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.

However, the SBR Framework, with its implementation on October 22, 2021^[4], has introduced a layered approach^[5] wherein NBFCs are classified as Base Layer (BL), Middle Layer (ML), Upper Layer (UL), on the basis of their asset size, risk perception, size of operations and nature of business. As per  the SBR Framework, the base threshold for the classification of NBFCs has been revised from Rs. 500 crores to Rs. 1000 crores – that is, entities which have asset size below Rs. 1000 crores shall be categorised under BL category.

Now, SBR Framework does not scrap the erstwhile SI Directions or NSI Directions; instead it introduces certain changes – while some are applicable commonly across all layers; other changes are layer-specific. The Framework says that NBFC-BL shall be subject to regulations “as currently applicable to NBFC-ND” and NBFC-ML shall be subject to regulations “as currently applicable to NBFC-ND-SI” (with certain changes as specified in the Framework) – refer, paras 2.3 and 2.4 of the SBR Framework.

Now, the classification and applicable regulation would appear as follows –

Asset size	Upto 500 crore	More than Rs. 500 crore, upto Rs. 1000 crore	More than Rs. 1000 crore
Classification before SBR	NSI	SI	SI
Classification after SBR	BL	BL	ML
Applicable regulations after SBR	NSI Directions	?	SI Directions

Hence, there would be entities which were NBFC-SIs, but due to revised threshold, has become a BL (let us call them ‘subject entities’ for the sake of discussion here). Will these entities continue following SI Directions or may now switch to NSI Directions?

One may see the language as used in para 2.3 of the Framework – it says,

“NBFCs in the Base Layer (NBFC-BL) shall be subject to regulations as currently applicable to NBFC-ND, except for the changes mentioned below at paras 3.1 and 3.2.”

The language may be confusing – reference to NBFC-ND does not clarify whether the same is NBFC-ND-SI or ND-NSI. Does it refer to respective regulations being so far applicable to such newly classified BL entities? If that is the case, will subject entities follow (or, continue following) SI Directions? Further ambiguity on this point has also arisen because of NBFC list as on February, 2023^[6], as uploaded on RBI website – several NBFCs falling under base layer, appear under NBFC-ND-SI category and several others appear under NBFC-ND-NSI category. Is RBI intending to retain the segregation between SI and NSI within the base layer?

This write-up tries to find an answer in light of the intent of the law-makers behind introducing SBR, and the Discussion Paper on Revised Regulatory Framework for NBFCs – A Scale-Based Approach^[7] (‘Discussion Paper’).

Significance of the Classification

First of all, it is crucial to understand that the classification of and the layer that the NBFC falls in shall have a bearing on what directions, norms and compliances it shall be subjected to. An NBFC-SI has been subjected to more stringent requirements than an NBFC-NSI (such as, need of board committees, concentration norms, etc.). As such, if it is said that the subject entities will have to comply with (or rather, continue complying with) SI Directions, then such subject entities will have to continue with stringent compliances, where other entities in the same layer (BL entities) would be continuing with relaxed norms under NSI Directions. On the other hand, if it is said that those subject entities are now BL and can thus, follow NSI Directions, such entities would be relieved of multiple compliances (as mentioned above).

Classification and criteria

In order to answer the problem statement, we first have to look at the intent behind SBR Framework. The Statement on Developmental and Regulatory Policies dated December 04, 2020^[8], stated as follows –

“Regulatory regime governing the NBFC sector is built on the principle of proportionality such that adequate operational flexibility is available to the sector through calibrated regulatory measures. However, there are rapid developments in the last few years, which have led to significant increase in size and interconnectedness of the NBFC sector. There is, therefore, a need to review the regulatory framework in line with the changing risk profile of NBFCs. It is felt that a scale-based regulatory approach linked to the systemic risk contribution of NBFCs could be the way forward.”

Further, the Discussion Paper, at several places clarifies that each layer has to be regulated on the basis of ‘principle of proportionality’ (see, discussion under para 3.2, 3.3)-

“–The principle of proportionality expounds that the degree of regulation of a financial entity should be commensurate with the perception of risk the entity poses to the financial system and the scale of its operation. . . Once an NBFC crosses the thresholds for identified parameters (size, leverage, interconnectedness, complexity, and supervisory inputs), it should be subject to proportionately higher regulation.

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Based on the discussion above, a regulatory framework anchored on proportionality can be introduced. If the framework is visualised as a pyramid, the bottom of the pyramid, where least regulatory intervention is warranted, can consist of NBFCs, currently classified as non-systemically important NBFCs (NBFC-ND), . . .

As one moves up, the next layer can consist of NBFCs currently classified as systemically important NBFCs (NBFC-ND-SI), deposit taking NBFCs (NBFC-D), HFCs, IFCs, IDFs, SPDs and CICs. The regulatory regime for this layer shall be stricter compared to the base layer.”

Further, the figure below Para 3.3 of the Discussion Paper shows NBFC-BL at the bottom of the pyramid and states that the same is equivalent to NBFC-ND but with a threshold at Rs. 1000 crores.

One should note here, that the Discussion Paper has used the reference of NBFC-ND for “Non-Banking Financial Company – Non-Systemically Important Non-Deposit taking Company” (see, the list of Abbreviations at the end of the Discussion Paper)

In fact, in paras 4.1 and 4.2, the Discussion Paper is unequivocally clear – it states:

“It may be noted that the regulatory framework envisages a progressive increase in the intensity of regulation. As has been discussed above, the extant regulatory framework for NBFC-NDs will now be applicable to Base Layer NBFCs while the extant regulatory framework applicable for NBFC-NDSI will be applicable to Middle Layer NBFCs.

 . . .

4.2.1 Structure – The Base Layer will consist of NBFCs currently classified as non-systemically important NBFCs (NBFC-ND) besides Type I NBFCs, NOFHC NBFC-P2P and NBFC-AA. The current threshold for systemic importance is ₹ 500 crore. This threshold needs recalibration, taking into account increase in general price levels as well as increase in real GDP since 2014. Accordingly, the threshold is proposed to be revised to ₹1000 crore. Out of 9425 non-deposit taking NBFCs, 9133 NBFCs have asset size of less than ₹500 crore. If the current threshold of systemic significance is raised to ₹1000 crore, the number of NBFCs in this layer would go up by 76 to 9209. NBFCs featuring in this layer will be known as NBFC-Base Layer (NBFC-BL).

 . . .

4.2.3 Regulatory Framework – NBFC-BL shall largely continue to be subjected to regulation as is currently applicable for NBFC-ND. However, as the threshold is being increased to ₹1000 crore, the regulatory framework can be supplemented by enhanced governance and disclosure standards. The specific changes in regulation will be:

. . . .”

Coming to the SBR Framework issued by RBI, the said notification does not define “NBFC-ND”; however mentions it at several places in juxtaposition to NBFC-ND-SI. For instance, see para 2.1, which states as follows –

“2.1 References to NBFC-ND, NBFC-ND-SI & NBFC-D – From October 01, 2022, all references to NBFC-ND shall mean NBFC-BL and all references to NBFC-D and NBFC-ND-SI shall mean NBFC-ML or NBFC-UL, as the case may be.”

The footnote clarifies as follows –

“It is clarified that existing NBFC-ND-SIs having asset size of ₹500 crore and above but below ₹1000 crore (except those necessarily featuring in Middle Layer) will be known as NBFC-BL.”

The said para read with the footnote amply clarifies that references to NBFC-ND-SI would only mean NBFC-ML and NBFC-UL (as the case may be), and NBFC-ND is only referring to NBFC-ND-NSI.

Closing Remarks

The aforesaid mentioned provisions of the SBR Framework, as supported by the Discussion Paper, sufficiently establish that all NBFCs in the Base Layer (including the subject entities having asset size more than Rs. 500 crore but less than Rs. 1000 crores) shall fall within the scope of compliance of the NBFC-ND-NSI Directions.

The intent of the SBR Framework is ‘regulation by proportion’. Therefore, one cannot contend that despite having multiple layers in the form of BL, ML, UL, TL; the regulatory intent was also to create a sub-classification within the BL. Such an interpretation would defy any logic, as by that interpretation, there would be no relevance of having a Middle layer and then applying SI Directions on entities falling under that layer as well as on a particular section of Base layer. The Discussion Paper consistently, and across several places highlights the need of increasing thresholds of entities lying at the bottom of the pyramid.

The RBI List (as mentioned above) might just be referring to the systemic classification as existing prior to the entity becoming a base layer. No-where, the SBR framework requires a subject entity to continue following NBFC-SI regulations. As such, in our view, the subject entity can switch to NBFC-NSI regulations.

However, given the scenario and prevalent ambiguity, RBI may be required to come up with clarification in this regard.

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^[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MD44NSIND2E910DD1FBBB471D8CB2E6F4F424F8FF.PDF

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

^[3] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MD49F29092016392149B3597145A1ACADCF520A1D1A97.PDF

^[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12179&Mode=0

^[5]Read our resources on SBR – https://vinodkothari.com/sbr/

^[6] https://rbidocs.rbi.org.in/rdocs/content/PDFs/NBFCsandARCs10012023.PDF

^[7] https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=20316

^[8] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50748