Unified framework for Non-fund based facilities, by banks and NBFCs

– Team Finserv (finserv@vinodkothari.com)

RBI has consolidated the regulatory framework for non-fund based facilities offered by various REs. The draft guidelines provide prudential requirements for non-fund based products being offered by Banks, NBFCs and AIFIs. This would also cover under its ambit guarantees extended by NBFCs, however restricting the exposure to just 5% of the total asset size. Non-fund based (NFB) facilities such as Guarantees, Letters of Credit, and Co-Acceptances are proposed to be governed under these guidelines. 

Additionally, the Draft Directions also provide regulations for providing partial credit support by REs to the bond issuances, including capital against the PCE norms. 

To understand the proposed provisions under the Draft Reserve Bank of India (Non-Fund Based Credit Facilities) Directions, 2025 (“Draft Directions”) dated April 9, 2025, the article is divided into two sections for ease of reference:

• General compliances for issuance of NFBs
• Specific norms for Partial Credit Enhancements (PCE)

Applicability

The Draft Directions consolidate multiple circulars for various REs into a single framework. The revised provisions are now proposed to be extended to all REs for their NFB credit exposures unless otherwise specified. Specifically, the Draft Directions is proposed to be made applicable to the following entities –

1. Commercial Banks (including Regional Rural Banks and Local Area Banks)
2. Primary (Urban) Co-operative Banks (UCBs)/ State Co-operative Banks (StCBs)/ Central Co-operative Banks (CCBs)
3. All India Financial Institutions (AIFIs)
4. All Non-Banking Finance Companies (NBFCs), including Housing Finance Companies (HFCs)

General Conditions Applicable to all NFB facilities 

• No NFB facility can be extended by an RE unless its credit policy includes specific enabling provisions to that effect. The policy will be required to outline the framework for issuing such facilities, including aspects such as types of NFB facilities, credit appraisal, internal controls, fraud prevention, monitoring mechanisms, delegation matrix, limits to avoid concentration due to NFBs and other necessary safeguards.
• Credit appraisal of an NFB facility shall be similar in rigour to a funded facility.
• A key provision under the Draft Directions is that REs can issue NFB facilities only for customers with an existing business relationship—either through a funded credit facility or a deposit account. This intends to ensure closer monitoring and better risk assessment, thereby reducing the risk of exposure to unfamiliar or unverified entities. However, there may be practical difficulties associated with such prerequisite criteria. For example, in case specialised entities intend to issue PCE against bonds issued by certain entities, the business relationship may not exist. 

General Conditions applicable for “Guarantee” Business

• The Draft Directions mandate that guarantees issued by REs must be irrevocable, unconditional, and incontrovertible. This means the guarantor cannot cancel the guarantee on their own, cannot add conditions that delay payment, and must honour the guarantee promptly and without dispute when invoked. 
• To manage risk effectively, the Draft Directions advise REs to avoid excessive exposure to unsecured guarantees. REs are expected to set appropriate internal limits both aggregate and individual for issuing such guarantees, to avoid concentration of such exposures .
• To formulate and implement specific policy on guarantees. As discussed above, REs are not permitted to issue any NFB facility unless their credit policy includes appropriate enabling provisions. The essential components that the policy should cover are illustrated in the diagram below:

• The Draft Directions highlight the benefits of using electronic guarantees, such as lower costs, quicker processing, and better protection against fraud. REs are encouraged to move towards issuing guarantees in digital form. For this, REs are required to create a clear Standard Operating Procedure.

Implications on Default Loss Guarantees

The Draft Directions clarify that any arrangement involving Default Loss Guarantee, also known as First Loss Default Guarantee (FLDG), whether between REs or with Lending Service Providers (LSPs) in case of digital lending, must follow the existing RBI guidelines on DLG. 

Importantly, the presence of a DLG cover should not replace proper credit assessment. REs are insisted to maintain strong credit appraisal and underwriting standards, regardless of whether they are receiving or providing the guarantee. If an RE provides a DLG, it must evaluate the loans just as thoroughly as if they were part of its own portfolio. This would in a way extend the scope of REs acting as LSPs and sourcing loans for other REs.

Guarantee business for REs

Under the Draft Directions, all NBFCs, UCBs, RRBs, and RCBs are permitted to issue financial guarantees. However, performance guarantees are restricted to scheduled UCBs and NBFCs classified in the middle and upper layers. A performance guarantee is a commitment to pay a certain amount if the borrower fails to meet ‘non-financial obligations’ under a contract—for example, not completing a project on time or not delivering goods as agreed.

To manage risk, it is proposed that these REs cap their total outstanding guarantee exposure at 5% of their total assets based on the previous financial year’s balance sheet. Within this, unsecured guarantees must not exceed 25% of the total guarantee limit. For instance, if an RE has total assets of ₹10,000 crore, it can issue guarantees up to ₹500 crore, of which only ₹125 crore can be unsecured.

Further, the maximum tenor of any performance guarantee issued by these entities is capped at 10 years.

Partial Credit Enhancements

Our detailed write-up on Partial Credit Enhancement covers the concept, its applications, limitations, current regulatory framework, and existing gaps. The PCE framework, introduced by the RBI in 2015, was initially limited to scheduled commercial banks. However, the Draft Directions significantly expand its scope, now permitting AIFIs, NBFCs in the Top, Upper, and Middle Layers, and HFCs to provide PCEs for bonds issued by corporates or SPVs for financing various types of projects. It also allows PCEs for bonds issued by non-deposit taking NBFCs (including HFCs) with an asset size of ₹1,000 crore or more and registered with the RBI.

The primary objective of this move is to improve the credit rating of such bonds, enabling corporates to raise funds from the bond market on more favorable terms.

Amendments in the PCE framework

• Maximum PCE by a single RE – The existing PCE framework restricts a single entity to providing only 20% of the total 50% PCE limit for a bond issuance. It is now proposed that the sub-limit of 20% be removed, enabling single entity to provide upto 50% PCE support.
• Investment in credit-enhanced bonds – Under the existing framework, only the entities providing PCE were restricted from investing in the bonds they had credit-enhanced. However, the new Draft Directions expand this restriction by prohibiting all REs from investing in bonds that have been credit-enhanced through a PCE, regardless of whether they are the PCE provider. The draft regulations states that same is with an intent to promote REs enabling wider investor participation
• External credit rating – To be eligible for PCE, corporate bonds shall be rated by a minimum of two external credit rating agencies at all times.

Capital Requirement for PCE

Under the existing framework, the bank providing PCE does not hold capital based only on its PCE amount. Instead, it calculates the capital based on the difference between: 

• The capital required on bond before credit enhancement. 
• The capital required on bond after credit enhancement. 

The objective was to ensure that the PCE provider should absorb the risks that it covers in the entire transaction. 

Under the Draft Directions the capital is required to be maintained by the REs providing PCE based on the PCE amount based on applicable risk weight to the pre-enhanced rating of the bond. 

Additional conditions for providing PCE to bonds of NBFCs and HFCs

The Draft Directions lay down specific conditions for providing PCE to bonds issued by NBFCs and HFCs. 

• Firstly, the bond must have a minimum tenor of three years. 
• Secondly, the funds raised through these PCE-backed bonds can only be used to refinance existing debt—not for fresh lending or other purposes. 
• Lastly, the PCE exposure of an RE to bonds issued by any single NBFC or HFC must be capped at 1% of the RE’s capital funds.