Should OCI be included as a part of Tier I capital for financial institutions?

India has been adopted International Financial Reporting Standards (IFRS) in the form of Indian Accounting Standards (Ind AS) in a phased manner since 2016. Different implementation schedules have been issued by different regulatory authorities for different classes of companies and they are:

  • Ministry of Corporate Affairs –
    • For non-banking non-financial companies – Implementation schedule started from 1st April, 2016
    • For non-banking financial companies – Implementation schedule started from 1st April, 2018
  • Reserve Bank of India –
    • For banking companies – The original scheduled start date was 1st April, 2018, subsequently, it was shifted to 1st April, 2019. However, a recent notification from the RBI has shifted the implementation schedule indefinitely.[1]
  • Insurance Regulatory Development Authority of India –
    • For insurance companies – The implementation schedule starts from 1st April, 2020.

Consequent upon implementation of IFRS, it is logical that the regulatory framework for financial institutions will also require modifications to bring it in line with the provisions requirements under the new standards.

Though the Ind AS already been implemented in the NBFC sector, no modifications in the existing regulations have been made. Consequently, this has led to the creation of several ambiguities; and one such is regarding treatment of the Other Comprehensive Income (OCI), as per Ind AS 109, for the purpose of computing Tier 1 capital.

This write up will solely focus on the issue relating to treatment of OCI for the purpose of Tier 1 capital.

Other Comprehensive Income (OCI)

Before delving further into specifics, let us have a quick recap of the concept of the OCI. The format of income reporting under Ind AS has undergone a significant change. Under Ind AS, the statement of profit or loss gives us Total Comprehensive Income which consists of a) profit or loss for the period and b) OCI. While the first component represents the profit or loss earned by the reporting entity during the financial year, OCI represents unrealized gains or losses from financial assets of the reporting entity.  

The intention of showing OCI in the books of the accounts, is that it protects the gains/losses of companies from oscillation. As the fair values of assets and liabilities fluctuate with the market, parking the unrealized gains in the OCI and not in the P/L account provides stability. In addition to investment and pension plan gains and losses, OCI also captures that the hedging transactions undertaken by the company. By segregating OCI transactions from operating income, a financial statement reader can compare income between years and have more clarity about the sources of income.

While profit or loss earned during the year forms part of the surplus or other reserves in the balance sheet, OCI is shown separately under the Equity segment of the balance sheet.

Capital Risk Adequacy Ratio

Moving on to the meaning of capital risk adequacy ratio (CRAR), it is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. The CRAR is used to protect creditors and promote the stability and efficiency of financial institutions. This in turn results in providing protection against insolvency. Two types of capital are measured: Tier-I capital, which can absorb losses without a bank being required to cease trading, and Tier-II capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

The concept of CRAR comes from the Basel framework laid down by the Basel Committee on Banking Supervision (BCBS), a division of Bank of International Settlement. The latest framework being followed worldwide is Basel III framework.

RBI has also adopted the Basel framework, however, with modifications to suit the economic environment in the country. The CRAR requirements have been made applicable to banks as well as NBFCs, however, the requirements vary. While banks are required to maintain 9% CRAR, NBFCs are required to maintain 15% CRAR.

To understand whether OCI should form part of CRAR, it is important to understand the components of CRAR.

Components of Tier I and II Capital as per RBI Master Directions[2] for NBFCs

For the purpose of this write-up, requirements have been examined only from the point of view of NBFCs, as Ind AS is yet to be implemented for banking companies.

CRAR comprises of two parts – Tier I capital and Tier II capital. Each of the two have been defined in the Master Directions issued by the RBI, in the following manner:

(xxxii) “Tier I Capital” means owned fund as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in the aggregate, ten percent of the owned fund; and perpetual debt instruments issued by a non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such companies as on March 31 of the previous accounting year;

The term “owned funds” have been defined as:

“owned fund” means paid up equity capital, preference shares which are 9 compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any;

Tier II capital has been defined as:

(xxxiii) “Tier II capital” includes the following:

  • preference shares other than those which are compulsorily convertible into equity;
  • revaluation reserves at discounted rate of fifty five percent;
  • General provisions (including that for Standard Assets) and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth percent of risk weighted assets;
  • hybrid debt capital instruments;
  • subordinated debt; and
  • perpetual debt instruments issued by a non-deposit taking non-banking financial company which is in excess of what qualifies for Tier I Capital, to the extent the aggregate does not exceed Tier I capital.

The above definitions of Tier I and II capital do not talk about OCI. However, the Directions were prepared before the implementation of Ind AS 109 and no clarity on the subject has come from RBI post implementation of Ind AS 109.

Therefore, for determining whether OCI should be made a part of Tier I or Tier II capital, we can draw reference from Basel III framework.

Components of Tier I capital as per Basel III framework [3]

As per Para 52 of the framework, the Tier I capital consists of:

Common Equity Tier 1 capital consists of the sum of the following elements:

  • Common shares issued by the bank that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies);
  • Stock surplus (share premium) resulting from the issue of instruments included Common Equity Tier 1;
  • Retained earnings;
  • Accumulated other comprehensive income and other disclosed reserves;
  • Common shares issued by consolidated subsidiaries of the bank and held by third parties (ie minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital. See section 4 for the relevant criteria; and
  • Regulatory adjustments applied in the calculation of Common Equity Tier 1

Retained earnings and other comprehensive income include interim profit or loss. National authorities may consider appropriate audit, verification or review procedures. Dividends are removed from Common Equity Tier 1 in accordance with applicable accounting standards. The treatment of minority interest and the regulatory adjustments applied in the calculation of Common Equity Tier 1 are addressed in separate sections.

The Basel III norms clearly states that accumulated other comprehensive income forms a part of the Tier I capital.

It is very interesting to note that RBI had also adopted Basel III framework on July 1, 2015, however, the framework adopted and introduced is silent on the treatment of the OCI, unlike the original Basel III framework. The reason for the omission of the concept of OCI is that the framework was adopted in India way before Ind AS implementation and under the erstwhile IGAAP, there was no concept of OCI or booking of unrealized gains or losses in the books of accounts.

It is well understood that due to the very recent implementation of IndAS 109, the guidelines have not been revised in line with the IndAS. However, going by the spirit of Basel III regulation, this leaves us very little doubt what the treatment of OCI for the purpose of CRAR computation should be. Therefore, one can safely conclude that the OCI should form part of Tier I capital, unless, anything contrary is issued by the RBI subsequently.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11506&Mode=0

[2] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/45MD01092016B52D6E12D49F411DB63F67F2344A4E09.PDF0

[3] https://www.bis.org/publ/bcbs189.pdf

Revised Guidelines on KYC & Anti-Money Laundering Measures for HFCs

Aadhaar Ordinance – Paving way for use of voluntary Aadhaar by Private Companies

By Simran Jalan (simran@vinodkothari.com)

Introduction

Supreme Court in the case of Justice K.S. Puttaswamy (Retd.) & Anr. V. Union of India, W.P. (Civil) 494/2012 dated September 26, 2018[1] (‘Aadhaar Verdict’) partially quashed section 57 of the Aadhaar Act, which dealt with use of Aadhaar by private companies or bodies corporate. Pursuant to the Aadhaar verdict, the private entities were not allowed to demand Aadhaar for establishing identity unless the same is pursuant to any law.

Consequently, it was proposed to amend the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 (‘Aadhaar Act’), Indian Telegraph Act, 1885 and the Prevention of Money Laundering Act, 2002 (‘PML Act’) in line with the Supreme Court directives. In order to ensure that personal data of Aadhaar holder remains protected against any misuse and Aadhaar scheme remains in conformity with the Constitution, the Aadhaar and Other Laws (Amendment) Ordinance, 2019[2] (Ordinance) was passed.

In this write-up we intend to discuss the outcome of the Ordinance.

Read more

New scheme of NBFC classification

-Loan and investment companies merged into one

By Anita Baid (finserv@vinodkothari.com)

In furtherance to the  Sixth Bi-monthly Monetary Policy Statement[1] for 2018-19 dated February 07, 2019[2] on ‘Harmonisation of NBFC Categories’, the Reserve Bank of India (RBI) released a notification on February 22, 2019[3] to harmonise three different categories of NBFCs into one, based on the principle of regulation by activity rather than regulation by entity.

With the water tight categories segregating asset finance companies, loan companies and investment companies having gone, what impact will the new scheme of regulations have on NBFCs?

Clearly, NBFCs will have more liberty in planning their asset allocation, with their business strategies in mind rather than regulation. Asset finance companies will, in particular, enjoy this new flexibility, as the earlier regime was fraught of difficulties of classification as to whether funding a taxi is like funding a productive/economic asset which will qualify for “productive/economic asset” category, and whether a car used for personal purpose will not. Neither will NBFCs have to maintain that productive/unproductive asset distinction, nor will they have to keep personal loans, LAP or loans against shares within limits on the fear of crossing the 60% bright line.

However, the new dispensation should not mean that companies will have blurred lines of asset allocation. In fact, strategy and asset focus would continue to define whether the NBFC in question goes for fin-tech enabled small business loans, or LAP, or equipment finance, or construction equipment lending.

Harmonisation of three categories into one

The evolution of the NBFC sector has resulted in several categories of NBFCs intended to focus on specific sector/ asset classes. At present there are twelve broad categories of NBFC, based on the nature of activity, namely,

Investment activities Lending or similar activities Other activities
Ø  Investment Company

Ø  Core Investment Company

Ø  Non-Operative Financial Holding Company

 

Ø  Loan Company

Ø  Asset Finance Company

Ø  Micro Finance Institution

Ø  Infrastructure Finance Company

Ø  Infrastructure Debt Fund

Ø  Factor

Ø  Mortgage Guarantee Company

Ø  Peer-to-Peer Lending Platform

Ø  Account Aggregator

 

Out of around 10,190 NBFCs operating in India, more than 95 per cent (10,082) are non-deposit taking NBFCs. Too many categories only increase compliance cost for the entire non-banking sector and monitoring cost for the regulator. RBI has harmonised three different categories of NBFCs into one, based on the principle of regulation by activity rather than regulation by entity. Accordingly, the three categories of NBFCs viz. Asset Finance Companies (AFC), Loan Companies (LCs) and Investment Companies (ICs) have been merged into a new category called NBFC – Investment and Credit Company (NBFC-ICC).

Though it was expected to merge all the existing categories of NBFC, mentioned above, however, only the following three categories have been merged into one:

  1. Asset Finance Company (AFC): An AFC is a company which is a financial institution carrying on as its principal business the financing of physical assets supporting productive/economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipment, moving on own power and general purpose industrial machines.
  2. Investment Company (IC): IC means any company which is a financial institution carrying on as its principal business the acquisition of securities.
  3. Loan Company (LC): LC means any company which is a financial institution carrying on as its principal business the providing of finance whether by making loans or advances or otherwise for any activity other than its own but does not include an Asset Finance Company.

The merged category has been defined as follows:

“Investment and Credit Company – (NBFC-ICC)” means any company which is a financial institution carrying on as its principal business- asset finance, the providing of finance whether by making loans or advances or otherwise for any activity other than its own and the acquisition of securities; and is not any other category of NBFC as defined by the Bank in any of its Master Directions. 

The objective of this harmonisation is to allow greater operational flexibility to NBFCs. Post the aforesaid harmonisation, there shall be the same set of regulations for all the three categories of NBFCs even as they vary widely in their business focus and sources of funding. Further, the principal business criteria for AFC was calculated as aggregate of financing real/physical assets supporting economic activity and income arising therefrom is not less than 60% of its total assets and total income respectively, which has been reduced to the same level of 50%, pursuant to the harmonisation.

The classification of an NBFC as an AFC or LC or IC was done by the RBI at the time of issuance of the certificate of registration. Apart from satisfying the principality test, which has now been harmonised for all the three categories, there does not seem any other implementation issue in this regard.

Further, the term non-banking financial company has also been defined in the Master Directions for deposit taking NBFCs[4] as follows:

“non-banking financial company” means only the non-banking institution which is an investment and credit company or a mutual benefit financial company or a factor registered with the Bank under section 3 of Factoring Regulation Act (2011);

According, the broad head of NBFC now consists of only three categories:

  1. NBFC-ICC
  2. Mutual Benefit Financial Company (MBFC)
  3. NBFC-Factor

Here, MBFC means any company which is a financial institution notified by the Central Government under section 620A of the Companies Act, 1956 (Act 1 of 1956) and NBFC Factor means a nonbanking financial company as defined in clause (f) of section 45-I of the RBI Act, 1934 which has its principal business as defined in paragraph 40 of these directions and has been granted a certificate of registration under sub-section (1) of section 3 of the Factoring Regulation Act, 2011.

This definition is however restricted to only deposit taking NBFCs and does not extend to non-deposit taking NBFCs. Also, the said definition of NBFC does not include micro finance institutions, Infrastructure Finance Company and Infrastructure Debt Fund as an NBFC.

All related Master Directions for non-systemically important non-deposit taking, systemically important non-deposit taking company, deposit taking company, standalone primary dealers and residuary non-banking companies have been updated accordingly.

Cap on investment limit

The RBI has capped investment limit of deposit taking NBFC-ICC in unquoted shares of another company which is not a subsidiary company or a company in the same group of the NBFC to 20% of its owned fund. The text of the relevant regulation is reproduced herein below:

  1. Restrictions on investments in land and building and Unquoted shares

(1) No ICC, which is accepting public deposit, shall, invest in

a) land or building, except for its own use, an amount exceeding ten per cent of its owned fund;

b) unquoted shares of another company, which is not a subsidiary company or a company in the same group of the non-banking financial company, an amount exceeding twenty per cent of its owned fund.

Provided that the land or building or unquoted shares acquired in satisfaction of its debts shall be disposed off by the non-banking financial company within a period of three years or within such period as extended by the Bank, from the date of such acquisition if the investment in these assets together with such assets already held by the non-banking financial company exceeds the above ceiling;

Explanation. – While calculating the ceiling on investment in unquoted shares, investments in such shares of all companies shall be aggregated. Provided further that the ceiling on the investment in unquoted shares shall not be applicable to an investment and credit company in respect of investment in the equity capital of an insurance company upto the extent specifically permitted, in writing, by the Bank.

It is to be noted that investments done by non-deposit taking NBFCs having an asset size of more than 500 crores are already regulated by the concentration norms.

Ratings based risk weight

Along with the aforesaid harmonisation, differential regulations relating to a bank’s exposure to the three categories of NBFCs viz. AFCs, LCs and ICs also stand harmonised.[5]

Currently, the benefit of risk weighting based on ratings is applicable only in case of asset finance companies as per Master Circular-Basel III Capital Regulations dated July 1, 2015. That is to say, in case of all other NBFCs, such as loan companies, the risk weights are 100% irrespective of the rating of the borrower NBFCs.

Under extant guidelines on Basel III Capital Regulations, exposures/claims of banks on rated as well as unrated NBFC-ND-SIs, other than AFCs, Non-Banking Financial Companies – Infrastructure Finance Companies (NBFCs-IFC) and Non-Banking Financial Companies – Infrastructure Development Fund (NBFCs-IDF), have to be uniformly risk-weighted at 100%. With a view to facilitating flow of credit to well-rated NBFCs, a separate RBI circular stipulates that exposures to all NBFCs, excluding Core Investment Companies (CICs), will be risk weighted as per the ratings assigned by the rating agencies registered with SEBI and accredited by the RBI, in a manner similar to that of corporates. Exposures to CICs will continue to be fully risk-weighted.

Conclusion

The harmonisation intends to ensure better administration and uniformity of norms. It is also connected with another proposal to provide risk weight by the banks on the lending to NBFCs based on the credit rating. Further, this comes as a major relief to AFCs who were always facing deicidal issue whether the asset class qualifies as financing real/physical assets for productive / economic activity.

The new regulatory ambit of Investment and Credit Companies will have a huge number of NBFCs, as most NBFCs were investment companies as per RBI parlance.

Notably, the Companies Act, 2013 (sec 186) continues to distinguish, from the viewpoint of exemption from lending/investment limits, between companies principally engaged in the business of lending, and those engaged in the business of investments.


[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=46237

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=46235

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11483&Mode=0

[4] Master Direction – Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016

[5] Our detailed article can be read here- http://vinodkothari.com/2019/02/rbi-bi-monthly-credit-policy-nbfcs-moved-to-a-ratings-based-risk-weight-regime/

RBI removes cap on investments in corporate bonds by FPIs

By Abhirup Ghosh (abhirup@vinodkothari.com), (finserv@vinodkothari.com)

The Reserve Bank of India (RBI) in its Sixth Bi-monthly Monetary Policy Statement for 2018-19 dated February 07, 2019[1] had declared that for the purpose of widening the spectrum of investors in the Indian corporate bond market, it will remove the cap on investment to be made by FPIs on corporate bonds. In furtherance to the declaration, the RBI on 15th February, 2019[2] issued a notification giving effect to the proposal.

Before we understand what the impact of the notification will be, let us recapitulate what the restrictions were. Read more

RBI Bi-monthly Credit Policy: NBFCs moved to a ratings-based risk weight regime

By Finacial Services Division (finserv@vinodkothari.com)

The RBI’s Statement on Developmental and Regulatory Policies dated February 1, 2019 proposes that henceforth, bank lending to NBFCs will be risk-weighted based on the Basel II risk weights, based on the rating of the NBFC in question. This facility was earlier available only to asset finance companies, and has now been proposed to be extended to all NBFCs, excluding core investment companies (CICs). The likely impact of this new dispensation may be to encourage banks  to lend to NBFCs other than the asset finance companies, such as those focusing on loans against properties, personal loans, or loans other than to productive assets. This measure may be aimed at easing the present liquidity strain affecting the NBFC sector, though, it is not sure whether the lower risk weight itself will be a strong motivator for banks to consider lending to NBFCs. Read more