-Financial Services Division (email@example.com)
The RBI had, in its Statement on Development and Regulatory Policies dated December 4, 2020, highlighted a need to review the regulatory framework in line with the changing risk profile of NBFCs. The NBFC sector has witnessed various changes in the regulatory framework in the past few years, making it more comprehensive. However, the tremendous growth in the sector combined with regulatory arbitrage enjoyed by the NBFCs is now leading to systemic risk. Hence, it is necessary to tighten the regulatory norms for NBFCs holding a major chunk of market share.
In line with the aforesaid announcement, the RBI released a discussion paper on January 22, 2021 seeking inputs from industry participants. The following write-up analyses the major propositions made by the RBI.
Concerns behind the present regulatory proposal- regulatory arbitrage
The operational flexibility provided to the NBFCs has enabled it to assume a scale that would potentially impact systemic stability. In recent years, the regulator has identified structural arbitrage and prudential arbitrage between banks and NBFCs. Where the former emanates from differences in legislative and licensing framework like net owned funds, branch approval requirements, etc. While the latter is concerning CRAR, prescribed leverage, liquidity guidelines, etc.
There also exists some form of corporate governance and disclosure relaxation for NBFCs in comparison to banks such as instructions on compensation policy for WTD/CEOs/Risk Control Staff and most of SCB being listed and thus abiding by the listing requirement.
NBFCs have become more interconnected with the financial system. Linkages are due to the substantial exposure that banks have in NBFCs. As per the financial stability report of January 2021, the NBFCs were the largest net borrowers of funds from the financial system. Where the gross payables and receivables stood around ₹9.37 lakh crore and ₹0.93 lakh crore as of end-September 2020. More than half of this funding was supported by scheduled commercial banks (SCBs) followed by Asset Management Companies-Mutual Funds (AMC-MF) and Insurance Companies. Further, the discussion paper noted that there are seven NBFCs (including HFCs) each having an asset size exceeding 1 lakh crore and above.
The unconstrained growth of the NBFC sector in addition to the lenient regulatory framework within an interconnected financial system may sow the seeds of systemic risk. In the present scenario, the failure of any large and deeply interconnected NBFC is capable of transmitting shocks into the entire financial sector and causing a disruption even to the operations of the small and mid-sized NBFCs.
Classification of NBFCs
The proposed framework provides for the regulation on a scale-based approach. This essentially means that regulatory and supervisory resources are to be more focused on the entities which have become too big to fail ‘TBTF’ owing to their systemic interconnectedness with other financial market participants. The degree of regulation is to be based on the ‘principle of proportionality’. The three triggers of scale based regulation are:
- Risk perception: This parameter is based on the size, leverage, and interconnectedness of the NBFC with market participants in terms of the prescribed threshold.
- Size of operations: The size of the balance sheet of an NBFC beyond a certain prescribed high threshold would be an important independent factor in the determination of regulation.
- Nature of activity – Just performing financial activity cannot give rise to systemic risk. Like Type 1 NBFCs which do not access public deposits and neither have customers, interfaces are to be regulated with a light touch. The essence of such a form of NBFCs is that the financial activity is being carried out by net-owned funds. However, some activities are regarded as high risk owing to their systemic connectivity and business model. The draft paper categorizes NBFC-HFC, IFC, IDF, SPD, and CIC as they are interconnected with other financial institutions while performing credit intermediation.
The RBI has proposed a scale-based four-layered structure regulatory framework–viz. Base Layer (NBFC-BL), Middle Layer (NBFC-ML), Upper Layer (NBFC-UL), and Top Layer. The classification of layers is made commensurate to the regulatory intervention required- i.e. the base layer having the least regulatory intervention and the intervention increasing as the one moves up the pyramid. The proposed categorisation/classification as provided in the discussion paper is summarized in the fig below:
CICs poised to be put under greater scrutiny. They are proposed to be regarded as Middle Layer NBFC (NBFC-ML) along with NBFCs currently classified as systemically important NBFCs (NBFC-ND-SI), deposit-taking NBFCs (NBFC-D), HFCs, IFCs, IDFs, SPDs. Though CICs and SPDs will fall in the Middle Layer of the regulatory pyramid, the existing regulations specifically applicable to them will continue to apply. However, a pertinent question for discussion would be whether the activity-based classification of NBFC-AA, P2P, NOFHC in Lower Layer and NBFC-HFC, IFC, IDF, CIC, and SPDs in Middle Layer justified.
Increased NOF & harmonisation of NPA recognition
Further, NOF is proposed to be raised to Rs. 20 crores. Further, in order to ensure a smooth transition, a well-defined timeline will be prescribed by the RBI for existing NBFCs, spanning over a period of, say, five years. For new registrations, the higher NOF norms will get implemented immediately on the issue of instructions.
NPA recognition based on 90 DPD will be extended to all NBFCs including those which are not systemically important.
Recognition of NBFCs in Upper Layer
NBFC categorisation is based on an annual review. The paper recognises two parameters; quantitative and qualitative:
- The quantitative parameters will have 70% weightage.
- The qualitative parameters will have 30% weightage.
The table below represents quantitative and qualitative parameters as proposed:
|Quantitative Parameters (70%)|
|Size & Leverage||Size: Total exposure (on-and off-balance sheet)
Leverage: total debt to total equity
|Interconnectedness||i) Intra-financial system assets:
– Lending to FIs
– Securities of other FIs
– Mark to market REPO
– OTC derivatives
ii) Intra-financial system liabilities
– Borrowings from FIs
– Marketable securities issued by finance company to FI
– Mark to market OTC derivative with FIs
iii) Securities outstanding (issued by NBFC)
|Complexity||i) Notional amount of OTC derivatives
– CCP centrally
– Bilateral OTC
ii) Trading and available for sale securities
|Qualitative Parameters/Supervisory inputs (30%)|
|Nature and type of liabilities||– Degree of reliance on short term funding
– Liquid asset ratios
– Callable debts
– Asset backed funding Vs. other funding
– Asset liability duration and gap analysis
– Borrowing split (secured debt, CCPS, CPs, unsecured debt)
|Group Structure||– Total number of entities
– Total number of layers
– Total intra-group exposure
|Segment Penetration||Importance of NBFC as a source of credit in a specific segment or area||10|
The scoring will be done on a sample basis, by dividing the individual NBFCs amount by the aggregate sum of all the indicators in the sample. The score for each category will be converted into basis points and the overall systemic significance score will be based on the relative importance of the NBFC compared with other NBFCs in the sample.
The sample criteria for the purpose of the above parameter-based measurement is to be as follows:
- Excluding the top 10 NBFCs (based on asset size) as they will automatically fall in upper layer regulation.
- The sample will include the next 50 NBFCs based on total exposure (including off-balance sheet)
- NBFCs designated as NBFC-UL in the previous year
- NBFCs added to sample by supervisors judgment
For leverage calculation, the individual score of NBFC is to be divided by the average leverage of the sample. An NBFC-UL will be subjected to enhanced regulatory requirements similar to that of banks at least for a period of four years from its last appearance in the category, even where it does not meet the parametric criteria in the subsequent year.
NBFCs in Base Layer
The base layer would cover NBFCs with asset size up to Rs 1000 crores. The major propositions for this layer are provided in the table below:
|Proposals for NBFCs in Base Layer|
|1.||The current regulations require NPA classification of the asset having more than 180 DPDs the same is proposed to be reduced to 90 DPDs in order to bring it in sync with the regulatory guidelines for other classes of NBFCs|
|2.||The board shall be required to have –
(i) Adequate experience and educational qualification
(ii) At least one of the directors should have experience in retail lending in a bank/NBFC
|3.||For the Risk Management Committee-
(i) Overall role and responsibilities to be laid out, and
(ii) Composition could be Board or Executive level as to be decided by the Board
|4.||The regulations for sale of stressed assets shall be made at par with banks once guidelines are finalized|
|5.||Additional disclosures on type of exposures, related party transactions, customer complaints shall be prescribed|
NBFCs in Middle Layer
Several new regulatory requirements are proposed for this category in addition to the proposals for the base layer. There are no changes proposed in capital requirements for NBFC-ML.
|Proposals for NBFCs in Middle Layer|
|1.||Board approved policy taking into account all risks for Internal Capital Adequacy Assessment shall be required.|
|2.||The extant credit concentration limits prescribed for NBFCs for lending and investment is proposed to be merged into a single exposure limit of 25% for a single borrower and 40% for group of borrowers anchored to Tier 1 capital instead of Owned Funds|
|3.||Compulsory Rotation of auditors shall be applicable- After completion of continuous audit tenure of three years, Auditors shall not be eligible for re-appointment for a period of six years (two tenures)|
|4.||i) Appointment of a functionally independent Chief Compliance Officer.
ii) Additional Corporate Governance and Disclosure Requirements, including requirement for Secretarial Audit.
|5.||It has been proposed that no KMP of an NBFC shall be allowed hold office in any other NBFC-ML or NBFC-UL or subsidiaries, further, an Independent Director cannot be director in more than two NBFCs (NBFC-ML and NBFC-UL) at the same time|
|6.||Board approved internal limits and adequate disclosures would be required for exposure to sensitive exposures and Dynamic vulnerability assessment by NBFCs shall be required. Sub-limit within the commercial real estate exposure ceiling should be fixed internally for financing land acquisition
|7.||Restrictions on grant of loans and advances for/to the following:
(a) buy back of shares/ securities
(b) activities leading to Ozone Depleting Substances
(c) Directors and relatives of directors
(d) Officers and relatives of Senior Officers
(e) Real Estate – only where project approvals other permissions are in place.
|8.||The IPO financing by NBFCs shall be capped at Rs.1 crore. There is no limit prescribed for NBFCs at present, while there is a limit of Ts. 10 lakh for banks for IPO financing.|
|9.||Mandatory for NBFCs with more than 10 branches to have Core Banking Solution for NBFCs|
NBFCs in the Upper layer
In addition to the regulations applicable to NBFC-ML, a set of additional regulations will apply to NBFC-UL, they are:
|Proposals for NBFCs in Upper Layer|
|1.||CET 1 may be prescribed at 9% within the Tier I capital
In addition to the CRAR requirements, NBFCs will also be subjected to a leverage requirement
|2.||Differential Provisioning being similar as banks for standard assets to be made applicable|
|3.||For Concentration norms-
(i) Large Exposure Framework (LEF) as applicable to banks with suitable modification will apply
(ii) Transition time for implementation
|4.||Corporate Governance norms to be similar lines as applicable for Private Sector Banks. Additional governance regulations such as specifying qualification of board members, providing detailed disclosure on group companies including consolidated financial position and details of related party transactions.|
|5.||Adequate phase-in-time for a mandatory listing to be provided. However, disclosure requirements will kick in earlier than the actual listing within the broad implementation plan for NBFC-UL|
|6.||Removal of Independent Director shall require supervisory approval|
NBFCs in Top Layer
The top layer is currently empty and will get populated in case RBI takes a view that there has been an unsustainable increase in the systemic risk spill-overs from specific NBFCs in the Upper Layer. NBFCs in this Layer will be subject to higher capital charges, including Capital Conservation Buffers. There will be enhanced and more intensive supervisory engagement with these NBFCs.
The RBI has sought the opinion of the stakeholders within a period of one month. However, the proposals seem to bring in stricter times for the otherwise leniently regulated NBFC sector. Further, it is notable that the nature of activities carried out by HFCs differs largely from that of other classes of NBFCs. Hence, increasing the NOF requirement to bring the same at par with the requirement for HFCs, may not be in the interest of the NBFC sector at large. NBFCs were formed to reach the credit gaps where banks could not. This was achievable only due to the liberalised regulatory framework. The intent of the paper is not to reduce the credit outreach of NBFCs but to regulate the ones posing a risk on the system. Hence, it is crucial to attain equilibrium between regulation and promotion.