question)

• It cannot take demand deposits, meaning savings or current accounts that can be withdrawn at any time.
• It cannot issue cheques drawn on itself, so it is not part of the payment and settlement system.
• Its depositors get no DICGC cover. DICGC (Deposit Insurance and Credit Guarantee Corporation) insures bank deposits.

Types of NBFC

• Investment and credit companies (NBFC-ICC)
• NBFC-MFIs, which give microfinance loans
• Housing finance companies (HFCs), whose regulation moved from NHB to RBI in 2019
• Infrastructure finance companies
• Core investment companies, which mainly hold shares in their own group companies

4. Scale-based regulation (SBR) of NBFCs

• Scale-based regulation: rules get tighter as an NBFC grows larger and more important to the whole system. A small NBFC is not treated like a giant one.
• Timeline: announced October 2021, effective October 2022.

Layer	Who	Regulation
Base layer	Small NBFCs	Light
Middle layer	All deposit-taking NBFCs and larger non-deposit NBFCs	Moderate
Upper layer	NBFCs identified by the RBI as systemically important	Must list within 3 years and keep CET1 of 9%
Top layer	Ideally empty	Used only if an upper-layer NBFC becomes a serious risk

• CET1 (Common Equity Tier 1): the highest-quality capital, mainly shareholders' equity and retained profits. It absorbs losses first.
• Listing means the NBFC's shares trade on a stock exchange. This brings market discipline and public disclosure.
• PCA (Prompt Corrective Action) has also been extended to NBFCs. Under PCA, the RBI puts limits on a weak NBFC once its capital or asset quality crosses set thresholds.

5. Shadow banking

• Shadow banking: credit intermediation (taking money from savers and lending it to borrowers) by entities outside regular banking, such as NBFCs and money-market funds.
• Regulation is lighter.
• There is no deposit insurance.
• Paul McCulley coined the term in 2007.

• The FSB (Financial Stability Board) now calls it "non-bank financial intermediation" (NBFI).

• Global scale: non-bank financial intermediaries hold about half of global financial assets (2025). Their share has grown from about 40% to nearly 50% since the 2008 global financial crisis [6].

• Why this matters:
• Most non-banks face lighter prudential regulation. Prudential regulation means rules that keep a lender safe, such as capital and liquidity requirements.
• Many disclose little about their assets, leverage (borrowed money) and liquidity.
• This makes weak points and links with banks harder to see [6].

6. Asset-liability mismatch (ALM): the core risk

• Asset-liability mismatch: the gap between the maturity of what a lender owns (its loans, which are assets) and what it owes (its borrowings, which are liabilities).
• A simple chain:
• the NBFC funds long loans with short borrowing,
• then it must roll over the borrowing (borrow again) every few months,
• then if markets panic and no one lends, it cannot repay,
• so a liquidity crisis follows, even if its loans are good.

Worked example: ALM gap

• An NBFC lends Rs 1,000 crore as 15-year housing loans. Repayments come back at about Rs 70 crore a year.
• It funded these loans with Rs 1,000 crore of 3-month commercial paper.
• Every 3 months it must find Rs 1,000 crore of new money. In the same 3 months it receives only about Rs 17.5 crore.
• If lenders stop buying its paper, the funding gap is about Rs 982 crore in a single quarter.

Case studies

• IL&FS default (September 2018):
• It funded long infrastructure loans with short-term money.

• It defaulted, trust in NBFCs broke, and credit to NBFCs froze.

• DHFL (2019):

• It funded long-term housing loans with commercial papers (CPs), which are short-term unsecured notes.
• It was the first financial service provider taken to the IBC under Section 227.

• Section 227 lets the government notify financial firms for insolvency resolution. Normally the Insolvency and Bankruptcy Code (2016) does not cover them.

• Contagion (the spread of trouble from one firm to others):

• mutual funds and banks held NBFC paper,
• so NBFC losses hit them too,
• so funding for all NBFCs dried up, including the healthy ones.

7. Bank-NBFC interlinkage

• Banks are the largest lenders to NBFCs. So NBFC stress can come back to banks as NPAs.
• RBI circular, 16 November 2023, titled "Regulatory measures towards consumer credit and bank credit to NBFCs" [4]:
• On bank loans to NBFCs, risk weights rose by 25 percentage points above the risk weight linked to the NBFC's credit rating, wherever that risk weight was below 100% [4].
• Exempt: loans to HFCs and NBFC loans that count as priority sector [4].
• Unsecured consumer credit moved to a 125% risk weight. Microfinance and SHG loans were excluded from this [4].

• Banks had to review their credit standards by 29 February 2024 [4].

• Risk weight means how much of a loan counts when working out the capital a bank must hold (Basel norms). A higher risk weight means more capital is needed, so lending becomes costlier and slower.

Worked example: risk weight

• A bank lends Rs 100 crore to an NBFC rated AA, with a 30% risk weight.
• Risk-weighted assets = Rs 30 crore. At a total capital requirement of 11.5%, the bank must hold about Rs 3.45 crore of capital.
• After the 2023 increase, the risk weight is 55%. Risk-weighted assets become Rs 55 crore, and required capital becomes about Rs 6.3 crore.

• The same loan now needs almost twice the capital.

• These risk weights were partly rolled back in 2025 (NCERT scaffold, verify current).

8. Digital lending

• Digital lending: loans that are sourced, assessed, disbursed (paid out) and recovered through apps or platforms.
• Key terms:
• LSP (Lending Service Provider): the tech firm working for the lender.

• DLA (Digital Lending App): the app used to offer the loan.

• RBI guidelines, September 2022, laid down these core rules:

• money flows only between the borrower's account and the regulated entity's account,
• borrowers get a Key Fact Statement (KFS),

• borrowers get a cooling-off period in which they can exit the loan.

• DLG/FLDG guidelines (2023): DLG or FLDG (Default Loss Guarantee, or First Loss Default Guarantee) is a promise by the LSP to cover the lender's first losses. It is capped at 5% of the portfolio.

• RBI (Digital Lending) Directions, 2025, issued 8 May 2025 (RBI/2025-26/36), replaced the earlier instructions with one consolidated set of rules [5]:
• They apply to commercial banks, co-operative banks, NBFCs (including HFCs) and all-India financial institutions [5].
• No disbursal to any third-party account, including an LSP's account. Repayments go straight to the lender [5].
• KFS must show the APR (Annual Percentage Rate, the all-in yearly cost of the loan), the monthly repayments and any penal charges. The digitally signed KFS reaches the borrower automatically by email or SMS [5].
• Cooling-off period: at least 1 day. The borrower can exit by repaying the principal plus proportionate APR, with no penalty [5].
• DLG cap: at most 5% of the total amount disbursed from that loan portfolio [5].
• Public directory of DLAs: lenders had to report their apps on the RBI's CIMS portal (Centralised Information Management System) by 15 June 2025. The details are published on the RBI website [5].
• Multiple-lender LSPs (from 1 November 2025): an LSP that works with several lenders must show an unbiased comparison of loan offers. "Dark patterns" (design tricks that push users to a choice) are not allowed [5].

Prelims Hooks

• The Nachiket Mor Committee (2013) proposed differentiated banks. Payments banks and SFBs were licensed in 2015.
• Payments banks: deposit cap of Rs 2 lakh per customer. They can issue debit cards but no credit cards and no loans. At least 75% of demand deposits must be in SLR securities.
• SFBs: at least 50% of loans must be up to Rs 25 lakh. The PSL target is 75% of ANBC (40% to named sub-sectors, 35% flexible) [2].
• Minimum capital: payments bank Rs 100 crore, SFB Rs 200 crore.
• NBFCs are regulated under Chapter IIIB of the RBI Act and registered under s.45-IA. Test: financial assets above 50% of total assets AND financial income above 50% of gross income.
• Trap: NBFCs cannot take demand deposits or issue cheques drawn on themselves, and their deposits have no DICGC cover.
• HFCs moved from NHB to RBI regulation in 2019.
• SBR has four layers. The top layer is ideally empty. Upper-layer NBFCs must list within 3 years and keep CET1 of 9%.
• DHFL was the first financial service provider taken to the IBC under Section 227.
• Digital Lending Directions 2025 (8 May 2025): DLG capped at 5%, a public DLA directory through CIMS, and a minimum 1-day cooling-off period [5].

Mains Points

• Inclusion vs stability:
• Differentiated banks and NBFCs reach people that universal banks miss, such as migrants, micro firms and the thin-file poor.
• But lighter rules and the lack of deposit insurance move risk outside the safety net.

• Scale-based regulation tries to balance the two: light rules for small NBFCs, bank-like rules for systemic ones.

• Asset-liability mismatch and contagion (IL&FS, DHFL):

• Short-term market funding for long-term loans can turn one default into a system-wide funding freeze.

• Policy responses:

  • ALM and liquidity norms
  • PCA for NBFCs
  • Section 227 IBC resolution
  • risk weights on bank loans to NBFCs [4]

• Bank-NBFC interlinkage as a macroprudential lever:

• A macroprudential tool protects the whole financial system, not just one lender.
• The RBI's November 2023 risk-weight increase [4] cooled fast-growing unsecured and NBFC credit.
• The trade-off: slower credit growth versus fewer future NPAs.

• Globally, non-banks hold about half of all financial assets [6]. So the monitoring gaps are worldwide, not only Indian.

• Digital lending and consumer protection:

• Direct fund flows, the KFS with APR, the cooling-off period and a public app directory [5] target predatory apps and hidden charges.
• Fintech-led credit can widen inclusion, but only if these safeguards are enforced.