RBI warns NBFCs against using algorithm-based credit to boost their portfolio

The Reserve Bank of India (RBI) on Thursday warned non-banking finance companies (NBFCs) against certain systemic risk, complexity and interconnectedness.

Addressing a conference of heads of assurance of NBFCs held in Mumbai, Swaminathan J, Deputy Governor, RBI said that many NBFCs are increasingly turning to rule-based credit engines to accelerate the growth of their lending portfolios.

He added with concern that while automation can enhance efficiency and scalability, NBFCs should not allow themselves to be blinded by these models.

Overreliance on historical data or algorithms may lead to oversights or inaccuracies in credit assessment, particularly in dynamic or evolving market conditions. 

Therefore, NBFCs must maintain a clear-eyed perspective on their capabilities and limitations, supplemented by continuous monitoring and validation of credit scoring models, he added.

He highlighted the liquidity risk arising from concentration of funding sources and maturity mismatches adding that overreliance on a few funding sources can worsen liquidity risks for NBFCs, especially during market stress. 

Maturity mismatches between assets and liabilities can also increase funding squeezes.

Diversification and prudent liquidity management are crucial, he added.

RBI stressed the need to invest in Early Warning Systems, Stress Testing capabilities and Vulnerability Assessments, Monitoring of Cyber Key Risk Indicators.

"Customer protection is one of the core elements of policy making at RBI."

Given the service-oriented nature of the financial services industry, safeguarding the interests of customers should rank foremost among the priorities of our regulated entities as well, he added during the conference of heads of assurance of NBFCs.

Speaking on the development, Kushal Rastogi, Founder & CEO, Knight Fintech, said: "Capital markets are vital for NBFCs, providing the necessary funding for their operations and capital to lend. NBFCs typically create liabilities first, then use these to generate assets. That is the only way to expand the balancesheet and business. However, reliance on capital markets exposes them to various market risks. NBFCs can raise debt through term loans, issuing fixed-income securities like CPs and NCDs, or through ECBs and MLDs. Each of these options carries its own risks and challenges." 

He further said, "On the other hand, raising debt often requires raising more equity to avoid excessive leverage, which is often demanded by debt providers, leading to a continuous dilution of promoter equity. This can reduce promoter control and interference in strategic direction.

"To address this, the co-lending model offers a solution. NBFCs can partner with banks in a 20/80 arrangement, allowing them to draw credit lines without on-balance-sheet debt or equity dilution. Co-lending provides strong unit economics and benefits all parties involved, offering a sustainable funding alternative."