A scale based approach to regulating NBFCs

Discussion Paper on Revised Regulatory Framework for NBFCs: A Scale Based Approach

By Richa Bhagat and Disha Dubey

The Non-Banking Finance Company space has attracted the Reserve Bank of India’s (RBI) gaze, again, of late with the regulator releasing a statement and a discussion paper at different times in the space of the last 60 days.

On December 4 2020, the RBI in a statement[1] on developmental and regulatory policies, set out the need for regulation and supervision over NBFC (Non-Banking Financial Companies).

A Discussion Paper[2] on the same was published on January 22, 2021 inviting responses and suggestions by February 22, 2021.

NBFCs are regulated in India on the principle of proportionality: calibrated regulatory measures that are commensurate with the scale of its operation and with the perception of risk that the entity poses to the financial system. This calibrated approach is aimed at allowing NBFCs adequate operational flexibility.

This approach will lead to judicious use of regulatory and supervisory resources as entities posing systemic risks would be regulated and supervised more closely as compared to others.

Over the years, the NBFC sector has undergone a significant evolution. The higher risk appetite of NBFCs has contributed to their size, complexity and interconnectedness making some of the entities systemically significant, posing potential threat to financial stability. Hence, under the current circumstances, the regulatory framework of NBFC needs to be reoriented to be updated with the current financial realities.

Hence the RBI’s recent concern to review its regulations.

The Discussion Paper of 21 January proposes splitting up of NBFCs in 4 (four) categories as follows:

4. The bottom of the pyramid, where least regulatory intervention is warranted, can consist of NBFCs, currently classified as non-systemically important NBFCs (Non-Banking Financial Company – Non-Systemically Important Non-Deposit taking Company) NBFCP2P (Non-Banking Financial Company – Peer to Peer Lending Platform), NBFCAA (Non-Banking Financial Company – Account Aggregator), NOFHC (Non-Operative Financial Holding Company) and Type I NBFCs.
5. The next layer proposed shall consist of NBFCs currently classified as systemically important NBFCs (Non-Banking Financial Company – Systematically Important Non-Deposit taking Company (NBFC-ND-SI), deposit taking NBFCs (NBFC-D), HFCs (Housing Finance Company), IFCs (Infrastructure Finance Company), IDFs (Infrastructure Debt Fund), SPDs (Standalone Primary Dealer) and CICs (Core Investment Company). The regulatory regime for this layer shall be stricter compared to the base layer.
6. The next layer is proposed to consist of NBFCs which are identified as systemically significant among NBFCs (The parametric matrix for identifying such NBFCs will be based on Quantitative parameters & Qualitative Parameters as discussed in the table below). The regulatory framework for this category of NBFCs shall be similar to those of banks, with suitable modifications.
7. The top layer of the pyramid will remain empty unless supervisors take a view on specific NBFCs. In other words, if certain NBFCs lying in the upper layer are seen to pose extreme risks as per supervisory judgement, they can be put to significantly higher and bespoke regulatory/ supervisory requirements.

The Scale based Framework as a pyramid structure

 

Layer based classification and proposed regulatory framework:

S.No.	NBFCs Layer	Identification Parameters	Proposed Framework
1.	Base Layer (NBFC-BL)	Current threshold of systemic importance to be raised to INR 1000 crores.	Entry point norms will be revised from INR 2 crores to INR 20 crores.
			Responsibilities of Risk Management Committee to be prescribed.
			1 (one) Director shall have experience in retail lending in a bank/NBFC.
			Disclosure Requirements will be widened.[1]
			NPA classification to be reduced from 180 days to 90 days.
2.	Middle Layer (NBFC-ML)	All non-deposit taking NBFCs classified currently as NBFC-ND-SI and all deposit taking NBFCs	NBFCs shall be subject to the requirement of having a Board approved policy on Internal Capital Adequacy Assessment Process (ICAAP)[2]
			Statutory auditors shall be appointed for a tenure of 3 (three) years.[3]
			Chief Compliance Officer (CCO) to be appointed  to ensure an effective compliance culture.
			Compensation Guidelines for NBFCs along the lines of banks can be considered to address issues arising out of excessive risk taking caused by misaligned compensation packages.
			Independent director shall not be on the board of more than two NBFCs.
			Additional Disclosures as prescribed for banks proposed to be made applicable to NBFCs. (outlined in Schedule 1)
			IPO financing by NBFCs to be fixed at INR 1 crore per individual for any NBFC.
			Restrictions applicable on loans and advances (outlined in Schedule 2)
			Guidelines on sale of stressed assets by NBFCs will be modified on similar lines as that for banks.
			NBFCs with 10 (ten) and more branches shall mandatorily be required to adopt Core Banking Solution.
3.	Upper Layer (NBFC-UL)	Quantitative Parameters- §  Size & Leverage §  Inter Connectedness §  Complexity	In addition to the regulations applicable to NBFC-ML, a set of additional regulations will apply to NBFC-UL.
		Qualitative Parameters- §  Nature & type of liabilities §  Group Structure §  Segment penetration (importance of the NBFC as a source of credit to a specific segment or area)
			Common Equity Tier 1 (CET 1) could be introduced for NBFC-UL to enhance regulatory capital. CET 1 may be prescribed at 9% within the Tier I capital.
			NBFCs will also be subjected to a leverage requirement to ensure that the growth of the NBFC is supported by adequate capital.
			NBFCs falling in Upper Layer are prescribed differential standard asset provisioning on lines of banks.
			In case of NBFCs, there are separate limits for lending, investment and for both lending and investment put together. The proposal is to merge the two limits while retaining the overall ceiling.
			NBFC-UL should be subjected to mandatory listing requirement on the lines of private banks. (Corporate Governance Regulations outlined in Schedule 3)
4.	Top Layer	Top Layer is supposed to remain empty. The layer can get populated in case the Reserve Bank takes a view that there has been unsustainable increase in the systemic risk spill-overs from specific NBFCs in the Upper Layer. Such NBFCs judged to be extreme in supervisory risk perception would be pushed to the Top Layer from the Upper Layer	A comprehensive legislative solution would be required to address the issue of resolution of failing NBFCs to take care of the unique nature of resolution of financial institutions including the need to protect depositors’ interest, avoiding moral hazard, ensuring continuity of critical financial services, etc.

[1] Disclosures on type of exposure, related party transactions, customer complaints etc.

[2] Objective is to ensure availability of adequate capital to support all risks in the business as also to encourage NBFC to develop and use better risk management techniques for monitoring and managing their risks.

[3] Not eligible for re-appointment in the same NBFC for a period of 6 years.

Schedule 1

Corporate Governance and Disclosure Requirements applicable to NBFC-ML

 There are certain disclosures prescribed for banks, which would be equally relevant for NBFCs in the middle layer. Making some of these disclosure requirements applicable to NBFCs would bring greater transparency and at the same time provide a better understanding of the entity to the stakeholders. Additional disclosures which are proposed to be made applicable to NBFC-ML are:

• Corporate Governance report like composition and category of directors, relationship between directors, shareholding of non-executive directors, etc;
• Disclosure on modified (i.e. non-clean) opinion expressed by auditors, its impact on various financial items and views of management on audit qualifications;
• Items of income and expenditure of exceptional nature;
• Breach in terms of covenants, incidence/s of default; and
• Divergence in asset classification and provisioning based on inspection findings.

Further, Governance requirements which are proposed to be made applicable to NBFC-ML are:

1. Compliance certificates by Chief Executive Officer and Chief Financial Officer covering various aspects including financial statements, absence of transactions, submissions to auditors, etc;
2. Requirements for Secretarial Audit;

• Obligations of independent directors, senior management, personnel, directors and promoters, key management;

1. Limits on directorships/ membership of committees of listed entities
2. Role of various committees (Audit Committee, Nomination and Remuneration Committee, Stakeholder’s relationship, Risk Management) and review of information by Audit Committee;
3. Vigil mechanism and requirements pertaining to related party transactions; and

• Corporate Governance requirements for subsidiaries of listed entities.

Schedule 2

Regulatory Restrictions on lending on NBFC-ML

Regulatory restrictions on loans and advances imposed on banks may not necessarily be applicable/ desirable for NBFCs in all respects. However certain restrictions, required to be extended to NBFCs in the middle layer are enumerated below:

1. To not allow NBFCs to provide loans to companies for buy-back of shares/securities;
2. Restrictions placed on granting loans and advances to directors, their relatives and to entities where directors or their relatives have major shareholding (10% or more of the paid-up share capital);
3. Restrictions placed on granting loans and advances to officers and relatives of senior officers;
4. To not allow NBFCs to extend finance for setting up of new units consuming/producing the Ozone Depleting Substances (ODS); and
5. While appraising loan proposals involving real estate, NBFCs to ensure that the borrowers have obtained prior permission from government / local governments / other statutory authorities for the project, wherever required.

Schedule 3

Listing and Corporate Governance in NBFC-UL

NBFCs deemed to pose higher systemic risk need to maintain highest corporate governance standards and a diffused ownership structure to minimise the possibility of abuse of dominance. Since NBFCs lying in the Upper Layer have ability to cause adverse systemic risks, the regulatory tools can be calibrated on the lines of the private banks; that is, such NBFCs should be subject to mandatory listing requirement and should follow the consequent Listing Obligations and Disclosures Requirements as provided by the Securities Exchange Board of India (SEBI) for listed companies.

The following governance regulations are suggested for NBFCs in the upper layer:

• Qualification of Board members – Board members shall be qualified for their positions. They should understand their oversight and corporate governance role and be able to exercise sound, objective judgment about the affairs of the NBFC. The composition of the Board should ensure mix of educational qualification and experience within the Board. Specific expertise of Board members will be a prerequisite depending on the type of business pursued by the NBFC.
• Removal of Independent Directors before completion of their normal tenure will be subject to approval by the supervisors.
• Group Structure – It will be ensured that the group structure is not complex and opaque. The same may be based on the supervisory judgement and based on factors indicated in the qualitative parametric analysis. NBFCs will provide detailed disclosure on group companies including consolidated financial position and details of related party transactions.
• Remuneration policies – Guidelines on compensation for Whole Time Directors / Chief Executive Officers / Other Risk Takers will be framed on the lines as applicable to Private Sector Banks. The Remuneration Committee will be vested with greater responsibility in this regard.

***

List of Abbreviations

1.	CIC	Core Investment Company
2.	CRAR	Capital to Risk Assets Ratio
3.	ICAAP	Internal Capital Adequacy Assessment Process
4.	IDF- NBFC	Infrastructure Debt Fund –Non-Banking Finance Company
5.	IPO	Initial Public Offer
7.	NBFC	Non-Banking Financial Company
6.	NBFC HFC	Non-Banking Financial Company– Housing Finance Company
8.	NBFC-AA	Non-Banking Financial Company– Account Aggregator
9.	NBFC-D	Deposit taking Non-Banking Financial Company
10.	NBFC-ICC	Non-Banking Financial Company– Investment and Credit Company
12.	NBFC-IFC	Non-Banking Financial Company– Infrastructure Finance Company
13.	NBFC-MFI	Non-Banking Financial Company– Micro Finance Institution
14.	NBFC-MGC	Non-Banking Financial Company– Mortgage Guarantee Company
15.	NBFC-ND:	Non-Banking Financial Company – Non-Systemically Important Non Deposit taking Company
16.	NBFC-ND-SI	Non-Banking Financial Company– Systematically Important Non-Deposit
17.	NBFC-P2P:	Non-Banking Financial Company – Peer to Peer Lending Platform
18.	NOFHC	Non-Operative Financial Holding Company
19.	NPA	Non Performing Asset
11.	SEBI	Securities Exchange Board of India
20.	SPD	Standalone Primary Dealer

 

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

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=51011.

[3] Disclosures on type of exposure, related party transactions, customer complaints etc.

[4] Objective is to ensure availability of adequate capital to support all risks in the business as also to encourage NBFC to develop and use better risk management techniques for monitoring and managing their risks.

[5] Not eligible for re-appointment in the same NBFC for a period of 6 years.