India's shadow lenders will stay relevant to the country's financial system and may not face a wave of consolidation as they come under tighter regulation from October after the central bank's new rules for the sector kick in.

The Reserve Bank of India has sought to exercise greater control over nonbanking financial companies, or NBFCs, in recent years after the high-profile collapse of Infrastructure Leasing & Financial Services Ltd. in 2018 threatened the nation's financial sector. NBFCs will be divided into four categories based on their size, activity and perceived riskiness, according to rules announced in 2021. Companies that fall in the so-called "upper layer" will be required to maintain common equity Tier 1 capital of at least 9% of their risk-weighted assets and face restrictions on their credit exposure and investment.

As the regulatory gap between banks and NBFCs narrows, India's biggest private-sector lender in terms of assets announced that it would merge with its parent, the nation's biggest housing finance company. The planned merger between HDFC Bank Ltd. and Housing Development Finance Corp. Ltd. is unique and is unlikely to be a template for M&A activity between banks and NBFCs, said Hemindra Hazari, an independent analyst with a specialization in banking and economy research.

"HDFC Bank could not have its own mortgage portfolio because its parent was a mortgage financier," Hazari said, noting the key reason for the two institutions to coalesce. For existing banks, there may not be too many incentives to acquire NBFCs as they can do much the same business activities as the shadow banks, the analyst added.

Stricter regulation

So far, NBFCs have enjoyed less-stringent rules compared with the tightly regulated banking sector. That allowed NBFCs to offer cheaper loans, taking advantage of their lower costs. Now, as many of them start to look more like banks, NBFCs need more capital.

While there could be some large NBFCs converting to, or merging with, banks to access more stable retail deposits, as a sector, NBFCs will continue to exist given the key role that they play, said Krishnan Sitaraman, senior director and deputy chief ratings officer at CRISIL. NBFCs are not allowed to accept on-demand deposits from customers. They are not a part of the central bank's payment and settlement system and cannot issue checks.

"As NBFCs grow in size and scale, if they do not have a retail liability channel, access to resources may become a key sensitivity beyond a threshold level," Sitaraman said.

Still, NBFCs and banks play a complimentary role to each other in the Indian financial system. NBFCs are strong in developing deep customer relationships and serving customers that other lenders cannot reach, while banks have an advantage on the liabilities side.

"Stronger NBFCs will benefit as they meet the tighter regulations. Lenders and investors of these stronger NBFCs will benefit from the external validation that is provided by NBFCs meeting these tighter regulations," said Rajesh Rajak, CFO of IIFL Finance, an NBFC.

"[Tighter regulations] will translate into lower funding costs for the stronger NBFCs. Weaker NBFCs will see lesser regulatory arbitrage," Rajak added.