Commercial Real Estate exposures: Lending risks and Regulatory focus

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– Team Finserv | finserv@vinodkothari.com

Background

Lending backed by value or liquidity of certain types of assets is regarded as sensitive sector exposure and calls for a special focus of the lending institution from a risk management perspective. Regulators view it with attention, for reasons of the vulnerability of these exposures to cyclical price changes, as also the contribution of such lending to asset bubbles and systemic instability. Capital market and commercial real estate lending are two instances. Lending to capital markets (equity shares) may cause an excess flow of liquidity into stocks, thereby creating an asset bubble. When the bubble bursts, lending goes bad, and of course with several other systemic implications. Same is the case with commercial real estate. Flow of easy or cheap money causes investor interest in CRE to build up, thereby causing prices to spiral up, resulting into asset bubble.

It is for this reason that CRE exposures have always been seen by regulators with concern.

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PML Act and Rules: Recent changes may have new compliance requirements

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-Team Finserv | finserv@vinodkothari.com

Background

Financial sector entities have to follow PMLA and related rules, including by way of KYC Directions. The Finance Ministry came up with various amendments pertaining to the Prevention of Money-Laundering Act, 2002 (“PML Act”) and the Prevention of Money-Laundering (Maintenance of Records) Rules, 2005 (‘PML Rules’). The amendments pertain to revised thresholds for ascertainment of beneficial ownership (25% to 10%), implementation of group wide policies for compliance with provisions of Chapter IV, expanding the obligations under PMLA to service providers of virtual digital assets, etc.

Effective date and applicability:

The amendment shall be effective from the same date, i.e. March 07, 2023. It may be noted that the Master Direction – Know Your Customer (KYC) Direction, 2016  (‘KYC Directions’) are issued and updated by the regulator based on the amendment in PML Act and PML Rules. However, the Regulated Entities (RE) are required to ensure compliance with the provisions of PML Act and PML Rules, as amended from time to time. Hence, necessary steps must be taken based on the amendments.

Whether applicable to existing or new customers?

Customer Due Diligence (as required under the PML Act and Rules) is required to be undertaken at the time of commencement of a financial transaction or account-based relationship with the customer. Accordingly, necessary steps must be taken by the RE to ensure compliance with the Amendment Rules for all new customers or new financial transactions undertaken with existing customers after March 07, 2023. However, it is also pertinent to note rule 9(12) of the PML Rules which requires reporting entities to exercise continuous due diligence with respect to the business relationship with every clients.

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Base Layer NBFCs amenable to NSI or SI regulations?

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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.

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RBI Regulation of Investment Companies: Futile, counter-productive and counter-intuitive

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–Vinod Kothari | finserv@vinodkothari.com

The RBI has launched a major base-layer study of “base-layer NBFCs”, whereby audit firms will be surveying these NBFCs. Apparently, the audit firms will visit their offices to see if there is a physical office (which means a name plate outside the office), whether that physical office houses other offices too (an anachronistic objective in the age of co-working spaces), track the directors and the beneficial owners of such companies. The RBI’s definition of “beneficial owners” is remarkably different from the very same concept under section 90 of the Companies Act, which, after huge rounds of discussion, settled on certain rules for determination of such beneficial owners, and given the fact that the Companies Act is already tracking beneficial owners, it is interesting to note that the RBI would do its own enquiry into such beneficial owners.

Understandably, this massive exercise, with a budget of Rs. 2.36 crores, has been launched to do a reality check on the 9471 entities forming part of the so-called “Base layer”, which, by the regulators’ own determination, are entities which do not matter much for the financial system. Once again, out of these base layer entities, approximately 97% of the entities qualify as “investment and credit companies”.

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Liquidity stress testing for NBFCs

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– Vinod Kothari

finserv@vinodkothari.com

Stress testing is a part of risk management process. Stress testing envisages those plausible, however, low frequency events, which may occur and disrupt the operations. In the context of a financial intermediary – stress may be seen either in the solvency (that is, capital is not sufficient to absorb the risks or losses), or liquidity (that is, the bank is perfectly solvent, and yet, does not have enough liquidity to discharge immediate liability).

The need for stress testing comes from para 15A (para 15 for non-systemically important NBFCs) read with Annex II of the Master Directions for NBFCs[1] which provide as follows:

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P2P Lending in India – A Report

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Register to our premium section to access the full Report

Updated: Q3, 2022-23

Report Sample

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– Team Finserv | finserv@vinodkothari.com

Our previous instalment of the report – https://vinodkothari.com/wp-content/uploads/2020/01/India-P2P-report-2019-2020-1.pdf

Our earlier write-up on the topic – https://vinodkothari.com/2021/12/p2p-lending-fintech-disruption-in-financial-intermediation/

The Dos and Don’ts of Penal Charges

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RBI to release guidelines on penal charges 

– Tejasvi Thakkar, Executive | finserv@vinodkothari.com

Introduction 

The Reserve Bank of India (‘RBI’) announced various policy measures in its Statement on Developmental and Regulatory Policies dated February 08, 2023, which includes introduction of guidelines for regulating the penal charges levied by financial institutions in case of delay or default in repayment of loans or where there is a non-compliance of ‘material’ terms and conditions. RBI observed that some of the financial institutions were levying unreasonable penal charges. It has time and again been RBI’s concern that financial institutions levy excessive charges under the garb of different names such as penal charges, penal interests, legal charges, notice charges, levy charges etc. A large number of customer grievances with respect to excessive penal charges and divergent practices have influenced the regulator to think on these lines.  

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Workshop on Emerging RegulatoryFramework for NBFC-ML

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Tweezing out for dormancy: RBI intends to intensify regulatory audits of NBFCs

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  • By CS Anita Baid, Vice President, Vinod Kothari Consultants P. Ltd.

As per reports available on public domain[1], the RBI intends to intensify regulatory audits of non-banking finance companies, to find dormancy, non-compliance, non clarity of business models, or other risks that the regulator may wish to check. The intent seems to be weed out the truant ones out of the crowd of over 9000 NBFCs that exist. It is a fact that in the recent years, the RBI has been granting lesser new registrations, and canceling more of existing registrations, causing the number to come down. It is also important to note that if the number of NBFCs looks overwhelming, it is not because so many companies are into real operation: it is because the regulations currently define a company investing its owned capital into financial investments, with absolutely no access to either public funds or customer interface, as an NBFC, by imputing the public interest that actually does not exist. The number would have been a lot lesser had the regulator had the realisation that if there are no public funds, no customer interface and investment of owned funds being done, there is no reason for the regulator to interfere, as the intent of the country’s Central Bank cannot be to regulate investment activity that one does with one’s own money.

While this issue remains to be advocated for a potential reform, in the meantime, it is important for NBFCs to brace up for the RBI’s inquisitorial interest.

This article is intended to help NBFCs to be better prepared for such regulatory interface.

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Compliance Risk Assessment

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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.

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