Round-Tripping Reined: RBI Rolls Out Relaxed Rules for Investments in AIFs

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-Sikha Bansal, Senior Associate & Harshita Malik, Executive | finserv@vinodkothari.com

Background

The RBI’s regulatory approach to investments by Regulated Entities (REs) in Alternate Investment Funds (AIFs) has undergone a remarkable transformation over the past two years. Initially, the RBI responded to the risks of “evergreening”, where banks and NBFCs could mask bad loans by routing fresh funds to existing debtor companies via AIF structures, by issuing stringent circulars in December 20231 and March 20242 (collectively known as ‘Previous Circulars’). The December 2023 circular imposed a blanket ban on RE investments in AIFs that had downstream exposures to debtor companies, while the March 2024 clarification excluded pure equity investments (not hybrid ones) from this restriction. This stance aimed to strengthen asset quality but quickly highlighted significant operational and market challenges for institutional investors and the AIF ecosystem. Many leading banks took significant provisioning losses, as the Circulars required lenders to dispose off the AIF investments; clearly, there was no such secondary market. 

In response to the feedback from the financial sector, as well as evolving oversight by other regulators like SEBI, the RBI undertook a comprehensive review of its framework and issued Draft Directions- Investment by Regulated Entities in Alternate Investment Funds (‘Draft Directions’) on May 19, 20253. The Draft Directions have now been finalised as Reserve Bank of India (Investment in AIF) Directions, 2025 (‘Final Directions’) on 29th May, 2025. The Final Directions shift away from outright prohibitions and instead introduce a carefully balanced regime of prudential limits, targeted provisioning requirements, and enhanced governance standards. 

Comparison at a Glance

A compressed comparison between Previous Circulars and Final Directions is as follows –

ParticularsPrevious CircularsFinal DirectionsIntent/Implication
Blanket BanBlanket ban on RE investments in AIFs lending to debtor companies (except equity)No outright ban; investments allowed with limits, provisioning, and other prudential controlsMove from a complete prohibition to a limit-based regime. Max. Exposures as defined (see below) taken as prudential limits
Definition of debtor companyOnly equity shares excluded for the purpose of reckoning “investment” exposure of RE in the debtor companyEquity shares, CCPSs, CCDs (collectively, equity instruments) excluded Therefore, if RE has made investments in convertible equity, it will be considered as an investment exposure in the counterparty – thereby, the directions become inapplicable in all such cases.
Individual Investment Limit in any AIF schemeNot applicable (ban in place)Max 10% of AIF corpus by a single RE, subject to a max. of 5% in case of an AIF, which has downstream investments in a debtor company of RE.Controls individual exposure risk. Lower threshold in cases where AIF has downstream investments.
Collective Investment Limit by all REs in any AIF schemeNot applicableMax 20%4 of AIF corpus across all REsWould require monitoring at the scheme level itself.
Downstream investments by AIF in the nature of equity or convertible equityEquity shares were excluded, but hybrid instruments were not. All equity instruments Exclusions from downstream investments widened to include convertible equity as well. Therefore, if the scheme has invested in any equity instruments of the debtor company, the Circular does not hit the RE.
Provisioning100% provisioning to the extent of investment by the RE in the AIF scheme which is further invested by the AIF in the debtor company, and not on the entire investment of the RE in the AIF scheme or 30-day liquidation, if breachIf >5% in AIF with exposure to debtor, 100% provision on look-through exposure, capped at RE’s direct exposure5 (see illustrations below)No impact vis-a-vis Previous Circulars. 
For provisioning requirements, see illustrations later. 
Subordinated Units/CapitalEqual Tier I/II deduction for subordinated units with a priority distribution modelEntire investment deducted proportionately from Tier 1 and Tier 2 capital proportionatelyAdjustments from Tier I and II, now to be done proportionately, instead of equally. 
Investment PolicyNot emphasizedMandatory board-approved6 investment policy for AIF investmentsOne of the actionables on the part of REs – their investment policies should now have suitable provisions around investments in AIFs keeping in view provisions of these Directions
ExemptionsNo specific exemption. However, Investments by REs in AIFs through intermediaries such as fund of funds or mutual funds were excluded from the scope of circulars. Prior RBI-approved investments exempt; Government notified AIFs may be exempt
Provides operational flexibility and recognizes pre-approved or strategic investments.No specific mention of investments through MFs/FoFs – however, given the nature of these funds, we are of the view that such exclusion would continue.
Transition/Legacy TreatmentNot applicableLegacy investments may choose to follow old or new rulesSee discussion later.

Key Takeaways: 

Detailed analysis on certain aspects of the Final Directions is as follows:

Prudential Limits 

Under the Previous Circulars, any downstream exposure by an AIF to a regulated entity’s debtor company, regardless of size, triggered a blanket prohibition on RE investments. The Final Directions replace this blanket ban with prudential limits:

  • 10% Individual Limit: No single RE can invest more than 10% of any AIF scheme’s corpus.
  • 20% Collective Limit: All REs combined cannot exceed 20% of any AIF scheme’s corpus; and
  • 5% Specific Limit: Special provisioning requirements apply when an RE’s investment exceeds 5% of an AIF’s corpus, which has made downstream investments in a debtor company.

Therefore, if an AIF has existing investments in a debtor company (which has loan/investment exposures from an RE), the RE cannot invest more than 5% in the scheme. But what happens in a scenario where RE already has a 10% exposure in an AIF and the AIF does a downstream investment (in forms other than equity instruments) in a debtor company? Practically speaking, AIF cannot ask every time it invests in a company whether a particular RE has exposure to that company or not. In such a case, as a consequence of such downstream investment, RE may either have to liquidate its investments, or make provisioning in accordance with the Final Directions. Hence, in practice, given the complexities involved, it appears that REs will have to conservatively keep AIF stakes at or below 5% to avoid the consequences as above. 

Now, consider a scenario – where the investee AIF invests in a company (which is not a debtor company of RE), which in turn, invests in the debtor company. Will the restrictions still apply? In our view, it is a well-established principle that substance prevails over form. If a clear nexus could be established between two transactions – first being investment by AIF in the intermediate company, and second being routing of funds from intermediate company to debtor company, it would clearly tantamount to circumventing the provisions. Hence, the provisioning norms would still kick-in. 

Provisioning Requirements

Coming to the provisioning part, the Final Directions require REs to make 100 per cent provision to the extent of its proportionate investment in the debtor company through the AIF Scheme, subject to a maximum of its direct loan and/ or investment exposure to the debtor company, if the REs exposure to an AIF exceeds 5% and that AIF has exposure to its debtor company. The requirement is quite obvious – RE cannot be required to create provisioning in its books more than the exposure on the debtor company as it stands in the RE’s books. 

The provisioning requirements can be understood with the help of the following illustrations:

ScenarioIllustrationExtent of provisioning required
Existing investment of RE in AIF Scheme (direct loan and/or investment exposure exists as on date or in the past 12 months)For example, an RE has a loan exposure of 10 cr on a debtor company and the RE makes an investment of 60 cr in an AIF (which has a corpus of 800 cr), the RE’s share in the corpus of the AIF turns out to be 7.5%. The AIF further invested 200 cr in the debtor company of the RE. The proportionate share of the RE in the investment of AIF in the debtor company comes out to be 15 cr (7.5% of 200 cr). However, the RE’s loan exposure is 10 crores only. Therefore, provisioning is required to the extent of Rs. 10 crores.
Existing investment of RE in AIF Scheme (direct loan and/or investment exposure does not exist as on date or in the past 12 months)Facts being same as above, in such a scenario, the provisioning requirement shall be minimum of the following two:-15 cr(full provisioning of the proportionate exposure); or-0 (full provisioning subject to the REs direct loan exposure in the debtor company)Therefore, if direct exposure=0, then the minimum=0 and hence no requirement to create provision.

Some possible measures which REs can adopt to ensure compliance are as follows: 

  1. Maintain an up-to-date, board-approved AIF investment policy aligned with both RBI and SEBI rules;
  2. Implement robust internal systems for real-time tracking of all AIF investments and debtor exposures (including the 12-month history);
  3. Require regular, detailed portfolio disclosures from AIF managers;
  4. appropriate monitoring and automated alerts for nearing the 5%/10%/20% thresholds; and
  5. Establish suitable escalation procedures for potential breaches or ambiguities.

Further, it shall be noted that the intent is NOT to bar REs from ever investing more than 5% in AIFs. The cap is soft, provisioning is only required if there is a debtor company overlap. But the practical effect is, unless AIFs develop robust real-time reporting/disclosure and REs set up systems to track (and predict) debtor overlap, 5% becomes a limit for specifically the large-scale REs for practical purposes. 

Investment Policy

The Final Directions call for framing and implementing an investment policy (amending if already exists) which shall have suitable provisions governing its investments in an AIF Scheme, compliant with extant law and regulations. Para 5 of the Final Directions does not mandate board approval of that policy, however, Para 29 of the RBI’s Master Directions on Scale Based Regulations stipulates that any investment policy must be formally approved by the Board. In light of this broader governance requirement, it is our view that an RE’s AIF investment policy should similarly receive Board approval. Below is a tentative list of key elements to be included in the investment policy:

  • Limits: 10% individual, 20% collective, with 5% threshold alerts;
  • Provision for real-time 12-month debtor-exposure monitoring and pre-investment checks;
  • Clear provisioning methodology: 100% look-through at >5%, capped by direct exposure; proportional Tier-1/Tier-2 deduction for subordinated units; and
  • Approval procedures for making/continuing with AIF investments; decision-making process
  • Applicability of the provisions of these Directions on investments made pursuant to commitments existing on or before the effective date of these Directions.

Subordinated Units Treatment

Under the Final Directions, investments by REs in the subordinated units7 of any AIF scheme must now be fully deducted from their capital funds, proportionately from Tier I and Tier II as against equal deduction under the Previous Circulars. While the March 2024 Circular clarified that reference to investment in subordinated units of AIF Scheme includes all forms of subordinated exposures, including investment in the nature of sponsor units; the same has not been clarified under the Final Directions. However, the scope remains the same in our view.

What happens to positions that already exist when the Final Directions arrive?

As regards effective date, Final Directions shall come into effect from January 1, 2026 or any such earlier date as may be decided as per their internal policy by the REs. 

Although, under the Final Directions, the Previous Circulars are formally repealed, the Final Directions has prescribed the following transition mechanism:

Time of making Investments by RE in AIFPermissible treatment under Final Directions
New commitments (post-effective date)Must comply with the new directions; no grandfathering or mixed approaches allowed
Existing InvestmentsWhere past commitments fully honoured: Continue under old circulars
Partially drawn commitments: One-time choice between old and new regimes

Closing Remarks

The RBI’s evolution from blanket prohibitions to calibrated risk-based oversight in AIF investments represents a mature regulatory approach that balances systemic stability with market development, and provides for enhanced governance standards while maintaining robust safeguards against evergreening and regulatory arbitrage. 

Of course, there would be certain unavoidable side-effects, e.g. significant operational and compliance burdens on REs, requiring sophisticated real-time monitoring systems, comprehensive debtor exposure tracking, board-approved investment policies, and enhanced coordination with AIF managers. Hence, there can be some challenges to practical implementation.  Further, the success of this recalibrated regime will largely depend on the operational readiness of both REs and AIFs to develop transparent monitoring systems and proactive compliance frameworks. 

  1.  https://vinodkothari.com/2023/12/rbi-bars-lenders-investments-in-aifs-investing-in-their-borrowers/ 
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  2.  https://vinodkothari.com/2024/03/some-relief-in-rbi-stance-on-lenders-round-tripping-investments-in-aifs/ 
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  3.  https://vinodkothari.com/2025/05/capital-subject-to-caps-rbi-relaxes-norms-for-investment-by-res-in-aifs-subject-to-threshold-limits/ ↩︎
  4.  The limit was 15% in the Draft Directions, the Final Directions increased the limit by 5 percentage points.
    ↩︎
  5.  This cap at RE’s direct loan and/or investment exposure has been introduced in the Final Directions.
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  6.  Para 29 of the RBI’s Master Directions on Scale Based Regulations stipulates that any investment policy must be formally approved by the Board. 
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  7. SEBI, vide Master Circular for AIFs, had put restrictions on priority distribution model. Later, pursuant to Fifth Amendment to SEBI (AIF) Regulations, 2024, SEBI issued a Circular dated December 13, 2024 wherein certain exemptions were allowed and differential rights were allowed subject to certain conditions. See our article here. ↩︎

Webinar on Demystifying Promoter & Promoter Group Puzzle

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Register here: https://docs.google.com/forms/d/e/1FAIpQLSc0muIwl_bxlNgcjkudmP9FOjQsecZuOXNjnOBRAk4L2_7vOQ/viewform

Webinar on PGs_Vinod Kothari.pptxDownload

NAME THEM ALL: SEBI reiterates mandatory disclosure of all promoter group entities in shareholding pattern, regardless of shareholding

“Immediate relatives” and not “relatives” for determining promoter group

Resource Centre on Promoter/Promoter Group Identification and Obligations

Let them pledge but don’t make it count: RBI’s clarification on voluntary pledge

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Harshita Malik | finserv@vinodkothari.com

The Banking Puzzle

I was giving a collateral-free loan only, but the borrower didn’t agree – he voluntarily came and pledged family gold and silver jewellery! 

This is perhaps the way Banks will be reacting after the RBI Clarificatory circular on Voluntary Pledge of Gold (‘Voluntary Pledge Circular’). The Voluntary Pledge Circular dated July 11, 2025 which addresses all Scheduled Commercial Banks (including RRBs & SFBs), State Co-operative Banks, District Central Co-operative Banks states that a a voluntary pledge of gold or silver as collateral by a borrower for an agricultural or MSME loan shall not amount to a violation of the Reserve Bank of India (Lending Against Gold and Silver Collateral) Directions, 2025 (‘Gold Lending Directions’), provided that the sanctioned amount is within the collateral-free limit laid down in the earlier RBI guidelines. 

It may be noted that as per separate RBI circulars dated December 6, 2024 and July 24, 2017 farm lending upto Rs. 2 lacs and MSE lending upto Rs. 10 lacs shall be done without collateral.

This clarification by the regulator may enable lenders to circumvent the regulations by categorizing collateral as a voluntary pledge for loans within the collateral-free caps, whereas in reality, the borrower may have been directly or indirectly compelled to offer such collateral.

Further, the circular also makes reference to the Gold Lending Directions. A question may arise if the Gold Lending Directions will apply even in the case of voluntary pledge of gold. 

The Gold Lending Directions should apply in all such cases of voluntary pledges to avoid a situation of regulatory arbitrage, where lenders could potentially bypass regulatory guidelines merely by categorizing the pledge as voluntary.

Our resources on the topic- 

  1. Bank-NBFC Partnerships for Priority Sector Lending: Impact of New Directions – Vinod Kothari Consultants
  2. RBI revises Priority Sector Lending Norms
  3. Meeting priority sector lending shortfalls: One more option
  4. PSL guidelines reviewed for wider credit penetration
  5. The new PSL Master Direction and its Impact on NBFCs

Overview of RBI (Project Finance) Directions, 2025

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Link to the YouTube video – https://www.youtube.com/watch?v=uCbe66Amk9w

Our article on the RBI (Project Finance) Directions, 2025

Presentation on Project Finance.pptxDownload

An Overview of GST Implications on Lease Transactions

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Yuttika Dalmia | finserv@vinodkothari.com

Introduction

Is Lease covered under GST?

Classification of Lease under GST: Supply of Goods or Services?

Application of Goods-Equivalent GST Rates on Leasing Services

Leasing under GST as Mixed and Composite Supply

Should CGST +SGST or IGST be charged on the supply ?

Point of Taxation

Input Tax Credit

Input Service Distributor

GST Rates

Conclusion

Introduction

In today’s dynamic business environment, leasing has emerged as a powerful financial strategy, allowing companies to access capital assets without significant upfront capital investment. While traditional forms of funding such as equity and loans serve to inject owned or borrowed capital into a business, leasing offers rented capital which enables operational agility with reduced financial commitment. For businesses aiming to streamline their operations and be future-ready, leasing is the smart way forward.

Under the GST framework, leasing is unequivocally classified as a supply of service, irrespective of whether the lease relates to movable or immovable property. Under accounting parlance, Leasing is classified into two categories: financial lease and operating lease. These classifications are based on the extent to which risks and rewards of ownership are transferred from the lessor to the lessee.

GST implications on leasing are governed by specific provisions relating to nature of supply, place of supply, time of supply, utilization of input tax credit and applicable tax rates. Understanding these is critical for lessors and lessees alike to ensure compliance, proper tax treatment , and optimal input tax credit  management.

This note presents an overview of the GST framework applicable to leasing transactions.

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“Immediate relatives” and not “relatives” for determining promoter group

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Limiting the ever expanding scope of PG by excluding children-in-law

Nitu Poddar, Partner | Nitu@vinodkothari.com

The definition of “promoter-group” in ICDR Regulations, though longstanding, has been into the highlights lately post the SEBI FAQ dated April 25, 2025 which have reiterated the provisions of Reg 31(4) of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘Listing Regulations’) requiring the listed companies to provide the list of all promoter / promoter group (‘P/ PGs’) in the shareholding pattern (‘SHP’) irrespective the shareholding in the company. 

While India Inc is still struggling with the practicality of collating the list of PGs arising from spouse-side immediate relatives and entities controlled by them, another practical issue to be fixed in the definition is the use of the term “relative” in the context of HUFs and firms

Issue – Overreach of the definition of “relatives” 

Item A and C of Reg 2(1)(pp)(iv) of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (‘ICDR Regulations’) pulls in the following entities in the PG list:

  • Body corporates in which HUFs and Firms – in which the “relatives” of promoters are members – hold ≥ 20% of equity share capital. 
  • Any body corporate in which such body corporate (as described above) holds  ≥ 20% of equity share capital.
  • HUFs and Firms where the “relatives” of promoters are holding ≥ 20% of total capital.

The key concern arises from the definition of “relatives” as per section 2(77) of Companies Act, 2013 which is wider than the definition of “immediate relatives” as per reg 2(1)(pp)(ii) of ICDR Regulations. 

  • The former includes spouses of the children (bahu and damad) who are not included in the definition of immediate relatives. 
  • Also, all the co-parcerners of an HUF are relatives u/s section 2(77) of Companies Act, 2013.

Consequence – Looping in non-PG entities as PG

This results in the inclusion of HUFs or firms where children-in-law or extended relatives are  holding ≥  20% of total capital as PG – even though these individuals (children-in-law) are not themselves promoters or immediate relatives under the ICDR framework.

Such interpretations expand the promoter group to cover entities indirectly connected through individuals not formally recognized as part of the promoter group, creating ambiguity in the definition.

Sensible interpretation – aligning with immediate relatives

To make sense of each clause of the definition of PG, in our view, the word “relative” in clause Item A and C of Reg 2(1)(pp)(iv) should be limited to “immediate relatives” as defined in sub-clause (ii) of reg. 2(1)(pp) of ICDR Regulations.

May refer to our related resource on the subject matter below:

Paradox of privacy

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Whether private NBFCs-ML are required to appoint IDs?

– Neha Malu, Associate | finserv@vinodkothari.com

Independent directors have long been regarded as critical instruments of corporate governance. They bring fresh perspectives, specialized knowledge and most importantly, an element of unbiased oversight to board deliberations. Think of them as neutral referees who ensure fair play in business operations and uphold the integrity of boardroom decisions. Their presence helps reduce conflicts of interest, curb excessive promoter influence and encourage more balanced and professionally informed decision-making.

Under the Companies Act, 2013, section 149 read with rule 4 of the Companies (Appointment and Qualifications of Directors) Rules, 2014 lays down the categories of companies that are mandatorily required to appoint independent directors[1]. These categories do not include private companies. The rationale is intuitive: private companies, by their very nature of being closely held, are presumed to function under greater internal control, thereby reducing the perceived need for external board oversight. The whole basis of “privacy” of a private company will be frustrated if there are independent persons on its board.

Further, wholly owned subsidiaries are explicitly exempted from the requirement to appoint independent directors under rule 4(2), regardless of their nature or size.

And accordingly, a point of regulatory discussion arises in the case of (i) private NBFCs and (ii) NBFCs that are wholly owned subsidiaries, classified in the middle layer or above under the SBR Master Directions. While the Companies Act, 2013 does not mandate the appointment of independent directors for private companies and explicitly exempts WOS from such requirement, the corporate governance provisions under the SBR Master Directions require the constitution of certain committees, the composition of which hints towards the presence of independent directors.

This gives rise to a key question: Does a private NBFC or a wholly owned subsidiary, solely by virtue of its classification under the middle layer or above, become subject to an obligation to appoint independent directors?

Committees for NBFC-ML and above, the composition of which includes IDs

Upon classification as an NBFC-ML or above, conformity with corporate governance standards becomes applicable. Below we discuss specifically about the committees, the composition of which also includes IDs:

Name of the CommitteeCompositionRemarks
Audit Committee [Para 94.1 of the SBR Master Directions]Audit Committee, consisting of not less than three members of its Board of Directors. If an NBFC is required to constitute AC under section 177 of the Companies Act, 2013, the Committee so constituted shall be treated as the AC for the purpose of this para 94.1.As per section 177, an AC shall comprise a minimum of  three directors, with Independent Directors forming a majority. Hence, in case the NBFC is not covered under the provisions of section 177, the same may be constituted with any three directors, not necessarily being independent directors.
Nomination and Remuneration Committee [Para 94.2 of the SBR Master Directions]Composition will be as per section 178 of the Companies Act, 2013.The provisions indicate that the NRC shall have the constitution, powers, functions and duties as laid down in section 178. In this context, Companies Act requires every NRC to consist of at least three non-executive directors, out of which not less than one-half should be independent directors.
IT Strategy Committee [Para 6 of the Master Direction on Information Technology Governance, Risk, Controls and Assurance Practices]The Committee shall be a Board-level IT Strategy Committee (a) Minimum of three directors as members (b) The Chairperson of the ITSC shall be an independent director and have substantial IT expertise in managing/ guiding information technology initiatives (c) Members are technically competent (d) CISO and Head of IT to be permanent inviteeChairperson of the Committee is required to be an ID.
Review Committee [Master Direction on Treatment of Wilful Defaulters and Large Defaulters]The Composition of the Committee shall be as follows: The MD/ CEO as chairperson; and Two independent directors or non-executive directors or equivalent officials serving as members.Where the NBFC has not appointed IDs, NEDs or equivalent officials to serve as members of the Committee.

Divergent Market Practices

With respect to appointment of IDs on the Board and induction in the Committees, two interpretations are seen in practice in the case of private companies and WOS:

First, since the Companies Act does not mandate the appointment of independent directors in the case of private companies and explicitly exempts WOS, private NBFCs and WOS often rely on these statutory exemptions. The SBR Master Directions make a general reference to the Companies Act without distinguishing between company categories, which further supports the view that these entities constitute the relevant committees without appointing independent directors.

Second, given that NBFCs in the middle layer or above have crossed the ₹1,000 crore asset threshold and fall under enhanced regulatory scrutiny, some take the view that such entities should align with the intended governance standards and appoint independent directors, even if not required under the Companies Act.

Closing thoughts

The SBR Framework takes into account the systemic concerns associated with different NBFCs and thus classifies them into different layers. The corporate governance norms are applicable to ML, UL and TL NBFCs, which, given their asset sizes, are expected to operate at huge volumes and carry a great magnitude of risks. Such NBFCs may have access to public funds (by way of bank borrowings, debenture issuance etc.), wherein large lenders or public would have exposures and consequent high systemic risks. Hence, looking at the constitution (that is whether the NBFC is a private limited or public limited) becomes less important, and looking at the size, activity and function becomes more important. 

Thus, it may not be right to conclude that NBFCs registered as private companies and WOS can do away with the mandatory composition prescriptions merely due to the constitutional form of their entity. Looking at the intent and idea of SBR Framework, the applicable NBFCs may be required to appoint independent directors irrespective of the form of their constitution. The scale-based regulation emanates from the idea that NBFCs having high risk should be effectively monitored. Thus, the regulations should be followed in spirit to effectively mitigate the risks arising in the course of the NBFC’s functioning.

[1] Pursuant to the provisions of section 149(4) of the Companies Act read with rule 4 of the Companies (Appointment and Qualifications of Directors) Rules, 2014, following companies are mandatorily required to appoint independent directions: listed companies, public companies having paid up share capital of ten crore rupees or more; or turnover of one hundred crore rupees or more; or having in aggregate, outstanding loans, debentures and deposits, exceeding fifty crore rupees as per the latest audited financial statements.

Read more:

What is a non-banking financial company?
Resources on Scale Based Regulations

More Than Enough: Overcollateralisation as credit enhancement in Securitisations 

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Vinod Kothari, Dayita Kanodia and Archisman Bhattacharjee | finserv@vinodkothari.com

Overcollateralisation (OC) is a widely employed credit enhancement technique in securitisation transactions, serving as a layer of protection for investors. In essence, it refers to a situation where the value of the underlying asset pool exceeds the amount of the liabilities, that is, the securities issued. 

A simple illustration of OC is as follows: 

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Mind the Gap: Plugging Risk Blind Spots with ICAAP for NBFCs

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-Chirag Agarwal (finserv@vinodkothari.com)

In our previous article, we discussed the expectations of the regulator along with a probable approach for NBFCs towards ICAAP. Notably, while ICAAP is applicable to banks as well as NBFCs (middle and upper layer), our present write-up focuses on ICAAP in the context of NBFCs.  The inclusion of ICAAP for NBFCs marks a significant shift, from a one-size-fits-all capital adequacy regime, towards a more tailored, risk-sensitive approach that reflects the unique risk profile of each NBFC.

While RBI has not mandated a rigid format or methodology for ICAAP, it has emphasised the need for internal capital assessments that are proportional to the nature, scale, and complexity of operations. The challenge, however, lies in the absence of detailed guidance or templates. Unlike banks that have had years to mature their ICAAP practices, most NBFCs are at the beginning of this journey.

This article attempts to fill that gap. As a sequel to our previous overview, it delves further into how different elements & each category of risk—credit, market, operational, liquidity, concentration, and others—should be considered for ICAAP. 

It may be noted that while the RBI has not issued specific guidelines for NBFCs to undertake ICAAP, they are instructed to be guided by the Master Circular – Basel III Capital Regulations to the extent applicable.

Need of ICAAP for NBFCs

The goal of ICAAP is not merely compliance, it is an internal assessment to ensure that the capital maintained by the NBFC is adequate, not just by regulation, but by the realities of its risk environment. 

The risk weights prescribed for computing the minimum capital adequacy are based on the general experience of the regulators with respect to the respective asset classes. However, risks associated with the assets also depend on the credit underwriting qualities of the originator, the geography in which it operates, concentricity, borrower composition, nature of underlying collateral,  etc. As a result, regulatory risk weights may not always reflect the true risk. This is where ICAAP comes in.

ICAAP helps NBFCs assess whether they hold enough capital based on their specific risk profile, going beyond the regulatory minimum. This self-assessment often goes beyond the basic rules. For example, an NBFC might consider capital required for additional risks, such as market risk, reputational risk, operational risk, etc, even though these aren’t always covered by the minimum capital requirements set by regulators. It might also use its own methods to evaluate more common risks like credit, market, or operational risks.

Apart from these risks, there are several other factors that are often overlooked but are essential to consider under ICAAP. These include off-balance sheet exposures, the NBFC’s future strategic plans, its compensation practices, etc.

NBFCs approach to ICAAP

An NBFC should not treat ICAAP as a mere compilation of regulatory templates such as capital adequacy, liquidity, or other prescribed formats. Doing so would reduce ICAAP to a regulatory compliance exercise, rather than a genuine internal assessment of how capital relates to the NBFC’s inherent risks.

In addition to serving as an assessment of capital adequacy, ICAAP also functions as a key decision making tool for the management. For instance, it helps evaluate whether the company’s existing capital levels are sufficient to support proposed business plans, assess the potential adverse impact of riskier asset classes on business continuity, and determine if planned growth would require capital infusion alongside debt raising. It also allows the company to assess whether its current trajectory is sustainable. In this manner, ICAAP effectively serves as a business continuity check for NBFCs.

Considering the above, the framework of ICAAP should be robust enough to assist management sufficiently. Accordingly, we discuss key elements of ICAAP in the subsequent section.

Key Elements under ICAAP

ICAAP consists of various elements. The detailed discussion on each element is discussed in subsequent sections. The various elements under ICAAP are as follows:

Listing and Assessment of Key Risk

The most critical element of ICAAP is the assessment of risks faced by the NBFC. It is important to note that there are two possible approaches: one, to consider only material risks, and the other, to consider all risks faced by the NBFC. The former approach is for NBFCs with simpler operations, while the latter is more appropriate for NBFCs with moderately complex operations, based on the management’s assessment.

Based on this assessment, a comprehensive list of risks should be identified and categorised as follows:

  • Quantitative Risks: Risks that can be measured and quantified reliably should be assessed using the best available data, tools, and methodologies. The methods employed will naturally differ across NBFCs, depending on their risk profile, operational scope, and internal systems. NBFCs are exposed to various types of risks, including credit risk, market risk, operational risk, interest rate risk, credit concentration risk,  etc. 
  • Qualitative Risks: While the aforementioned risks can be quantified, there are certain other risks which cannot be quantified such as reputational risk and business or strategic risk, and may be equally important for an entity and, in such cases, should be given same consideration as the more formally defined risk types. For example, an entity may be engaged in businesses for which periodic fluctuations in activity levels, combined with relatively high fixed costs, have the potential to create unanticipated losses that must be supported by adequate capital. Additionally, an entity might be involved in strategic activities (such as expanding business lines or engaging in acquisitions) that introduce significant elements of risk and for which additional capital would be appropriate.

Other key elements under ICAAP

Off-Balance Sheet Items: Off-balance sheet items represent potential obligations that do not appear directly on the institution’s balance sheet but can lead to substantial future liabilities. Examples include loan commitments, letters of credit, derivatives, securitizations, and guarantees.

While these exposures may not currently affect a firm’s capital or liquidity metrics, they carry contingent risks that can materialize under stress conditions. If not adequately monitored and incorporated into risk assessments, off balance sheet items may result in underestimated capital needs, particularly under adverse scenarios.

ICAAP Implications:

  • Institutions must employ robust risk identification frameworks to capture the nature, size, and likelihood of off-balance sheet exposures becoming on-balance sheet liabilities.
  • Stress testing should simulate adverse market or credit conditions to evaluate how these contingencies might impact capital adequacy.
  • Capital buffers should be calibrated to reflect not just current exposure, but also potential future liabilities from these items under both baseline and stressed conditions.

Compensation Practices: Compensation structures have a direct influence on employee behavior and, by extension, the institution’s risk culture. When short-term incentives are misaligned with long-term stability goals, they may encourage excessive risk-taking, leading to undesirable financial outcomes and reputational damage.

ICAAP Implications:

  • The capital adequacy framework must consider how incentive structures align with the institution’s risk appetite. Compensation policies should be reviewed to ensure they do not drive behaviors that conflict with prudent risk management.
  • NBFCs should establish compensation deferral mechanisms (e.g., clawbacks, performance-based vesting) and ensure these are factored into risk planning to reinforce sound decision-making.

Future Strategic Plans: Strategic initiatives such as geographic expansion, launching new products, or entering new markets often involve heightened or novel risks. These initiatives may expose the institution to unfamiliar regulatory environments, new credit or operational risks, or increased competition.

ICAAP Implications:

  • Future business plans must be embedded into capital planning and risk modeling. This includes estimating the impact of new initiatives on capital demand, funding needs, and operational capacity.
  • Scenario analysis should test how strategic changes could affect capital ratios under both expected and stressed conditions, especially when entering volatile or unfamiliar sectors.
  • Management must ensure that adequate risk mitigation strategies are in place, and that the institution holds sufficient capital to support growth without compromising its resilience.

Stress Testing: As part of the ICAAP, NBFCs must, at a minimum, conduct periodic stress tests, with a focus on material risk exposures. These tests are designed to assess the institution’s vulnerability to unlikely but plausible adverse events or significant changes in market conditions that could negatively impact its financial position. By implementing a structured stress testing framework, management gains a deeper understanding of the entity’s potential exposures under extreme but realistic scenarios—thereby improving preparedness and resilience. But what exactly is stress in this context? In ICAAP, stress refers to adverse deviations from the base case or normal operating conditions. It could be in the form of macroeconomic shocks, sector-specific downturns, or internal events—such as operational breakdowns or large-scale defaults. The purpose of stress testing is not to predict the future but to examine what could happen if things go wrong. 

There is no fixed threshold for the severity of stress scenarios. However, the scenarios should be severe enough to test the NBFC’s capital and liquidity buffers, yet plausible enough to remain relevant. For example:

  • Interest rate shock of +250 basis points
  • 30% increase in delinquency rates
  • Sudden collapse in collateral valueNBFCs should ideally run multiple stress levels—mild, moderate, and severe—to observe performance across a range of conditions.
  • Adverse regulatory action halts lending in a key segment.
  • Widespread borrower fraud in a key region.
  • Natural disaster (e.g., flood or earthquake) affecting multiple branches, etc

Quantitative Risks

Credit Concentration Risk 

Credit concentration risk arises when a financial institution’s exposures are not well-diversified—either across counterparties, sectors, geographies, asset classes, or even business models. In simple terms, it is  the risk of putting too many eggs in one basket. Risk concentrations are arguably the single most important cause of major problems in entities. Credit risk concentrations, by their nature, are based on common or correlated risk factors, which, in times of stress, have an adverse effect on the creditworthiness of each of the individual counterparties making up the concentration. The credit concentration risk calculations shall be performed at the counterparty level (i.e., large exposures), at the portfolio level (i.e., sectoral and geographical concentrations) and at the asset class level (i.e., liability and assets concentrations). There could be several approaches to the measurement of credit concentration in the entity’s portfolio. One of the approaches commonly used for the purpose involves the computation of Herfindahl-Hirschman Index (HHI). Under the HHI approach, an entity first decides what level of portfolio diversification it considers to be ideal—this is called the target HHI. The HHI for the actual credit portfolio is then calculated and compared with the target HHI. If the actual HHI is higher than the target, it indicates that the portfolio is more concentrated (i.e., riskier) than desired.

To compensate for this additional concentration risk, the NBFC needs to hold extra capital. The amount of additional capital is determined by using a multiplier. This multiplier increases in proportion to how far the actual HHI exceeds the target. The multiplier is the interpolated value of Loss given Default at the current HHI level where the minimum LGD is at the target HHI level and the maximum LGD occurs at the highest possible HHI level i.e. 1. Essentially, the more concentrated the portfolio is, the higher the capital buffer required.

Stress Testing: Stress scenarios for concentration risk can involve:

  • Counterparty default stress, where the largest or top 20 borrowers default simultaneously.
  • Sectoral collapse, where an entire sector (e.g., real estate or microfinance) underperforms.
  • Geographic shocks, like drought or political disruption in a key operating region.

The stress scenarios would result in higher Loss Given Defaults and consequently higher capital requirements for stress scenarios.

Credit Risk

Credit Risk is the most important component of capital required for lending institutions. Despite implementing the most rigorous credit underwriting processes, it is impossible to completely eliminate the possibility of credit defaults. This is because certain factors can evolve over time, potentially leading to heightened strain within the portfolio. Companies use Expected Credit Loss (ECL) models to estimate credit risk. However, it’s important to understand that ECL models are designed to capture only the ‘expected’ portion of credit losses—those that are likely to occur based on current conditions and historical data. Hence, entities should also consider using additional models or approaches to estimate the capital required to cover unexpected losses—those rare, extreme events that could have a significant financial impact but are not captured by ECL models. NBFCs may apply stress scenarios to the probability of default and loss given default parameters in their Expected Credit Loss models, beyond what is assumed in the base case, in order to capture potential unexpected losses.

Stress Testing: To stress credit risk, NBFCs can alter the assumptions used in their ECL models or conduct additional simulations to capture unexpected losses. Examples include:

  • Increasing default rates by 50% to 100% over historical averages.
  • Reducing recovery rates by 20% to simulate distressed recoveries.
  • Assuming sector-specific shocks, such as stress in MSME lending or rural portfolios.

Market Risk 

An entity should be capable of identifying risks arising from trading activities due to movements in market prices. This assessment should take into account factors such as instrument illiquidity, concentrated exposures, one-way market conditions, non-linear or deep out-of-the-money positions, and the likelihood of substantial changes in correlations. Stress testing exercises incorporating extreme events and market shocks should be specifically designed to highlight key vulnerabilities within the portfolio in relation to relevant market developments.

Stress Testing: For market risk, NBFCs should simulate movements in interest rates, exchange rates, and asset prices. Examples of stress scenarios include:

  • A 250–300 bps rise in interest rates, increasing cost of funds and decreasing bond portfolio values.
  • Drop in collateral prices (e.g., gold or real estate) by 20%–30%.
  • Liquidity contraction in trading instruments, rendering assets difficult to exit.

The idea is to identify exposures where market volatility could result in valuation losses or income shocks.

Operational Risk 

An entity should be equipped to evaluate potential risks arising from deficiencies or failures in internal processes, personnel, and systems, as well as from external events. This assessment should also consider the impact of extreme events and shocks associated with operational risk. Such events may include a sudden surge in process failures across multiple business units or a major breakdown in internal controls. As a general practice, companies often use the Business Indicator Component Model for computing the capital requirement for operational risk. In this model, the risk is computed by multiplying the average income of the entity with a prescribed factor. 

Stress Testing: Stressing operational risk requires assumptions about adverse internal or external events. For instance:

  • Simulating a cyberattack that shuts down core systems for 5–10 days.
  • Widespread process failures during a system migration or staff shortage.
  • Vendor risk, where a critical third-party service fails.

Qualitative Risks

Compliance Risk

NBFCs in India operate within a highly regulated environment. NBFCs usually are regulated by multiple regulators, and non-compliance with applicable norms would not only result in imposition of penalties/fines but in few cases may even threaten the continuity of operations of the business. Compliance risk may further act as a trigger factor for other risks faced by the Company, as non-compliance may threaten reputation, operations, profitability as well as other aspects of the Company’s operations. Accordingly, compliance risk is considered as a significant risk for the NBFCs. For ICAAP purposes, entities may begin by identifying the sources of risk and evaluating the internal controls and mitigation measures already in place. Based on this assessment, they can then determine the residual risk—the portion of risk that remains unaddressed—and accordingly estimate the capital required to cover it.

IT Risk

In the current business environment, almost all the businesses, including that of the NBFCs, are assisted by information technology infrastructure, while these assets assist entities in streamlining its processes and reducing risk due to human errors it also poses a significant risk, due to possibility of malfunctioning and downtime.

Off-balance sheet items

An entity may have various contingent liabilities and on occurrence of certain events if these liabilities were to materialize, they could lead to expenses / losses for the entity. 

Hence, despite the uncertainty surrounding these arrangements, it is essential that the entity maintains sufficient capital considering the likelihood of happening of these events.

Compensation practices 

An effective compensation framework plays a critical role in aligning employee behaviour with the long-term objectives of the organization to manage human resource risk. It shall be ensured that the compensation policy does not inadvertently prioritize short-term gains for senior management over the long-term interests of the organization. These measures are designed to prevent compensation practices that may incentivize excessive risk-taking or compromise the Company’s long-term goals in pursuit of short-term performance.

To strike the right balance between performance incentives and long-term business objectives, the entity shall maintain an appropriate mix of variable and fixed pay for its employees. This approach aims to encourage improved performance while safeguarding the Company’s overall long-term interests.

These practices fosters a culture of responsible decision-making and ensures that the employees are motivated to achieve sustainable success and growth, aligning individual performance with the broader objectives of the organization.

Future projections 

In ICAAP, making future projections is important to check if the institution will have enough capital to stay strong in the coming years, even if things go wrong. These projections usually cover the next 3 to 5 years and include key numbers like expected CRAR (capital to risk-weighted assets ratio), future income, asset growth, and risk levels. The CRAR should be estimated by looking at how much capital the institution will earn and keep, how much new capital it might raise, and how much its risk-weighted assets are likely to grow. Income should be projected based on how much the institution expects to earn from interest, fees, and other sources, while also considering possible loan losses and other costs. The growth in assets should reflect the business plans and also think about where and to whom loans will be given. Based on this, the risk-weighted assets should also be estimated to understand how risky the future asset base might be. 

Conclusion

ICAAP represents more than just a regulatory formality—it is a critical framework for NBFCs to understand and manage their unique risk landscape. By systematically identifying, assessing, and planning for both quantifiable and unquantifiable risks, and by applying stress testing to challenge their assumptions, NBFCs can ensure they are adequately capitalised for both expected and unexpected events. A well-executed ICAAP also considers various “blind spots” which often gets overlooked which includes off balance sheet items, compensation practices, future projections, etc. ICAAP not only strengthens financial resilience but also fosters a risk-aware culture, enabling NBFCs to navigate uncertainty with greater confidence and strategic clarity.