Urgent Notice: RBI’s Revision on Regulatory Framework for NBFCs

In terms of complexity, technical sophistication, interconnection, operations, and scale, NBFCs have developed significantly throughout the years. With new products, several NBFCs have begun to move into new financial services areas. Because of the significant rise of NBFCs in recent years, the RBI has updated the regulatory framework for NBFCs in order to guarantee transparency in their activities. We’ll discover more about the RBI’s Regulatory Framework Revision for NBFCs in this blog.

Background

The Reserve Bank of India (RBI) has announced a new scale-based regulatory framework for non-banking financial firms (NBFCs) that will take effect on October 1, 2022. The scale-based approach covers a variety of aspects of NBFC regulation, including capital requirements, governance standards, prudential regulation, and more. Based on their size, activity, and perceived riskiness, the regulatory framework for NBFCs will be divided into four levels.

NBFCs in the lowest tier will be referred to as NBFC – Base Layer (NBFC-BL), while those in the middle and upper layers will be referred to as NBFC – Middle Layer (NBFC-ML) and NBFC – Upper Layer (NBFC-UL). Regardless of other factors, the top 10 qualifying NBFCs in terms of asset size will always be in the upper stratum.

The RBI has changed the non-performing asset (NPA) categorization for all types of NBFCs to more than 90 days under the new framework. When it comes to the Board’s experience, at least one of the directors must have relevant experience working in a bank or NBFC, given the requirement for professional competence in managing the affairs of NBFCs.

There will also be a limit of one crore per borrower for financing Initial Public Offering subscriptions (IPO). The Central Bank noted in a statement that NBFCs might set more cautious limitations.

What is NBFC?

A Non-Banking Financial Company (NBFC) is a financial company that is not a bank and is registered under the Companies Act of 2013[1]. Although the NBFC provides a variety of financial services, it does not hold a banking license. Its activities include stock acquisition, advances and loans, stock, hire-purchase insurance, bonds, and chit-fund industry. However, any entity whose primary business is industrial activity, agriculture, the sale or acquisition of any commodities (excluding securities), the provision of any services, or the purchase, sale, or construction of any immovable property is excluded.

The Reserve Bank of India (RBI) regulates the functioning and activities of non-banking financial companies (NBFCs) under the Reserve Bank of India Act, 1934.

What is the objective of the NBFC regulatory framework revision?

The need to review and establish a scale-based strategy for regulating and suggesting appropriate actions to promote a healthy financial system was the primary motivation for changing the doctrines that underpin the existing regulatory framework. The regulatory frameworks for NBFCs were created by the RBI in order to stay up with changing circumstances and to re-examine the regulatory framework’s viability.

What is the regulatory framework for NBFCs?

According to RBI, the supervisory and regulatory framework for NBFCs is built on a four-layered structure:

1. NBFC Base Layer – The non-systemically NBFC at the base layer is categorised as an NBFC-Non Deposit Taking, Non-operative Financial Holding, NBFC Non-Aggregator License, Peer to Peer Lending, and NBFC for asset size of Rs. 1000 Crores. 

• NBFCs now categorised as NBFC-ND (including Type I NBFCs), Peer to Peer Lending Platforms (“NBFC P2P”), Non-Operative Financial Holding Company (NOFHC), and Account Aggregators (“NBFC-AA”) will be included in NBFC-BL. 
• According to the Discussion Paper, they are NBFCs with low risk perceptions due to their activities, and hence should be subject to lax regulatory scrutiny.

Though the regulations governing the base layer have not changed much, there have been some noticeable changes, such as the raising in 

• the INR 500 crore threshold for systemic importance to INR 1,000 crore, allowing more NBFCs to enter the NBFC-BL fold.
• Stricter admission conditions have been set to meet growing capitalisation demands for tackling cyber security and anti-money laundering risks, with the minimum net-owned fund being raised from INR 2 crore to INR 20 crore.
• The time period for categorising non-performing assets has been reduced from 180 to 90 days.
• The Central Bank has changed the NBFC –BL criteria from Rs 2 crore to Rs 20 crore, and the NPA balancing period has been reduced from 180 days to 90 days.

2. NBCF Middle Layer – It covers non-deposit-taking systemically important NBFCs (NBFC-ND-SI), stand-alone primary dealers, deposit-taking NBFCs, infrastructure debt funds, housing finance, and core investment companies. 

• The exposure limitations are now linked to the Tier Capital rather than the Owned Funds. The cap for IPO fundraising has been set at Rs 1 crore.
• This category includes all non-deposit taking NBFCs that are currently classed as systemically significant, as well as all deposit taking NBFCs that do not fit the Upper Layer’s regulatory requirements. 
• This layer is also expected to include NBFC-HFCs, IFCs, infrastructure debt funds (“NBFC-IDF”), freestanding primary dealers (“SPD”), and CICs, regardless of asset size.

The concentration and financing rules of the NBFC-ML will alter in the following ways:

(i) The lending and investment limitations are proposed to be combined into a single exposure limit of 25% and a group exposure limit of 40%, calculated using Tier 1 capital rather than net owned funds;

(ii) With the introduction of an INR 1 crore ceiling per individual per NBFC, restrictions on share buy-backs, restrictions on loans to directors/their family, and other regulations, finance regulation will become more harsh;

(iii) a requirement to have a Board-approved policy on Internal Capital Adequacy Assessment Process, similar to banks, and 

(iv) the introduction of governance norms such as the formation of a remuneration committee, additional disclosures, and rotation of statutory auditors, and 

(v) a requirement to have a Board-approved policy on Internal Capital Adequacy Assessment Process, similar to banks.

3. NBFC Upper Layer – At least 25 to 30 NBFCs are encapsulated in the upper layer. This layer’s NBFC will function similarly to a bank. It’s known as CET, and it’s possible that Common Equity Tier (CET) I Capital would be used to boost NBFC-UL regulatory capital. CET has been available at a 9% interest rate on Tier I capital.

• The NBFCs in the Upper Layer will be selected based on both quantitative and qualitative criteria – 

(a) qualitative factors such as size (35%), interconnectedness (25%), and complexity (10%); and 

(b) qualitative parameters such as supervisory inputs (5%). (30 percent , which includes type of liabilities, group structure and segment penetration). The top 10 NBFCs (by asset size) will automatically fall into this group, according to the Discussion Paper.

The Discussion Paper envisions NBFC – UL regulatory control along the same lines as banks, including:

(i) maintaining a 9 percent minimum common equity tier 1 (“CET 1”) capital (equivalent to the Basel III mandatory CET 1 for banks);

(ii) a leverage requirement that would serve as a brake on an NBFC-unrestrained UL’s expansion;

(iii) subjecting NBFC-ULs to the differential standard asset provisioning rules applied to banks (rather than the present 0.4 percent for systemically significant NBFCs); and

(iv) imposing an obligatory listing requirement, similar to that imposed on private banks.

4. NBFC Top Layer –In the structure, the NBFC at the top layer is left empty. Essentially, the top tier of the pyramid structure should be left unfilled unless the supervisors are interested in certain NBFCs. According to supervisory judgments, if some NBFCs in the upper layer are exposed to significant risks, they will be subjected to significantly increased regulatory or supervisory requirements.

• According to the Discussion Paper, the top layer should be left unfilled. If a company in the NBFC-UL category is judged to pose an unsustainable systemic risk, it may be transferred to this tier and subjected to specialised examination.

NBFCs have been a critical cog in the financial markets’ wheel since the introduction of Chapter IIIB in the RBI Act, 1934 in 1963, and any move to overhaul the regulatory framework applicable to them will have far-reaching consequences. The approach of classifying NBFCs based on size and systemic risk/importance retains the essence of previous regulatory review – however, the proposal to stratify all NBFCs into a three-layered pyramid (with the top layer left empty) and focus on using qualitative and quantitative parameters to classify NBFCs is a welcome change.

If the Discussion Papers ideas are accepted, NBFC – ML and NBFC – UL will need to significantly revise their governance and compliance structures, affecting approximately 500 NBFCs in India. It would also be interesting to examine how the Discussion Paper relates to the RBI’s Internal Working Group Report for Banks, which was released on November 20, 2020, and suggests additional banks and the conversion of NBFCs (with assets above INR 50,000) into banks.

What is the guideline for the revised regulatory framework for NBFCs?

The following is the guideline for the revised regulatory framework for NBFCs:

• A Layered Approach-

It has been updated into the four-layered structure described above under this framework. The framework comprises the following elements:

1. A Pyramid Structure – This pyramid-shaped structure requires the least amount of regulatory intervention. It has been further classified as non-systemically important NBFCs such as NBFC P2P, NBFC-ND, and leading Platforms such as NOFHC, NBFCAA, and Type I NBFCs, as well as systematically significant NBFCs such as Deposit-taking NBFCs (NBFC-D), NBFC-ND-SI, IDFs, HFCs, SPDs, CICs, and IFCs in the third layer.
2. Adverse Regulatory Arbitrage- The banks would be contacted to discuss covering NBFCs under this layer in order to mitigate the systemic risk in the event of a spillover. The regulatory arbitrage is split into two sections:
   a) Structural arbitrage
   b) Prudential arbitrage.

• The banks maintain the SLR and CRR against time demand liabilities in the structural arbitrage instance.

• The NBFC benefits from the flexibility in asset categorization, capital adequacy, and provisioning standards in the Prudential arbitrage case.
• Existing Regulatory Framework- The framework will apply to NBFC-NDs that have regulatory frameworks that are still in place. It will be applied to the NBFCs’ foundation layer. The NDSI will be used in the intermediate layer of NBFCs.
• Changes to the lower layer- NBFCs will also apply to the top layer NBFCs unless there is a dispute noted.
• The systemic significance level is now 500 crores, however, it has been raised to Rs 1000 crores.
• NPA Classification Days – The NPA classification days have been lowered from 180 to 90 days.

Policy Rationale

The underlying premise of differential regulation for NBFCs (often referred to as “shadow banks”) vs. universal banks was that NBFCs (often referred to as “shadow banks”) had less stringent supervision and more operational flexibility – hence the historical regulatory arbitrage and “light-touch” overview model. As a result, NBFCs have had a relatively free hand in building sectoral and regional expertise, bringing to market a variety of financial products and services (such as loan against shares), and contributing to India’s current Fintech revolution in the digital lending area.

However, given the financial sector’s vulnerability as a result of the COVID-19 pandemic’s crippling economic impact, there was a need to retain tighter regulatory control of NBFCs in order to avoid systemic shocks. “Unbridled expansion assisted by a less stringent regulatory framework inside an interconnected financial system might sow the seeds of systemic danger,” according to the Draft Proposal.

When a large and deeply interconnected NBFC experiences financial stress (due to the borrow long, lend short business model), shockwaves are felt throughout the financial sector, including banks, mutual funds, retail and institutional investors, and even small and mid-sized NBFCs, causing disruptions. Due to wholesale debt investments by MFs in NBFC debt paper, which resulted in a string of bond defaults, SEBI amended Mutual Fund standards, resulting in several recent significant NBFCs facing liquidation/defaults and rating downgrades.

To address this, the RBI is now exploring a scale-based regulatory framework to link NBFCs’ systemic importance with proportional regulatory measures. As a result, the four-tiered structure is based on a proportionality concept in the degree of control.

The basic idea of proportionality envisions a more streamlined and rational approach to allocating the RBI’s supervisory resources — NBFCs that pose bigger systemic risks would be regulated and overseen more rigorously. The following are the primary elements examined in the Discussion Paper’s graded approach:

• Comprehensive risk perception – If an NBFC satisfies specific size, leverage, interconnectivity, complexity, and other criteria, it must be regulated in proportion to the risk it causes to the financial system.
• Size of operations – Regardless of other factors, if an NBFC’s balance sheet is large, it will need more monitoring; and
• Nature of activity – The emergence of sectoral and geographically specialised NBFCs implies that some would participate in activities with a more systemic influence than others. Because they do not accept public funds or have a customer interface, certain non-deposit taking NBFCs (“NBFC-ND”), such as Type-I NBFCs, do not pose a large scale systemic risk, but housing finance companies (“NBFC-HFC”), infrastructure finance companies (“NBFC-IFC”), and core investment companies (“CIC”) have business models that naturally involve greater financial risk.

Digital lending companies

Referring to digital lending companies that grew their businesses exponentially during the Coronavirus (Covid-19) pandemic by providing credit to people who desperately needed it to tide over financial distress, Rao stated that while the benefits of digital financial services were undeniable, the business conduct issues and governance standards adopted by such digital lenders had shaken India’s trust in digital means of finance.

He stated that the RBI has received and continues to receive numerous complaints about their severe recovery procedures, breach of data privacy, increased fraudulent transactions, cybercrime, high interest rates, and harassment. The RBI has constituted a committee to investigate the whole digital lending industry and is planning to issue restrictions.

“Unfortunately, such changes driven only by economic concerns have harmed the legitimacy of the whole system, which exists and thrives on confidence.” We should not sacrifice finance’s principles for mercurial or transitory profits. These benefits will accrue to the institutions in the long run if and when it is founded on a foundation of trust and mutual benefit,” Rao added.

Furthermore, he emphasised that the RBI has been at the forefront of building an environment conducive to the expansion of digital technology, but that innovation should not come at the expense of prudence and should not be designed to circumvent regulatory, prudential, and transparency standards.

RBI’s PERSPECTIVE

While differential regulation in the shadow banking sector is justified while the scale of operations of finance companies is low, it becomes critical to increase regulatory oversight over the sector once they reach a size and complexity that poses a risk to the financial system as a whole, according to Reserve Bank of India (RBI) Deputy Governor M Rajeshwar Rao.

The RBI recommended isolating bigger businesses and subjecting them to a tighter set of “bank-like” norms in January of this year, with the goal of maintaining financial stability while allowing smaller NBFCs to continue to enjoy light-touch restrictions and develop with ease.

The central bank proposed a four-tier pyramid structure for the sector in a discussion paper published on its website: a base layer, a medium layer, an upper layer, and a hypothetical top layer.

The base layer will be made up of non-deposit-taking, non-systemically critical NBFCs that will continue to be subject to mild regulation but with more openness through increased disclosures and higher governance requirements.

The proposed structure includes deposit-taking NBFCs and systemically significant non-deposit-taking NBFCs in the intermediate tier, where the RBI hopes to close the arbitrage between banks and NBFCs.

The top 25-30 systemically significant NBFCs will comprise the upper tier, at the discretion of the RBI, and will be subject to “heightened regulatory rigour.”

Finally, if the RBI deems it essential, it may include a systemically important NBFC in the higher tier, which should ideally stay vacant, if the central bank believes the business is significantly contributing to systemic risk.

“A scale-based regulatory framework, proportionate to the systemic significance of NBFCs, may be an appropriate strategy,” Rao said, “where the amount of regulation and supervision will be a function of NBFC size, activity, and riskiness.”

He further stated that, while some arbitrages enjoyed by finance businesses may be lost, the scale-based approach will not interfere with the operational flexibility with which these financing companies do their business.

India’s shadow banking sector includes 9,651 NBFCs in 12 distinct categories, and as of March 31, 2021, the NBFC sector, including housing finance businesses, has assets of more than Rs 54 trillion, comparable to around 25% of the banking system’s asset size. Over the previous five years, the industry has risen at a compound annual growth rate (CAGR) of over 18%.

Rao expressed concern over the rate of expansion of NBFCs, saying, “…one has to understand if it is a demand-side pull or a supply-side push that is contributing to the rise of the NBFC industry.”

“Conventional knowledge holds that expansion as a result of demand-side pull factors translates into higher efficiency and better customer service.”

Supply-driven growth, on the other hand, might result from entrepreneurs who want to enter the financial services industry but are unable to match the scale and severe criteria expected of banks,” he noted.

In recent years, the sector has seen a number of big NBFCs fail, causing a liquidity crisis in the sector and preventing many smaller NBFCs from receiving necessary capital.

“In recent years, the reputation of the non-banking financial industry has been harmed by the demise of particular companies owing to idiosyncratic circumstances.” “The task is to reestablish trust in the sector by ensuring that a few companies or activities do not develop vulnerabilities that go unnoticed, create shocks, and give birth to systemic risk through their interlinkages with the financial system,” Rao explained.

“….any big NBFC or HFC failure may pose a risk to its lenders, with the potential to spread contagion.” Failure of any major and highly interconnected NBFC can impair the operations of small and mid-sized NBFCs by restricting their capacity to acquire money via a domino effect. “The loss of a significant core investment company (CIC) caused liquidity stress in the industry, shattering the illusion that NBFCs do not represent any systemic risk to the financial system,” Rao added.

Conclusion

As a result, it may be stated that the RBI has improved the structural pyramid hierarchy by revising the regulatory framework for NBFCs. The goal is to make the NBFC registration process easier and more flexible by providing the much-needed backstop inside the financial sector.

NBFCs must adhere to a standard exposure ceiling of 25% and 40% of Tier-1 capital for single and group borrowers, respectively.

Stricter Regulations For Certain types of NBFCs will be required to have a high net owned fund. The minimum net owned funds for investment and credit firms, microfinance companies, and NBFC-Factors must be raised to Rs 10 crore by March 31, 2027, according to the RBI.