In the backdrop of recent stress in the financial sector, especially in the speciality finance (i.e. NBFC) space, the Reserve Bank of India (“RBI”) has sought to address potential systemic risks by issuing a discussion paper on ‘Revised Regulatory Framework for NBFCs – A Scale-Based Approach’ (“Discussion Paper”) on January 22, 2021. The apex bank, through the Discussion Paper, has introduced a scale-based approach to the regulation of non-banking financial companies. Owing to their growing significance, linkages with the banking and capital markets sectors, and complexity in operations, the Discussion Paper proposes a four-tiered regulatory structure for NBFCs, based on proportionality of the NBFCs.

Currently, NBFCs are classified based on a variety of parameters – (i) whether or not ‘systemically important’, i.e., asset size of INR 500 crore or more (more stringently regulated and supervised); (ii) whether deposit taking or not; (iii) nature of business undertaken, i.e. Investment and Credit (ICC), Micro Finance Institutions (MFI), Account Aggregation, P2P Lending, Infrastructure Debt, Infrastructure Finance, etc.; and (iv) whether having customer interface and access to public funds, i.e.., Type I and Type II NBFCs.

The Discussion Paper seeks to streamline and consolidate the classification of NBFCs into four categories – Base Layer (“NBFC-BL”), Middle Layer (“NBFC-ML”), Upper Layer (“NBFC-UL”), and a possible Top Layer, based on size, risk perception, interconnectedness, complexity, nature of activity of the various NBFCs, etc.

Policy Rationale

The underlying premise of the differential regulation for NBFCs (often referred to ‘shadow banks’), as compared to universal banks, was one of lesser stringency in supervision and greater flexibility in operations – hence the historical regulatory arbitrage and ‘light-touch’ overview model. This led to NBFCs having a relatively free hand in developing sectoral and geographical expertise, bringing to the market a variety of financial products and services (e.g. loan against shares), and led to the recent Fintech revolution in the digital lending space in India.

However, due to the pressure created on the financial sector on account of the debilitating economic impact of the COVID-19 pandemic, a need was felt to maintain deeper regulatory oversight over NBFCs to prevent systemic shocks. The Discussion Paper mentions that “unbridled growth aided by less rigorous regulatory framework within an interconnected financial system can sow the seeds of systemic risk.”[1] When a large and deeply interconnected NBFC undergoes financial stress (given the borrow long, lend short business model), shockwaves are felt across various entities connected within the financial sector, including banks, mutual funds, retail and institutional investors, and even causes disruptions to small and mid-sized NBFCs. Some of the recent large NBFCs undergoing liquidation/ defaults and rating downgrades bear witness to these concerns – resulting in SEBI amending Mutual Fund norms given that wholesale debt investments by MFs in NBFC debt paper yielded a string of bond defaults.

To address this, RBI is now evaluating a scale-based regulatory framework to align the systemic significance of NBFCs to proportional regulatory interventions. Thus, the four-tiered structure is premised on a principle of proportionality in the degree of regulation.

The underlying principle of proportionality envisages a more streamlined and judicious approach in devoting supervisory resources of the RBI – NBFCs posing greater systemic risks would be regulated and supervised more stringently. The major factors considered for the graded approach in the Discussion Paper are – 

  • Comprehensive risk perception –If an NBFC meets certain parameters of size, leverage, interconnectedness, complexity, etc. it must be subject to regulation proportionate to the perceived risk it poses within the financial system;
  • Size of operations – Irrespective of other parameters, if the balance sheet size of an NBFC is significant, it will require greater supervision; and
  • Nature of activity – The development of sectoral and geography-specific NBFCs imply that some engage in activities that involve more systemic impact than others. For instance, certain non-deposit taking NBFCs (“NBFC-ND”) like Type-I NBFCs do not pose large scale systemic risk because they neither accept public funds nor have customer interface,[2] but housing finance companies (“NBFC-HFC”), infrastructure finance companies (“NBFC-IFC”), and core investment companies (“CIC”) have such business models that naturally involve greater financial risk.

Industry Implications

Guided by these parameters, the four proposed layers of NBFCs (with attendant regulatory oversight) are as follows:

  • NBFC-BL: Based on the nature of activity, NBFC-BL will consist of NBFCs currently classified 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”). The Discussion Paper views these as NBFCs with muted risk perceptions on account of their activity, and thus, appropriate as being subject to lenient regulatory oversight.

Though regulations for the base layer are not overhauled significantly, there are certain important changes such as – (i) the threshold for systemic significance has been raised from INR 500 crore to INR 1,000 crore bringing more NBFCs within the NBFC-BL fold; (ii) stricter entry norms have been introduced by raising the minimum net-owned fund from INR 2 crore to INR 20 crore to account for higher capitalisation requirements for managing cyber security and anti-money laundering risks; and (iii) reduction in the threshold for non-performing asset classification from 180 days to 90 days.

  • NBFC-ML: All non-deposit taking NBFCs classified currently as being systemically important and all deposit taking NBFCs that do not meet the specified parameters of regulation in the Upper Layer, would fall within this category. Further, NBFC-HFCs, IFCs, infrastructure debt funds (“NBFC-IDF”), standalone primary dealers (“SPD”) and CICs, irrespective of their asset size, are also contemplated to constitute this layer.

The NBFC-ML will see changes in its concentration and financing norms wherein: (i) the lending and investment limits are proposed to be merged into a single exposure limit of 25 per cent and a group exposure of 40%, which is computed based on Tier 1 capital rather than net owned funds; (ii) financing regulation will become increasingly stringent with the imposition of a INR 1 crore cap per individual per NBFC, restrictions on buy-back of shares, restrictions on loans to directors/their relatives, etc.; (iii) the introduction of governance norms such as constituting a remuneration committee, additional disclosures, and rotation of statutory auditors, and (iv) requirement to have a Board-approved policy on Internal Capital Adequacy Assessment Process, akin to banks.

  • NBFC-UL: The NBFCs in the Upper Layer will be determined on the basis of quantitative as well as qualitative criteria – (a) qualitative parameters such as size (35%), inter-connectedness (25%), complexity (10%); and (b) qualitative parameters like supervisory inputs (30%, which includes type of liabilities, group structure and segment penetration). According to the Discussion Paper, the top ten NBFCs (as per asset size) will automatically fall in this category.

The Discussion Paper contemplates regulatory oversight on NBFC – UL to be along similar lines as banks, including: (i) maintaining a minimum common equity tier 1 (“CET 1”) capital of 9% (similar to the Basel III mandated CET 1 for banks); (ii) a leverage requirement that would act as a backstop for regulating unchecked growth of a NBFC-UL; (iii) subjecting NBFC-ULs to the differential standard asset provisioning norms applicable to banks (as opposed to the 0.4% for systemically important NBFCs currently in place); and (iv) placing a mandatory listing requirement as is applicable to private banks.

  • Top Layer: The top layer is proposed to remain empty as per the Discussion Paper. In case any unsustainable systemic risk is perceived from a specific entity in the NBFC-UL category, it may be shifted to this layer and subject to specialised scrutiny.

Since the introduction of Chapter IIIB in the RBI Act, 1934 since 1963, NBFCs have formed a critical cog in the financial markets’ wheel and any move to overhaul the regulatory framework applicable to them, is going to have broad implications. 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 a top layer left empty) and focus on using qualitative and quantitative parameters to classify NBFCs is a welcome move.

If the proposals of the Discussion Paper are implemented, NBFC – ML and NBFC – UL will require significant revision of their governance and compliance frameworks, affecting over 500 NBFCs in India. It would also be interesting to see how the Discussion Paper ties into the RBI’s Internal Working Group Report for Banks issued on November 20, 2020, which proposes to have more banks and seeks conversion ofNBFCs (above INR 50,000 asset book) into banks.

[1] Discussion Paper, p. 15.

[2] Type I NBFCs are defined as “NBFC-NDs not accepting public funds/ not intending to accept public funds in the future and not having customer interface/ not intending to have customer interface in the future” as per the RBI press release dated June 17, 2016.