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[Banking] Shadow Banks, Wholesale Banks, Securitization: Functions & Features

Nachiket Committees recommendations
Posted By On 23/01/2014 @ 4:30 pm In Economy | 42 Comments

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Prologue
Securitization
What happened in Sub-prime crisis?
Shadow Banking
1. Shadow Banks: Why bad?
2. Shadow Banking in India?
3. Should India be worried?
4. Gold Loan Companies as Shadow Banks?
5. RBIs safeguards on Gold loan NBFC
5. Wholesale Bank?
1. Wholesale Investment Bank vs Wholesale Consumer Bank?
2. but Why Wholesale Banks?
3. Benefits of Wholesale Banks?
6. Mock Questions

Prologue
Under [Banking] Nachiket Committee article-series, so far weve seen following
1. What is financial inclusion, steps taken by RBI and Government to achieve it.
2. Nachi gave six point vision to achieve financial inclusion. Under that, Universal Bank account for
everyone. Access to banking within 15 minutes of walking distance.
3. Priority sector lending: meaning, benefits, constrains and Nachikets recommendation for 50% PSL
target and 0% SLR.
If youve not read those articles, go to Mrunal.org/economy.

Securitization
As such very technical topic and not important for exam but basic understanding necessary before
dwelling into Shadow Banking, Whole-sale banking. So, first lets construct a technically-not-so-correct
model:

A retail Bank has given home loans worth total 100 lakhs to 50 families @10% interest rate. (if
anyone defaults, bank snatch their house.)
An investment banker, Hrithik Roshan, buys these loan-files from the normal bank.
Hrithik makes a new company/entity, backed by those home loan files worth Rs.100 crores.
Then he breaks down those 100 lakhs into (10 lakh bonds x worth Rs. 10 each) and promise to pay
8% interest rate.
Aam Aadmi/retail investors/Mutual funds/insurance companies etc. buy these bonds.
Securities =some piece of paper that promises to some money to someone.
Shares, bonds, IPOs, Debentures these are all examples of securities.
So, What did the investment banker do in above example? He turned those mortgages (homes
loan files) into securities. [and made some profit in between].
This is called securitization.

Is it good or is it bad?
Good for banks because they can gather some new cash, look for new clients. (rather than waiting
for EMI payments for 20-30 years.)
Good for investors, because they can earn interest by buying those bonds.
Bad? Yes, when the game is played without good faith- as it happened in Sub-prime crisis.

What happened in Sub-prime crisis?

(normal) Banks gave loan to people who did not have the aukaat to repay the loans (hence they
were called Sub-prime Borrowers.)
But banks were smart, they securitized those loans, recovered money from investment bankers in
wall street.
Investment bankers in turn, sold securities (bonds) to aam aadmi/retail investors/pension

funds/mutual funds/hedge funds etc.

Then investment bankers used that money to buy even more loan-files from (normal) banks, and
created even more mortgage backed securities.
Everyone is happy. Bubble keeps blowing.
But soon, one after another, those sub-prime borrowers default on EMIs.
Wait, we shouldnt worry right? Because weve their loan papers, we can attach their property and
auction it to recover money.
But unfortunately, as many people defaulted on loans, there is over-supply of houses on
sale/auction => Real estate prices go down. if the house was originally worth 3 lakh dollars, now
itd sell not even for 30,000 dollars.
Thus whole system collapsed.=>2007s subprime crisis.
World: Since investors all over the world had joined this game, they also suffered losses=>2008
global financial crisis. Ripples were felt even in India.
Europe: Since European investors also lost money in Subprime crisis + Decline trade, tourism,
export+ Their own governments had MNREGAish Maai-baap mindset with huge fiscal deficits and
loss making PSUs=> PIGS crisis, sovereign default crisis, Greece crisis. (more on that, explained in
old articles under Mrunal.org/Economy)

Shadow Banking
1. Shadow Banks = organizations that function like banks but outside the banking regulation.
American examples- hedge funds, securitization companies, Special Investment Vehicles (SIV),
Money Market Funds (MMFs) etc.
2. This term came after subprime crisis in USA, 2007.
3. Shadow banks helped creating that asset bubble. But one day, home loan borrowers defaulted and
the bubble collapsed =>crisis.
4. Shadow banks have significant presence in Netherland, Hong Kong, USA, EU= they continue to
remain vulnerable to such crisis even in future.
Shadow Banks: Why good?
They provide quick source of loan/credit/finance/liquidity.

Shadow Banks: Why bad?

1. Shadow Banks lack transparency about their business model, modus operandi and profit margins.
2. Some companies intentionally adopt shadow banking model to evade banking regulations for
making higher profits. (e.g. CRR= bank earns no profit. SLR=bank earns barely ~8% interest. But if
NBFC lends money they usually get 15-25% interest.)
3. Since shadow banks dont have Backup plans like CRR, SLR, deposit insurance etc. =>theyre
more vulnerable to runs. (e.g. all depositors/FIIs pull out their money due to some rumor and
company collapses.)
4. Shadow banks dont enjoy powers under SARFAESI Act.= difficult for them to recover money
incase of loan defaults.
5. Shadow banks send/receive money from many sources (mutual funds, insurance cos. etc.) so if
Shadow bank collapses, itll have negative ripples in other areas of economy as well. (As it
happened during Sub-prime crisis =>global financial crisis.)
6. Even in China, recently one of the shadow bank defaulted, and ~3 billion yuan are lost. (Jan 2014)

Shadow Banking in India?

Not all the NBFCs are directly regulated by RBI. Observe:
NBFC

Function

example

Regulated
under

Insurance
companies

Take premium from you, invest It in

shares/bonds.

LIC, Bajaj Allianz

IRDA

Housing Finance
Companies

They arrange money from variety of

sources, lend it to home-loan seekers

Merchant Banking They lend money to company via

Companies
buying its shares / underwriting.

Stock Broker

They help buying-selling securities (of

their clients) and earn commission in

National
DHFL, Muthoot Housing finance
housing Bank
etc.
(NHB)
Canara Bank, Andhra Bank (and
many other banks- they take
SEBI
separate license to operate as a
Merchant Bank)
1. Indiabulls
2. Sherkhan

SEBI

companies

Venture Capital
They finance start-up companies via
Fund Companies equity. (=shares, partnership)
Nidhi
They borrow money from members,
Companies(mutual
lend it among the members.
benefit funds)

Chit Funds

3. Reliance Money

between.

IFCI, IDG

SEBI

South Madras Benefit Fund

Limited and many similar
names

Department
of Company
affairs

Members contribute money on

monthly basis, and give it to
one of their own member
through bidding.
Winner doesnt need to repay
loan directly, but needs to
contribute money on monthly
basis, so others can also win
next time.

1. Sriram Chit fund (TN)

2. Saradha Chit fund (=not State
really a chit fund but
governments
multi-level marketing
registrar.
scam MLM)

Some of these NBFCs do form one type of Shadow banking in India, because theyre outside the
traditional regulatory rules for Banks, dont have SLR-CRR emergency backup, still dwelling into depositsloan-credit-finance type work.
Among all these, Chit fund is the biggest headache. Why?
Constitution of India=>7th Sch.=> union list=> banking, post office savings, corporation, insurance,
stock exchange, future market fall here.
Hence union government make can make laws to setup All India regulators RBI for bank, SEBI for
securities and IRDA for Insurance.
But as per SC verdict, Chit fund=contract = falls under concurrent list. = both union and state can
make law. Hence chit funds government by their respective state laws. RBI only provides overall
guidelines. SEBI doesnt watch. thats how Saradha chit fund managed to evade regulatory
oversight and duped crores of rupees.

Should India be worried?

Ans. Not much. Reasons are following:
1. Indias financial system is still Bank dominated. ~60% of financial sectors assets are controlled by
banks. So NBFC =not large enough to cause an shock/asset bubble.
2. Largest NPAs are held by Public sector banks and not NBFCs. So if (god forbid) there is any
subprime type crisis in future, itll be because of those banks and not NBFCs.
3. American Shadow banks have MNC-like presence in various countries of Europe=> indirectly
responsible for PIGS crisis, EU Sovereign default etc. but their presence is not much in India
because of strict rules on FDI.
4. 2008: Global financial crisis=> Indian NBFC saw a few negative setbacks but theyre sorted now.
5. Indian NBFCs are strictly supervised by RBI/SEBI/IRDA/Government. Barring a few ponzi scams
and Saradha Chit fund scam, there is no major threat seen in recent times.
Besides Indian NBFC= shadow bank = automatically villains. That assumption is not true. Some positive
points about Desi-NBFCs:
1. ~80% of the NBFCs have CRISIL rating of AA or above. (= NBFCs will not cause systemic
instability in the economy.)
2. NBFCs provide door to door service, their loan recovery rates are also better than banks.
3. NBFCs have extended the reach of the financial services to the more difficult parts of the economy
via micro-finance.
4. Their agent-network / manpower is more efficient than public sector banks. (because they dont
have unions to go on strike every week.)
5. Public sector banks like SBI, Dena etc. =giant elephants, cannot move quickly. Their own
bureaucratic procedures slow them down. On the other hand, NBFCs are entrepreneur driven
companies. Main boss keeps an eye on everything and doesnt let any part of the company get
slow or sick.

Gold Loan Companies as Shadow Banks?

1. The gold-loan NBFCs were mostly catering South Indian borrowers. (Mannapuram, Muthoot etc.)
2. But in recent times, theyve seen high-growth and geographic penetration across the country.
(thanks to Akshay Kumar.)

3. These Gold loan NBFCs are regulated by RBI but they dont fall under traditional bank rules about
SLR, CRR norms.
4. So, Do they pose a systematic challenge like American Shadow Banks?
lets take an example:
Jan 2014: 10 gm gold =30,000 rupees. I deposit it a gold loan company, they give me Rs. 30000
(=loan to value ratio of 100%; if they gave me only Rs.15k, the loan to value ratio=50%).
Ive to repay this loan, with 25% interest by Dec 2014.
December 2014: price of gold still remains in the 29-30k region. Then ill not bother repaying the
loan (because Ive to give Rs.7500 interest). So, let them have the gold. I dont care much.
if large number of borrowers start doing ^this, system will collapse. Why? Because Gold Loan
company doesnt print currency notes at its office. They also have to arrange money from market
(mostly from banks and debentures sold to aam-admi/retail investors).
So, if gold loan company collapses, then negative ripples even in other sectors of economy.

RBIs safeguards on Gold loan NBFC

RBI has taken following steps in recent times to ensure it doesnt happen:
1. Gold loan NBFC must maintain loan to value (LTV) ratio maximum 75%. (meaning, if i give them 1
lakh worth gold, they should loan me only Rs.75,000 rupees.) This ensures, Ill try to repay the loan
and take back my deposited gold.
2. Gold loan NBFC with more than 1000 branches, must get RBI permission before opening any new
branches.
3. Strict rules for security and storage of such gold deposits.
4. Must insist on PAN card copy (for gold loans above Rs.5 lakhs)
5. RBI has ordered all NBFCs, not to lend money to any person for purchasing gold in any form (be
jewelry or coins or even gold Exchange Traded Funds (ETF) and gold Mutual Funds.
6. RBI has instructed Gold loan NBFC to maintain transparency in loan pricing and follow KYC norms.
7. They were asked to adhere to a revised fair practices code and customer grievances.

Wholesale Bank?
So far we know What is Shadow banking, how it can be a threat to economy.
Right now Desi-NBFC sector is still small (compared to Banks), but with time, some of these NBFCs
will grow extremely large.
Then, itll not be our best interest to let them continue as NBFC (Because theyre not covered
under CRR-SLR emergency backup.)
Therefore, Nachiket Committee recommends a new type of bank called Wholesale bank. So, large
NBFC could be allowed to transform into Wholesale banks and fall under full supervision by RBI.
Please note: Nachi also recommended Payment banks. Make sure youve read that topic first.
Click me

Lets make a comparative table of their features.

features

Sch.Commercial
Bank (SBI, PNB, Wholesale bank
ICICI)

Has to get
license under
Yes
Banking
regulation Act?
Ofcourse yes.
Can accept
Hence also
deposits from
called Retail
aam aadmi?
banks.
Access to
payment
system (can
Yes
give cheque
book?)

Payment Bank

NBFC

yes

Nope

No. They can only accept

deposits larger than Rs.5
crore. (hence called
Wholesale banks).

Yes

Only for deposit

taking NBFCs
(NBFC-D) like
Mahindra Finance.

Yes

Yes

No.

Yes

1. Not to retail/aamaadmi borrowers.

2. it only lends in niche
wholesale markets No
such as
infrastructure or
corporates.

Can give loans? Yes

CRR?

Yes

yes

SLR?

Yes

Yes

Entry capital
requirement?

500 Crores.

50 crores.

50 crores

5 cr for Microfinane
company. 2 cr for
others.

Yes.

Yes but at a wholesale

level. And they help retail
banks fulfill their PSL
targets.

No. because they

cannot lend money.

No.

PSL

yes
Nachi did not give
specific targets. But
they can invest in
SLR-securities.

Yes

Nope
Only for NBFC-D

SARFAESI
powers.*

Yes

Yes

No. because they

cant lend money!

No. except housing

finance companies

*SARFAESI powers= If you default on loan, theyll take away your mortgaged property. You cannot get stay
order from civil court. Youve to approach DRT (debt recovery tribunals) to get stay order, but they usually
rule in favor of banks.

Wholesale Investment Bank vs Wholesale Consumer Bank?

Within Wholesale bank, Nachi recommends two sub-types
Wholesale Investment Bank
Wholesale Consumer Bank
If given institution has 20
If given institution has more than 20 branches.
branches or less.
25% rural branching mandate will
Applies.
not apply.
They can act as Business Correspondent agents of other scheduled
No
commercial banks.

but Why Wholesale Banks?

Alright man, so far I know

Mohan

1. What is securitization, how it helps transforming mortgages into securities. And how it can
be a threat, if misused.
2. What is shadow bank? How does it pose danger to Economy?
3. That youve recommended new type of banks called Wholesale Banks.
but what is the purpose of creating this wholesale bank? What exactly will they do?

Nachi Their main focus = securitization of PSL loans.

Mohan How?
Nachi Lets re-apply our earlier technically-not-so-correct model.
1. Suppose Banks/NBFCs give loan to PSL areas worth Rs.100 crores. And for xyz reason they want
to get rid of that headache and arrange money quickly, rather than waiting for EMIs.
2. So, They sell loan-files to wholesale bank.
3. (recall wholesale bank can accept deposit of Rs.5 crore or more=they have really deep pockets to
buy so many loan files).
4. Now, Wholesale banker has purchased loan files worth Rs. 100 lakhs. He will create a structured
investment vehicle worth Rs.100 lakhs. Then hell divide it into (10 lakh bonds worth Rs.10 each).
Offering xyz% interest rate.
5. Who will buy these bonds? Ans. Retail banks like SBI, ICICI, PNB; mutual funds, insurance
companies, retail investors (aam Aadmi) etc.
6. Thus PSL loans are securitized
7. Wholesale bank can even such securitized loans from other entities/investment bankers in capital
market and resell it further.
Mohan But why should retail banks (like SBI , ICICI, PNB) bother with investing money in such thing?
Nachi Because itll be counted under their PSL target. (Ive recommended so in my report.)
Mohan Ok but why should Mutual funds, insurance companies, retail investors give money in such thing?
Because their investment will enjoy Tax-free status. So whatever profit they make, they wont
Nachi
have to pay a penny to Government. (Ive recommended so in my report.)
Man wait a minute. Something doesnt feel right.On one hand:
1. Banks have PSL target.
2. People want tax-free investment.
So they want to park their money.
Mohan On the other hand
1. RRBs, NBFCs operating in rural area they know wholesale bank will take care of their
loan-files.
2. So what if they also started lending to sub-prime borrowers in rural area who dont have
the aukaat to repay EMIs. Then system will collapse like it did in America?
Nachi Your concerns are valid but:

1. We already have investment bankers in India- performing almost the similar functions like these
wholesale banks. (Standard Chartered, Kotak Mahindra capital, Citigroup, Morgan Stanley etc.)
2. But theyve not caused any risks in India because our regulators (RBI, SEBI) are more vigilant and
strict than American counterparts.
Besides, if we assume only the worst case scenario, progress cannot be made. And The advantages of
wholesale bank, outweigh its risks. Observe:

Benefits of Wholesale Banks?

1. Wholesale banks will provide more liquidity in the system. (than in a situation where every bank
keeps its loan-files to itself.)
2. Wholesale banks also loan money to corporate clients, infra. Projects=> retail banks like SBI and
ICICIs cash is spared, that can be used as loans for small borrwers.
3. Regional rural banks, Cooperative banks etc transfer their local-risk to Wholesale banks via
securitization.
4. This will make local banks structurally more stronger (because theyll have less risk and less
liabilities.)
5. Big (retail) banks like SBI, ICICI etc. can fullfill their PSL targets by investing in Wholesale Banks
(mortgage) backed securities. Rather than wasting their time and manpower on finding borrowers
under PSL targets.
6. This type of flexibility will help banks become more Specialized and focus on a niche groups
e.g. RRB on farmers, SBI on small businessmen and middleclass, ICICI on corporate clients= new
level of economies of scale= banks operating cost decreases, profit increases, clients get better
services at lower prices.
7. Thus wholesale banks indirectly help in financial deepening and inclusion.
Nachis thought process for arriving @Wholesale Bank concept?
1. PSL related problems: farmers dont get loans on time, banks mostly focus on southern and
western states.
2. Large NBFC=shadow bank problem=>need to transform them into Banks.
3. But if these Large NBFCs become regular banks, then theyll also need to fulfill PSL targets=
difficult for them. E.g. suppose a NBFCs deals with only infrastructure-financcing. Later it
becomes bank. But its staff, organization structure doesnt have the skills/experience/presence in
rural areas to deal with Agri. Loans to fullfill PSL targets.
4. So, better let them handle PSL via securitization process rather than via physical banking in rural
areas.
5. This securitization will also provide investment opportunity for retail investors. (Because Nachi
offered tax-free status.)
6. Therefore, we should allow such large NBFCs to transform into wholesale banks, instead of asking
them to transform into retail banks.

Mock Questions
1. Correct statements
A. All NBFCs are regulated by SEBI
B. All NBFCs are regulated by RBI
C. Both A and B
D. Neither A nor B
2. Which among the following is/are covered under the Concurrent list in our Constitution?
A. Banking, Bankruptcy, Contracts
B. Contracts, Corporations, Trusts
C. Trusts, Contracts, Bankruptcy
D. None of above.
3. What do you understand by the term Shadow Banking?
A. A system wherein banks use technical loopholes to open more branches and expand
operations beyond what is permitted by RBI.
B. A system wherein scheduled commercial banks use technical loopholes to partially evade
their true liabilities under CRR, SLR and PSL.
C. A system wherein financial entities undertake activities akin to banks while remaining
outside the traditional regulatory regime which are otherwise applicable to banks.
D. None of above.
4. Recently, Nachiket Committee has recommended Securitization of PSL loans. What do you
understand by the term Securitization?
A. It is a process under which banks get insurance cover for their loans under PSL targets,
from General insurance companies.

B. It is a process under which the mortgages issued by banks and other lenders are converting
them into securities that can be sold to investors.
C. It is a process by which a mortgaged loan asset can be converted to cash without losing
value.
D. None of above.
5. Which of the following factor(s) make India less vulnerable to the risks from shadow banking?
A. RBI has specifically prohibited shadow bank entities from opening branches in India.
B. Under SARFAESI act, Government has specifically prohibited shadow bank entities from
giving loans to people.
C. Both A and B
D. Neither A nor B
6. Recently, Nachiket Committee has proposed a new model of banks, called Wholesale banks. Find
correct statement about them
A. Only Scheduled Commercial banks can setup such banks through subsidiary model.
B. Theyll enjoy the rights and privileges under SARFAESI Act.
C. Theyll have higher entry-capital requirements than commercial banks.
D. None of Above
7. (A) Chit fund companies are regulated by State laws. (R) The subject of Chit fund falls under State
list in 7th Schedule of Constitution of India.
A. Both the statements are individually true and Statement R is the correct explanation of
Statement A
B. Both the statements are individually true but Statement R is not the correct explanation of
Statement A
C. Statement A is true but Statement R is false
D. Statement A is false but Statement R is true
Q8. All NBFCs are exempted from
1. Maintenance of CRR
2. Maintenance of SLR
3. Priority sector lending targets.
Answer choices
A.
B.
C.
D.

only 1 and 2
only 2 and 3
only 1 and 3
all 1, 2 and 3.

Q9. Who among the following is/are not required to maintain a Cash Reserve Ratio (CRR)?
1. Shadow Banking entity
2. Merchant Banking entity
3. Housing Finance Company
Answer Choice
A.
B.
C.
D.

only 3
only 1 and 3
only 1 and 2
All 1, 2 and 3

Q10. Who among the following is/are fall under SEBIs direct regulatory watch?
1.
2.
3.
4.

Nidhi Company
Chit funds
Housing Finance Company
Merchant Banking company

Answer Choice
1.
2.
3.
4.

only 1 and 2
only 3 and 4
only 1, 3 and 4
all of them

Descriptive
1. Define Shadow Banks. Assess the vulnerability of Indian financial sector from the threat of Shadow
Banking. (10m| 200 words)
2. Examine the need for a super-regulator over the other regulators in banking-finance-insurance
sector with special reference to shadow banks. (10m| 200 words)

3. List the salient features and functions of these wholesale banks envisioned by Nachiket
Committee. (10m| 200 words)
4. Discuss recent initiatives by RBI to preserve stability in Gold Loan sector. (5m | 100 words)
Interview
1. Do you know the difference between:
A. Merchant banking vs corporate banking?
B. Wholesale banking vs retail banking?
C. Investment bank vs commercial bank?
2. Whenever someone raises even a hint of sub-prime like crisis in India or shadow banking in India,
the RBI-apologists defend saying our fundamentals are strong, our regulatory regime is strong. If
that is the case, why do Public sector banks have large NPAs?
3. And dont you think they pose danger of sub-prime crisis in India?
4. Some economists suggest government of India should completely disinvest from public sector
banks. Given the threat of Shadow banking and sub-prime crisis on side versus the inefficiencyunionism-strikes, BASEL norms and NPAs on the other side, where do you stand on this issue?
5. Do you think Contract as a subject should be shifted to Union list, to prevent any more chit fund
scams?Yes/No and Why?
Hints for MCQs
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

see the very first table given in the article.

M.Laxmikanths Appendix
akin to banks but outside regulation
mortgage=>securities
neither
only SARFAESI
Chit fund in concurrent list.
NBFC-D have to maintain SLR
None of them are banks.
All except Chit funds.

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