RBI discussion paper proposes four-tier structure for NBFC regulations

The Reserve Bank of India (RBI) on Friday released a discussion paper that aims to initiate scale-based regulatory framework for the non-banking finance sector (NBFCs), which have so far enjoyed regulatory arbitrage.

The discussion paper has said, the regulatory framework of NBFCs shall be based on a four-layered structure– base layer (NBFC-BL), middle layer (NBFC-ML), upper Layer (NBFC-UL), and top layer.

The base layer will comprise of non-deposit taking NBFCs, the middle layer will be populated by non-deposit taking systemically important NBFCs, deposit taking NBFCs, housing finance companies, and others. The regulatory regime for this layer shall be stricter compared to the base layer. Adverse regulatory arbitrage vis-à-vis banks can be addressed for NBFCs falling in this layer in order to reduce systemic risk spill-overs, where required.

Further, the upper layer will be populated by NBFCs which have large potential of systemic spill-over of risks and have the ability to impact financial stability.

“There is no parallel for this layer at present, as this will be a new layer for regulation. The regulatory framework for NBFCs falling in this layer will be bank-like, albeit with suitable and appropriate modifications”, the discussion paper said.

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And, the top layer will be occupied NBFCs lying in the upper layer, which are seen to pose extreme risks as per supervisory judgement, they can be put to significantly higher and bespoke regulatory/ supervisory requirements.

A host of parameters such as size, leverage, interconnectedness, substitutability, complexity, nature of activity of the NBFC, etc. will be considered to identify such NBFCs who can be shifted to the top layer.

The working paper has sought to increase the threshold for NBFCs to get classified as systemically important from Rs 500 crore to Rs 1,000 crore. Out of 9,425 non-deposit taking NBFCs, 9,133 NBFCs have asset size of less than Rs 500 crore. Hence, if the current threshold of systemic significance is raised to Rs 1,000 crore, the number of NBFCs in this layer would go up by 76 to 9,209. NBFCs featuring in this layer will be known as NBFCBase Layer (NBFC-BL), the paper said.

Furthermore, the paper has also sought to increase the net owned funds required for new NBFCs from Rs 2 crore to Rs 20 crore. However, a well-defined timeline will be prescribed for existing NBFCs, spanning over a period of five years to adhere to the new norms.

As far as regulatory framework of base layer NBFCs is concerned, it will be largely governed by regulations which are currently applicable for non-deposit taking NBFCs but the extant NPA classification norm of 180 days will be harmonized to 90 days.

For the middle layer NBFCs, which will consist of all deposit taking NBFCs, and systemically important non-deposit taking NBFCs, the regulatory structure as applicable for NBFC-ND-SI and NBFC-D at present will be applicable but adverse regulatory arbitrage posing systemic risk need to be addressed.

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The working paper has proposed no changes in the capital requirement of these NBFCs. Currently they have to maintain a CRAR of 15 per cent, with tier I capital of 10 per cent. When it comes to credit concentration, at present, separate (but identical) limits are specified for lending and investment exposures on any single borrower (SBL) and a group of connected borrowers (GBL) linked to owned funds. In the case of banks, under the Large Exposure Framework (LEF), the limits are linked to tier 1 capital.

The working has proposed that for the extant credit concentration limits for NBFCs for their lending and investment can be merged into a single exposure limit of 25{f08ff3a0ad7db12f5b424ba38f473ff67b97b420df338baa81683bbacd458fca} for single borrower and 40{f08ff3a0ad7db12f5b424ba38f473ff67b97b420df338baa81683bbacd458fca} for group of borrowers anchored to the NBFC’s Tier 1 capital.

It has also sought to introduce Internal Capital Adequacy Assessment Process (ICAAP) for NBFCs. The objective of ICAAP 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.

As far as governance arbitrage of NBFCs in the middle layer is concerned, the paper has suggested there should be rotation of auditors such that a uniform tenure of three consecutive years can be made applicable for statutory auditors of the NBFC and post that they cannot be reappointed for a period of six years. The NBFCs in this category have to appoint a functionally independent Chief Compliance Officer.

Furthermore, the paper has suggested compensation guidelines for NBFCs along the lines of banks to address issues arising out of excessive risk taking caused by misaligned compensation packages.

The paper has also proposed just like banks, the NBFCs should make additional disclosures such as corporate governance report like composition and category of directors, relationship between directors, shareholding of non-executive directors, etc, disclosure on modified 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.

NBFCs, unlike banks, do not have any specific sectoral restrictions for their exposure in the capital market and real estate sector.” As such, it would be appropriate for the regulator to leave it to the NBFC’s Board to decide internal limits on sensitive sector exposures, but it should be supplemented by adequate disclosures. Further, NBFCs will be advised to conduct a dynamic vulnerability assessment of various sectors and consider the same, while conducting their business”, the paper said.

When it comes regulatory restrictions on lending, the paper proposes to not allow NBFCs to provide loans to companies for buy back of shares or securities. Moreover, 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.

Importantly, the paper has proposed that NBFCs with 10 or more branches should mandatorily be required to adopt Core Banking Solution (CBS).

As for upper layer NBFCs, the top ten NBFCs, in terms of their asset size, will anyway reside in this layer, irrespective of any other factor. It is expected that a total of not more than 25 to 30 NBFCs will occupy this layer. While all the regulations applicable to middle layer NBFCs will be applicable to the upper layer also, in view of their large systemic significance and scale of operations, the regulation of the upper layer NBFCs will be tuned on similar lines as those for banks, though providing for the unique business model of the NBFCs as also preserving flexibility of their operations.

It has been proposed that the common equity tier capital of NBFCs in the upper layer should be at 9 per cent within the tier I capital. Furthermore, these NBFCs will have to maintain cash reserve requirements as well as leverage requirement to ensure that the growth of the NBFC is supported by adequate capital. And, the paper has suggested that NBFCs falling in upper layer are prescribed differential standard asset provisioning on lines of banks.

Also, the large exposure framework that is applicable to banks may be extended to these NBFCs with suitable adaption along with transition time for implementation.

When it comes to corporate governance of these NBFCs, the paper says they need to maintain highest corporate governance standards and a diffused ownership structure to minimise the possibility of abuse of dominance. Also, they should fix sensitive sector exposures (SSE) ceilings based on internal board approved policy.

“Apart from proposed framework for SSE suggested for NBFCs in this layer, the question considered is whether limits should be placed also on exposure to other specific sectors of the economy. Considering the unique nature of NBFCs, it will be incumbent upon the board of NBFCs to determine internal exposure limits on other important sectors”, the paper said.

As far as the top layer is concerned, it is supposed to remain empty but the RBI can populate it with upper layer NBFCs if they are of the view that tthere has been unsustainable increase in the systemic risk spill-overs from specific NBFCs in the upper layer.

“NBFCs in this layer will be subject to higher capital charge, including capital conservation buffers. There will be enhanced and more intensive supervisory engagement with these NBFCs. This will offer a framework for any NBFC to grow in size and complexity, provided it is able to build up capital commensurate with the additional risks and subject itself to intense supervisory scrutiny”, it said.