Like banks, NBFC-UL to maintain CET-1 capital

Manner of computation of CET-1  for NBFCs prescribed by RBI

– Qasim Saif | finserv@vinodkothari.com

Addressing risk faced by NBFCs and enhancing their capacity to absorb such risk has been a key point of consideration under the Scale Based Regulations (SBR) for NBFCs. SBR also intends to curb regulatory arbitrage available to very large NBFCs whose size of operations are more or less in line with that of banks.

To address the above, RBI has classified the NBFCs into four layers- base, middle, upper and top layer. The Top layer will get populated only when the RBI is of the opinion that there is a substantial increase in the potential systemic risk from specific NBFC.  The NBFCs in the Upper Layer (NBFC-UL) would comprise of those NBFCs which are specifically identified as warranting enhanced regulatory requirement based on a set of parameters and scoring methodology and the top ten eligible NBFCs in terms of their asset size. The upper layer would consist of a small number of NBFCs, which are significant from the point of view of systemic spill-overs and are therefore required to be subjected to tighter regulations, which would be in line with regulations applicable to banks.

In this regard, RBI while introducing the scale based regulations vide Circular dated October 22, 2021 had prescribed that NBFC-TL and NBFCs-UL would be required to maintain Common Equity Tier-1 (CET-1) capital of at least 9 percent of Risk Weighted Assets, in order to enhance the quality of regulatory capital. Accordingly, RBI vide its Circular dated April 19, 2022 (“Circular”) has prescribed the manner of computation of the CET 1 capital.

It shall be pertinent to note that Core Investment Companies shall not be required to maintain CET 1 capital rather, they would continue to maintain “Adjusted Networth”, as per the extant regulations.

The manner of computation provided is largely in line with that required for Banks, which in turn were adopted from Basel III Guidelines. Hence, in essence NBFC-UL and NBFC-TL would be maintaining capital as per Basel-III requirements but the quantum of capital to be maintained is much higher than that for banks as CRAR requirement for NBFCs is 15% whereas for Banks it is 9%.

However, alignment of computation with banks has caused few disconnects with the existing NBFC regulations. The write-up intends to critically analyse the requirement of CET 1 vis-à-vis regulation for banks, as well as existing regulation for large NBFCs.

Expected Impact of CET 1 requirement for NBFCs

Under the existing regulatory framework for NBFCs, Systemically Important NBFCs are required to maintain a regulatory capital of 15% against its risk weighted assets. This 15% capital comprises of 2 types of capital:

1. Tier-1 Capital^[1] – Minimum of 10%
2. Tier 2 Capital^[2] – Not more than Tier 1

It shall also be pertinent to note that Tier-1 Capital comprises of owned funds^[3] and perpetual debt instruments (PDI). However, PDIs cannot exceed 15% of the Tier-1 capital, hence maximum 1.5% of risk weighted assets can be financed through PDIs and the remaining  8.5% was to be provided from owned funds.

Considering the facts that, components of CET-1 are almost similar to owned funds, expect for compulsorily convertible debenture, and CRAR of NBFCs sector as a whole stood at 26.3 per cent as at end-September 2021^[4], in our view most NBFCs falling within the upper layer would be holding enough capital to comply with the requirement. Hence no major impact as such is envisaged.

Comparison of Components of Tier-1 capital with CET-1

The capital requirements for Systemically Important NBFCs shall continue to be guided by existing regulations. However, post implementation of SBR the requirement of maintaining CET-1 capital would be in addition to the existing capital adequacy requirement.

Similar to banks, NBFC-UL and TL would now have three layers of capital:

1. CET-1 [at least 9%]: First loss absorbing layer with highest quality of capital
2. AT-1 [remaining 1%]: Additional Tier-1 or AT-1 is formed of instruments that form part of Tier-1 capital but not CET-1. This layer consists of permanent capital which carry a priority of common equity, such as PDI and CCPS
3. Tier-2 [remaining 5%]: Also known a gone concern capital, this layer consists of instruments that are of character of debt but are subordinated to senior debt, hence providing a degree of cushion to senior debt investors

As CET-1 would be a part of Tier-1 capital, a brief comparison of their components is provided below along with our analysis:

Tier-1	CET-1	Our Observation
Paid up equity capital	Paid-up equity capital	Same
Free Reserves	In addition to free reserves following reserves/profits form part of CET-1: Statutory reservesOther disclosed free reserves, if any.Retained earnings at the end of the previous financial year.Profits in the current financial year may be included in CET-1 on a quarterly basis if it has been audited or subject to limited review by the statutory auditors of the NBFC. Further, such profits shall be reduced by average dividend paid in the last three years and the amount which can be reckoned would be arrived at as under: Expected Profit = Net Profit – 0.25 *Dividend*No. of Quarter[5] Impairment Reserve shall be not be recognised in CET-1 capital.	The inclusions are in line with requirements for the banks.   Statutory Reserve formed part of owned funds and would form part of CET-1.   Further, for impairment reserve[6], it shall neither form part of CET-1 nor Tier-1 capital.
Share Premium Reserve	Share Premium Reserve	Same
Capital Reserves representing surplus arising out of sale proceeds of asset	Capital Reserves representing surplus arising out of sale proceeds of assets	Same Only realised capital reserve are considered
	Revaluation reserves at a discount of 55%	Under the NBFC guidelines this item forms part of Tier-2 capital. However, in line with regulation for banks the said item shall form part of CET- 1.   The Circular state that “Revaluation reserves ……, be reckoned as CET1 capital at a discount of 55%, instead of as Tier 2 capital under extant regulations, subject to meeting the following conditions: XX” There may be a conflict that an item not forming part of Tier-1 is considered as CET-1, as this might result in unnatural situation where CET-1 is higher than Tier-1. However, in our view an item being CET-1 automatically becomes part of Tier-1 capital as CET-1 is a part of Tier-1 capital.   Hence revaluation reserve shall have different treatment for NBFC-UL/NBFC-TL[7]  and for other layers of NBFCs
Compulsorily Convertible Preference Share		CCPS shall form part of Tier-1 capital of the NBFC but not under CET-1 hence, would be similar of additional Tier-1 Capital.   For banks preference shares are considered under Tier-2 capital, except perpetual non-cumulative preference share which are considered under AT-1
Perpetual debt instruments issued by a non-deposit taking non-banking financial company in each year to the extent it does not exceed 15 per cent of the aggregate Tier-1
	Defined Benefit Pension Fund Assets and Liabilities: Defined benefit pension fund liabilities, as included on the balance sheet, must be fully recognised in the calculation of CET-1 capital (i.e. CET-1 capital cannot be increased through derecognising these liabilities). For each defined benefit pension fund that is an asset on the balance sheet, the asset should be deducted in the calculation of CET1.	In line with requirements for the Banks
Deductions:
Accumulated Losses	Accumulated Losses
Book value of intangible assets	Goodwill and all other intangible assets should be deducted from Common Equity Tier-1 capital.
DTA computed as under shall be deducted from Tier-I capital: DTA associated with accumulated losses; andThe DTA (excluding DTA associated with accumulated losses) net of DTL. Where the DTL is in excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither be adjusted against item (i) nor added to Tier I capital. The balance in DTL account shall not be eligible for inclusion in Tier I or Tier II capital for capital adequacy purpose as it is not an eligible item of capital. (ii) DTA shall be treated as an intangible asset and shall be deducted from Tier I Capital.	The following DTAs shall be deducted in full, from CET-1 capital DTAs associated with accumulated losses DTAs (excluding DTAs associated with accumulated losses) net of Deferred Tax Liabilities (DTL) Note: Where the DTL is in excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither be adjusted against item (i) nor added to CET1 capital.
Deferred revenue expenditure	–	No specific prescription in this respect.   Here it shall be pertinent to note that, Circular is based on requirement for Banks which is itself “adopted” from Basel-III regulations.   Basel-III regulations do not prescribe any specific treatment of deferred revenue expenditure as outside India concept of DRA does not exist.   In our view, DRA should be deducted from CET-1 as making deduction from Tier-1 whereas avoiding same in CET-1 may result in unwanted situation where Tier-1 capital is less than CET-1
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 aggregate, ten percent of the owned fund	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 aggregate, ten percent of the owned fund of the NBFC.	Same

 

Considerations for Securitisation Transaction

It shall be pertinent to note that clause (f) Para (ix), which provides for adjustment and deduction to be made from CET-1 capital states that, “Securitisation Transactions: NBFCs shall be guided by the Master Direction no. DOR.STR.REC.53/21.04.177/2021-22 dated September 24, 2021 titled Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 in this regard.”

In respect of Securitisation transactions the deductions/adjustments would majorly be for 2 items, which are discussed as follows:

1. Unrealised gains on transfer

Any unrealised gains on transfer of asset, where the same was recognised upfront till maturity of asset, is required to be deducted from CET-1 or net owned funds of the NBFCs. Prior to the said Circular, banks would deduct the gains from CET-1 and NBFCs from Owned funds (Tier-1 Capital).

As this clause is clear enough the deductions by NBFC-UL/TL shall be from CET-1.

2. Credit Enhancement

The credit enhancement provided in the securitisation transactions are required to be deducted from the capital of the originator. The erstwhile guidelines on securitisation provided that deduction from capital shall be made on a 50-50 basis that is to say, 50% from Tier-1 and 50% from Tier-2. However the said clarification is missing in the new securitisation guidelines dated September 24, 2022.

Hence, there may be a view that as per clause (f) of Para (ix) of the circular, the entire amount of credit enhancement shall be deducted from CET-1. Alternative view may be that deduction must be for item specifically mentioned for deduction from CET-1, that is unrealised gains, and that this clause shall not affect deductions in respect of credit enhancements.

We are inclined towards accepting the second view, as deduction of credit enhancements entirely from CET-1 capital would cause a significant constraints for the originator, as the capital against assets securitised prior to securitisation may be provided from Tier-1 or Tier-2 capital, but upon transfer credit enhancement being deducted from CET-1 would require more CET-1 capital after securitisation as oppose to the situation before, which may not be the intent of regulator.

Conclusion

RBI has prescribed the manner of computation of the CET 1 capital for NBFCs-UL and NBFc-TL. The manner of computation provided is largely in line with that required for Banks, which in turn were adopted from Basel III Guidelines. The prescription of CET-1 capital would result in formation of 2 layers within Tier-1. CET-1, which majorly consist of common equity and retained earnings and additional Tier-1, consisting of PDIs and CCPS.

However, in our view, the requirement of maintaining CET-1 would not have any major impact on the applicable NBFCs as most of the larger and systemically important NBFCs in India are adequately capitalised.

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^[1] “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 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 percent of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year.

^[2] “Tier II capital” includes the following:

(a) preference shares other than those which are compulsorily convertible into equity;

(b) revaluation reserves at discounted rate of fifty five per cent;

(c) 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;

(d) hybrid debt capital instruments;

(e) subordinated debt; and

(f) 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.

^[3] “Owned fund” means paid up equity capital, preference shares which are 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.

^[4] Financial Stability Report, December, 2021

^[5] N^th quarter of the year [For better understanding 0.25 is multiplied by number of quarters, hence if 3^rd quarter- 0.75 would be multiplied to average 3 years dividend]

^[6] Where impairment allowance under Ind AS 109 is lower than the provisioning required under IRACP (including standard asset provisioning), NBFCs/ARCs shall appropriate the difference from their net profit or loss after tax to a separate ‘Impairment Reserve’. The balance in the ‘Impairment Reserve’ shall not be reckoned for regulatory capital. [Para 2b. of RBI Circular dated March 13, 2020 on Implementation of Indian Accounting Standards]

^[7] NBFC-Top Layer, as all regulation applicable to NBFC-UL would be applicable to NBFC-TL also.