Most sectors of the economy have been completely liberalised for foreign direct investment (FDI) and the Foreign Investment Promotion Board (FIPB) was abolished in June 2017. Policy watchers in this space were, therefore, taken unawares by a cryptic announcement by the Ministry of Finance on 16 April, 2018, on the “Minimum capital requirements for ‘other financial service’ activities which are unregulated by any financial sector regulator and FDI is allowed under government route”.

Why the Press Release

To put it in perspective, this announcement has its genesis in the RBI’s FEMA Notification No. 375/2016-RB dated September 9, 2016, which was a big ticket change, doing away with the nearly two decades old stipulation of minimum capitalisation in the NBFC sector. The playing field was thus levelled and the financial sector regulations could prevail in an ownership agnostic fashion.

The formal Press Note announcing this change in fact came subsequently (see Press Note 6 of 2016 dated October 25, 2016). FEMA 375 firmly placed all regulated financial services activities in the fold of the respective financial regulators, instead of the latter having to concern themselves with the ownership pattern of the entity.

FEMA 375, however, laid down that activities that are not regulated by any regulator, or where only part of the activity is regulated, or where there is doubt regarding regulatory oversight, approval would need to be obtained from the Government with attendant minimum capitalisation requirements as may be decided by the Government. It is not known , in the public domain, as to how many approvals in the ‘unregulated financial services’ space have actually been accorded post issuance of FEMA 375. This information would have been useful. Be that as it may, what has been set out in the press release of April 16, 2018 is perhaps the way for the future.

The objective of the press release is clearly to declare upfront to all concerned, the “minimum FDI capital” required if a company is engaged in an activity that is “unregulated” .Further, the press release makes a distinction in the ‘minimum FDI capital’ between unregulated activity in terms of fund based (FB) and non-fund based (NFB) and places the requirement at US$ 20m and US$ 2m respectively (which translates to about Rs. 125 Crores and Rs. 12.5 crores respectively).

So far so good, but what actually creates the confusion is the reiteration in the ‘Explanatory Note’ of the erstwhile 18 NBFC activities into the then classification of FB and NFB. Most of these activities are actually already regulated with the possible sole exception of “Financial Consultancy” and perhaps specific Investment Advisory activities. So the intent behind the press release is not at all clear.

The Implications

There would thus appear to be the bizarre possibility of an ‘unregulated’ merchant banker, underwriter, stock broker etc., securing Government approval with FDI Capital of US$ 20m, and possibly remaining ‘unregulated’, whereas the regulator concerned is engaged in regulating the registered regulated entities engaged in the same business but having a capital which as per the regulations is mandated at a much lower level.

To carry the possibility further, having given FDI approval, would the Government then go on to become the regulator for such entities, when in fact as per the respective regulations in these activities, no entity can operate without registering with the financial authority concerned and adhering to financial regulation and oversight? If the intent of the press release is simply to force the entity to register, it can always do so, if it is eligible, with a lower requirement of capital, and proceed on the Automatic Route rather than through this method. On the other hand, if it is not eligible, should it be given approval at all by the government?

Historical Background

A bit of historical background would be in order at this stage. NBFCs were permitted FDI as early as Press Note 4 of 1997 on the FIPB route, initially in 14 activities (expanded to 19 subsequently), based on India’s international commitments to open up the sector. The classification into FB and NFB came in Press Note 6 of 1999 and the sector was placed on the automatic route – see Press Note 2 of 2001. The large minimum capitalisation for FDI (much more than the statutory minimum regulatory capital in the activities) was stipulated to ensure the entry of serious players. The NBFC activities listed did not really square with the way the RBI classified them and there was often confusion as to what exactly a specific activity named in the FDI policy could do.

Leasing and finance was one such activity that was not recognised by the RBI in its NBFC categorisation, which instead listed Loan Company and Investment Company. Both of these did not find a place in the 18 activities. Ultimately Loan Company was mostly accepted as a surrogate for Leasing and Finance, whereas Investment Company long remained a ‘pariah’. Entities regulated by SEBI are actually exempted from NBFC, but in the FDI Policy these came under the same umbrella and NBFC has become more of a generic term, instead of it being the specific topic in a chapter in the RBI Act. All these issues got quite effectively settled with the issuance of FEMA 375, leaving only the “unregulated financial services space”.

The Way Forward

At this point it is useful to ask why such a space exists in the first place. Is it because the regulators concerned – the RBI / SEBI etc. – do not think it is worth regulating or is it too onerous and micro to regulate? If that is so, should the Government be actually stepping in to approve FDI into the sector and consequently also indirectly assuming responsibility for regulating the activity when there are many other pressing matters?

Actually, as per the residuary clause in the FDI policy, the activity could well proceed on the automatic route. Take Financial Consultancy, for example, it is not clear as to how and what exactly one can regulate in this sector except to stipulate adherence to the basic principles like ensuring written contractual agreements, professional integrity, avoidance of conflict of interest, etc. These are the kind of stipulations to ensure consumer protection and these are best done through self-regulating agencies or professional bodies and creating an awareness of the need for dealing only with registered professionals.

The same goes for specific investment advisors (currently under deliberation with respect to mutual exclusion from distributorship). Unless the regulatory mechanisms are in place, there does not appear to be any specific purpose of intervention by way of minimum capitalisation, except that it creates an entry barrier. Incidentally in this press release, the minimum capitalisation stipulation for NFB activities has actually increased from the earlier US$ 0.5M on the automatic route to US$ 2m on approval route without any specific progress in terms of regulation in the sector; this actually moves India away from its objective of improving the ease of doing business.

As far as the fund-based activities are concerned, these should all come under some form of regulation. In fact, the large entry requirement of US$ 20m itself begs regulation. The spectrum of financial services does not end with the stipulated 18. There are many more beyond this, for example, in the past there have been specific approvals given to Primary Dealerships and Mortgage Guarantee Companies. These of course are regulated or came to be regulated later though they do not appear in the 18 specified activities. This also happened with Credit Rating Agencies, White label ATM operators, Pension Fund Managers, Wealth Management Products and Trusteeship services.

Nearer the present day, the RBI has already moved in with regulating the peer-to-peer space and has also issued an advisory regarding virtual currencies. There could also be many more financial or quasi financial services available in the developed world that have not hitherto been envisaged at all- the “unknown unknowns”.

The Last Word

In sum, it is felt that the move to place on approval route the ‘unregulated financial services’ as spelt out in the FEMA 375 notification was itself a backward step in the liberalisation of this sector. If the activity is not regulated, perhaps it was not meant to be and, in that case, it can fall under the residuary clause of the FDI Policy/FEMA.

If the activity is significant and meaningful enough to be regulated, or observed to be so, the task is best left to be determined by the financial regulators and this can even be done at the Government’s behest in its periodic structured and unstructured meetings with the regulators. The regulators themselves can even monitor the registration of companies in the financial space and call for regulation if need be.

However, to mandate Government approval and minimum FDI capitalisation for such activity post the actual dissolution of the FIPB appears to be ironic or a case of two steps forwards one step back.