Principal Economic Adviser Sanjeev Sanyal has cautioned against stringent regulations on non-banking financial companies (NBFC), saying it may lead to a shortage of capital towards a "significant" part of the economy.
Mr Sanyal's suggestion comes in the backdrop of multiple steps taken by the RBI to improve supervision of shadow banks after a liquidity crisis engulfed the sector post IL&FS collapse last year.
NBFCs have been placed under greater levels of scrutiny now. RBI had recently brought housing finance companies under the same rules as the non-banking finance companies.
"In a complex and interconnected financial system, imposing stringent bank- type regulations on NBFCs could either shut off capital to a significant part of the economy or shift systemic risk to yet another part of the financial system," said Mr Sanyal in a discussion paper authored by him.
"In such a case, only a nuanced regulatory trade-off with active and flexible supervision can be made to work."
The discussion paper is part of fresh initiative proposed by the Finance Ministry to encourage debates on issues left out in day-to-day discourse, Mr Sanyal said in a tweet.
Mr Sanyal argued that one of the unintended consequences of ever increasing bank regulations is that it shifts market activity to "shadow banks" where the scope for regulatory arbitrage is higher, especially as banks become more averse to lending to high risk borrowers and small borrowers.
This phenomenon has been witnessed in various forms in India and globally. According to the Financial Stability Board (FSB), after having shrunk following the Global Financial Crisis, the size of the non-banking financial intermediation sector globally has increased steadily in recent years, nearly doubling from $28.3 trillion in 2010 to $50.9 trillion in 2018, said Mr Sanyal.