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NBFC Regulation turned sixty
Vinod Kothari, finserv@vinodkothari.com
Not sure if any cake was cut[1], but NBFC regulation turned 60, on 1st Feb., 2024. It was on 1st Feb., 1964 that the insertion of Chapter IIIB in the RBI Act was made effective. This is the chapter that gave the RBI statutory powers to register and regulate NBFCs.
1964: Insertion of regulatory power
What was the background to insertion of this regulatory power? Chapter IIIB was inserted by the Banking Law (Miscellaneous Provisions) Act, 1963. The text of the relevant Bill, 1963 gives the object of the amendment: “The existing enactments relating to banks do not provide for any control over companies or institutions, which, although they are not treated as banks, accept deposits from the general public or carry other business which is allied to banking. For ensuring more effective supervision and management of the monetary and credit system by the Reserve Bank, it is desirable that the Reserve Bank should be enabled to regulate the conditions on which deposits may be accepted by these non-banking companies or institutions. The Reserve Bank should also be empowered to give to any financial institution or institutions directions in respect of matters, in which the Reserve Bank, as the central banking institution of the country, may be interested from the point of view of the control of credit policy.”
Therefore, there were 2 major objectives – regulation of deposit-taking companies, and giving credit-creation connected directions, as these entities were engaged in quasi-banking activities.
Read more →Consolidated NBFC Regulations for all Scales and Functions
– Anita Baid, Vice President | anita@vinodkothari.com
Updated as on 09.11.2023
The Reserve Bank of India (RBI) has issued a notification outlining a new regulatory framework for Non-Banking Financial Companies (NBFCs) on October 19, 2023 (‘SBR Framework’). The RBI has played a crucial role in regulating the NBFC sector over the years. With the sector’s evolution and changing dynamics, the regulator has been proactive in amending regulations. Previously, NBFCs were classified into two categories: systemically important and non-systemically important. However, starting from October 2022, the RBI introduced a new classification system based on layers: base, middle, upper, and top.
The reclassification introduced some progressive changes but also created certain ambiguities in the applicability of regulatory rules. Specifically, the terms “base layer” and “middle layer” were related with non-systemically important (non-SI) and systemically important (SI) NBFCs. When classifying NBFCs based on asset size, those with assets under Rs. 500 crores were considered non-SIs, while those with assets over Rs. 500 crores were classified as SIs.
However, the SBR Framework introduced a different set of criteria. According to this framework, NBFCs with assets less than Rs. 1000 crores are categorized as Base Layer entities, while those with assets exceeding Rs. 1000 crores are classified as Middle Layer entities. This creates a gray area for NBFCs with assets falling between Rs. 500 crores and Rs. 1000 crores.
To address this issue and provide a more streamlined regulatory framework, the RBI has issued the Master Direction – Reserve Bank of India (Non-Banking Financial Company – Scale Based Regulation) Directions, 2023 (‘SBR Master Directions’).
The SBR Master Direction, effective immediately, intends to consolidate the various regulations for NBFCs of different scales and functions in one place. The consolidation has streamlined various regulations issued under the SBR Framework governing the different layers of NBFCs. It brings clarity to compliance requirements and ensures that all NBFCs operate within a framework that is consistent and transparent. The SBR Master Directions is divided into sections for different categories of NBFCs, based on size as well as function:
- Regulations for Base Layer;
- Regulations for Middle Layer (this would be in addition to the regulations for BL);
- Regulations for Upper Layer (this would be in addition to the regulations for BL and ML);
- Regulations for Top Layer (to be specifically communicated upon classification in TL);
- Specific Directions for MFIs this is in addition to the regulations based on layers);
- Specific Directions for Factors and NBFCs registered under Factoring Act (this is in addition to the regulations based on layers);
- Specific Directions for IDFs (this is in addition to the regulations based on layers).
Further, the specific regulations issued by the RBI would still be relevant and continue to be applicable for Housing Finance Companies, Core Investment Companies, NBFC-P2P, NBFC-Account Aggegator, deposit taking NBFCs, Residuary Non-Banking Companies, Mortgage Guarantee Companies and Asset Reconstruction Companies. Additionally, based on the classification under the SBR Framework (BL or ML), the relevant provisions of the SBR Master Directions shall be applicable.
Previously, under the SBR notification dated October 22, 2021, the RBI clarified that all references to NBFC-ND (non-systemically important non-deposit taking NBFC) would now be referred to as NBFC-BL, and all references to NBFC-D (deposit-taking NBFC) and NBFC-ND-SI (systemically important non-deposit taking NBFC) would be known as NBFC-ML or NBFC-UL, depending on the case.
Furthermore, it specified that existing NBFC-ND-SI with asset sizes of ₹ 500 crore and above but below ₹1000 crore (except those necessarily categorized as Middle Layer) would be reclassified as NBFC-BL.
However, upon an initial review of the SBR Master Directions, it appears that certain guidelines that were typically applicable to NBFC-SI and should logically apply to NBFC-ML are explicitly retained for NBFCs with asset sizes exceeding ₹ 500 crores. Here is a list of such guidelines:
- Prudential Framework for Resolution of Stressed Assets dated June 07, 2019, as amended from time to time would be applicable on all NBFCs-D and non-deposit taking NBFCs of asset size of ₹500 crore and above. It may be noted that there are specific norms for restructuring of advances by non-deposit taking NBFCs with asset size less than ₹500 crore
- Non-Cooperative Borrowers identification shall be done by all NBFC-Factors, NBFCs-D and non-deposit taking NBFCs of asset s.ize of ₹500 crore and above.
- Refinancing of Project Loans to any existing infrastructure and other project loans by non-deposit taking NBFCs with asset size less than ₹500 crore.
- Framework for Revitalizing Distressed Assets in the Economy shall apply to non-deposit taking NBFCs with asset size less than ₹500 crore.
- Early Recognition of Stress and Reporting to Central Repository of Information on Large Credits (CRILC) reporting by all NBFC-Factors, NBFC-D and non-deposit taking NBFCs of asset size of ₹500 crore and above.
As the financial landscape continues to evolve, the RBI’s proactive approach ensures that the NBFC sector remains well-updated.
Upon further perusal of the SBR Master Directions, it can be noticed that there are certain regulations that were issued under the SBR Framework that have not been consolidated, such as follows:
- Compliance Function and Role of Chief Compliance Officer (CCO) – NBFCs
- Implementation of ‘Core Financial Services Solution’ by Non-Banking Financial Companies (NBFCs)
Further, there are specific master directions on information technology framework, fraud reporting, etc. that have not been consolidated. It may also be noted that para 4.2 clarifies that the SBR Master Directions consolidate the regulations as issued by Department of Regulation (DoR); any other directions/guidelines issued by any other Department of the RBI, as applicable to an NBFC shall continue to be adhered to. Accordingly, the aforesaid regulations that were issued by the Department of Supervision (DoS) or Department of Non-Banking Supervision (DNBS) have not been consolidated and are neither listed in the Repeal Section of the SBR Master Directions. There does not seem to be any reason for the aforesaid regulations to be repealed, and hence, it seems that only those circulars and notifications that are issued by the DoR have been considered while compiling the regulations, including those introduced under the SBR Framework. Considering that there are standalone notifications on the aforesaid issued by the DoS or DNBS, therefore, the said regulations should also continue to be applicable.
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Implementation of Compliance Function by NBFC-ML
Eliza Bahrainwala, Executive| eliza@vinodkothari.com
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Holding of promoter shares through investment companies: Dividend restrictions clog upstreaming and create tax inefficiency
Vinod Kothari & Payal Agarwal | corplaw@vinodkothari.com
Most of the promoter holdings in India, in companies large and small, are funneled through group investment companies. These companies, often with a complicated network of cross holdings, were created historically with multiple motives. While shadier motives such as re-routing of black money belong to some decades old practice, there have been multiple other reasons – from lowering of capital gains on holdings by not offering the market value of the listed operating entity, to camouflaging beneficial holdings or defying the definition of “promoter group”, etc etc. In many cases, the division of family holdings among sons or brothers is also done by dedicating an investment company to each such participant. In short, there have existed multiple reasons for networked holdings though layers of investment companies, with natural persons or groups of natural persons (HUFs, family trusts, etc) sitting somewhere at the end of the spectrum.
Over time, these practices have become increasingly unviable, and tough. For example, the possibility of avoiding capital gains tax by disregarding the value of listed stocks at operating company level and transferring the holding entity, which is obviously unlisted, was struck at by the introduction of Rule 11UA of the Income tax Act which requires an “adjusted NAV” computation w.e.f. 1st April, 2017 that takes into consideration the fair value of the investments too. The possibility of garbing the identity of natural persons was further challenged by the introduction of sec. 90 of the Companies Act read with the Significant Beneficial Owners Rules with effect from February, 2019, mandating the disclosure of indirect holdings of significant beneficial owners. Cross-holdings may still avoid classification as a “promoter group” entity, but over a period of time, the sheer burden of compliance by itself outweighs the benefits.
Read more →Base Layer NBFCs amenable to NSI or SI regulations?
Rhea Shah, Executive | finserv@vinodkothari.com
Background
Prior to the implementation of the SBR Framework, NBFCs were classified into Systemically Important (SI) and Non-Systemically Important (NSI) on the basis of the overall risk involved in their operations and the economic importance of the operations that they undertake. NBFCs with asset size upto 500 crores were classified as NSI, and those with Rs. 500 crores and above, were classified as SI and are respectively governed by Master Direction – Non-Banking Financial Company – Non-Systemically Important Non-Deposit taking Company (Reserve Bank) Directions, 2016[1] (‘NSI Directions’) and Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016[2] (‘SI Directions’). Besides, there are certain other directions [e.g. Master Direction – Monitoring of Frauds in NBFCs (Reserve Bank) Directions, 2016[3]], which are applicable to NBFC-SIs and not NBFC-NSI. Even the return filing requirements differ for NBFC-SIs and NBFC-NSIs.
Read more →Compliance Risk Assessment
Guidance for implementation by NBFCs
Subhojit Shome, Assistant Manager | subhojit@vinodkothari.com
Introduction
The RBI published the Compliance Function and Role of Chief Compliance Officer (CCO) – NBFCs[1] on April 11, 2022 (‘Compliance Circular’) that are applicable on Middle Layer (NBFC-ML) and Upper Layer NBFCs (NBFC-UL) and the deadline to put into place the framework for this function falls due on October 1, 2023 for NBFC-ML and April 1, 2023 for NBFC-UL entities.
The circular brings up the significant aspect of Compliance Risk, a concept that has been for long relevant for Banks[2] and now becomes applicable for specified NBFCs as well. The Compliance Circular define Compliance Risk as follows:
‘the risk of legal or regulatory sanctions, material financial loss or loss of reputation an NBFC may suffer, as a result of its failure to comply with laws, regulations, rules and codes of conduct, etc., applicable to its activities.’
Hence, Compliance Risk goes beyond mere fines and penalties that may arise as a result of compliance irregularities and the Compliance Function needs to consider the entire gamut of adverse events that a company may be exposed to as a result of compliance failures. These may include events with extreme impact such as suspension of business operation or loss of reputation as a result of enforcement action against senior management.
As a crucial piece of being able to anticipate such risks and to put necessary mitigation measures in place the Circular mandates putting in place an effective compliance risk assessment framework and the senior management to review such assessment annually.
Read more →2022 in retrospect: Regulatory activity in the financial sector
– Vinod Kothari | finserv@vinodkothari.com
It has been a brisk year in terms of activity – a busy regulator kept all regulated entities busier. This year marked the initiation of a new SBR framework for NBFCs – hence there was a lot of buzz in terms of understanding the new regulatory framework. The names of 16 Upper layer entities were declared by the RBI – consisting of 5 HFCs, 10 NBFC-ICCs, one CIC[1]. As is the design, UL entities are treated at par with banks in terms of regulatory intensity –hence, there is a LEF (large exposure framework), differential provisioning norms in case of standard assets, CET-1 capital requirement, mandatory listing etc.
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