From Subsidiary to Shadow Bank: How RBI’s 2025 Directions Eliminate the Bank-Group NBFC Model

[Faraz and Mantasha are students at Faculty of Law, Jamia Millia Islamia.]

On 5 December 2025, the Reserve Bank of India issued the Reserve Bank of India (Commercial Banks – Undertaking of Financial Services) (Amendment) Directions 2025 (Amendment), amending the extant Master Direction. Although this is ostensibly an update to the governance framework, the underlying message is quite radical in nature. Through this regulation, the Amendment has eliminated the economic reasoning that justified treating non-banking financial companies (NBFCs) separately from existing banking entities.

Banking groups have, for several decades, relied on the existence of NBFCs to create opportunities for regulatory arbitrage, which caters to specialized markets with flexibility that is not otherwise allowed in banking. This Amendment attacks that model on three fronts: operational redundancy, structural uncertainty, and capital inefficiency. "The policy pincer" that is inevitably driven by such a framework could well mean the massive consolidation of NBFCs into their parent banks, resulting in the homogenization of risk rather than diversification.

Regulatory Mirroring and the Erosion of Proportionality under Paragraph 18(4)

Paragraph 18(4) of the Reserve Bank of India's regulatory directions represents a decisive shift in the treatment of NBFCs within banking groups, recalibrating the basis of regulatory classification from systemic importance to structural affiliation. According to paragraph 18(4)(i), the provisions that are applicable to upper layer NBFCs would also apply to all NBFCs that fall within a group structure, whether the NBFC is recognized as an Upper Layer or not by the Reserve Bank of India itself. This is operationally reinforced under paragraph 18(4)(ii), which holds that the restrictions specified under the Reserve Bank of India (Commercial Banks - Credit Risk Management) Directions shall apply mutatis mutandis to all fresh, renewed, or increased loans and credits sanctioned or disbursed by the entities of the NBFC group.

These provisions collectively establish a regime of regulatory mimicry, whereby bank-affiliated NBFCs must navigate the entirety of the regulatory environment, which is typically reserved for institutions of proven systemic significance. The implication of this is the emergence of a regulatory avatar, according to which subsidiaries assume the regulatory identity of their parent banks, regardless of their own asset base and risk profiles.

This contrasts with the Scale-Based Regulation framework unveiled by the RBI in October 2021, which categorizes NBFCs into four tiers: base, middle, upper, and top, based on objective factors such as asset size, interconnectedness, and estimated risk. Upper layer classification traditionally reflects heightened systemic relevance and attracts stringent capital adequacy norms, governance standards, and disclosure requirements. Paragraph 18(4) deviates from this rational risk-based logic by substituting group nexus as the determinative criterion. Regulatory burden is thus imposed not because an NBFC is systemically significant, but because it is structurally proximate to a bank, a departure from the Basel-endorsed doctrine of regulatory proportionality, which requires supervisory intensity to correspond to institutional scale and risk rather than organizational form.

Such a proportionality requirement is further reinforced under Paragraph 18(4)(ii), with the mutatis mutandis applicability of the harmonized norms for banking credit risk. On one hand, while the term itself means "with necessary changes to be made," there is no indication in the term about the extent to which these adaptations may be permissible. Credit models for commercial banks are based on banks utilizing deposits, with strict liquidity requirements and homogeneous underwriting standards. NBFCs, by contrast, often serve niche segments, such as informal sector enterprises, gig economy workers, and small agricultural borrowers, where alternative methodologies, like cash-flow analysis or transaction-based lending, are essential.

The practical consequence is illustrated by an imaginary Alpha Bank and its subsidiary, Alpha Finance, which was established precisely to serve borrowers whom the parent bank cannot reach under traditional banking norms. Once Paragraph 18(4) applies, Alpha Finance must comply with identical restrictions on promoter financing, land acquisition exposure, and borrower concentration, whilst meeting Upper Layer capital and governance requirements. The subsidiary becomes a regulatory clone stripped of the operational flexibility that justified its creation.

Structural Ambiguity and Supervisory Discretion under Paragraph 18(3)

Paragraph 18(3) of the Reserve Bank of India’s directions introduces a seemingly modest organizational principle that, in practice, generates significant structural uncertainty for banking groups. It establishes a general preference that “any form of business shall be undertaken by one entity in a bank group,” thereby creating a presumptive rule of functional singularity. This presumption is qualified: a bank may undertake the same business through more than one entity where a “proper rationale such as business segmentation or specialisation” exists, provided the rationale is recorded and approved by the Board.

The difficulty lies not in the objective of rationalization, but in the indeterminate nature of the qualifying standard. The term “proper rationale” is undefined and operationally unelaborated. Although the provision cites segmentation and specialization as illustrative examples, these are expressly non-exhaustive and offer little guidance on the threshold of acceptability. As a result, Paragraph 18(3) does not prohibit structural duplication ex ante but leaves it perpetually exposed to ex post supervisory reassessment.

This indeterminacy gives rise to supervisory subjectivity. In prudential regulation, certainty is critical, particularly where corporate structures involve long-term capital allocation, governance arrangements, licensing, and technology investment. Paragraph 18(3) provides no mechanism for ex ante validation of whether a given rationale will satisfy supervisory expectations. A structure tolerated today based on board approval and regulatory silence may be questioned or rejected years later under a different supervisory interpretation of segmentation or specialization. Compliance thus remains provisional rather than conclusive.

The strategic consequences are material. Faced with the risk of retrospective invalidation, banking groups are incentivized toward conservatism. This creates a disadvantage in innovation at the institutional level because there may be reluctance to create a dedicated NBFC subsidiary, either for borrowers in the unorganized sector or for regional markets and alternative loan models, due to a lack of certainty regarding the regulatory framework. Over time, such forces push the system towards a “one bank-one entity” scenario, even when a logical case exists for multiple institutions.

Capital Constraints and the Policy Pincer under Paragraphs 22–25

Paragraphs 22 to 25 set strict quantitative constraints on the amount of capital to be invested, while Paragraphs 23 and 24 state the upper limit of equity investment in a single entity to be 10% of the bank’s paid-up share capital and reserves, and in the aggregate, the maximum limit to be 20% of the aggregate of all entities, respectively. While these provisions operate as strict prudential boundaries, a deep internal tension emerges when read alongside Paragraph 18(4), which indiscriminately subjects bank-affiliated subsidiaries to capital-intensive upper layer NBFC norms.

Such tension is realized through a policy pincer. To begin with, Paragraph 18(4)(i) requires upper layer compliance, which is underpinned by the need for high Tier I capital, conservation buffers, and enhanced risk-weighting requirements that presume access to deep, low-cost capital. Second, Paragraphs 23 and 24 simultaneously cap the primary supply channel: parental infusion. Even where capital needs arise solely from regulatory reclassification rather than asset deterioration, the parent remains legally constrained. The result is structurally paradoxical: the Reserve Bank mandates systemic-grade resilience from the subsidiary while legally restricting the parent’s capacity to fund it, leaving the subsidiary with a regulatory obligation but without regulatory enablement.

This interaction produces regulatory capital starvation. The parent bank cannot leave subsidiaries under-capitalized without inviting supervisory sanction, yet cannot inject sufficient capital without violating investment limits. This results in subsidiaries facing a menu of suboptimal responses, including reducing their balance sheets and pruning niche lending, attracting external equity capital that may potentially weaken their strategic focus, or drifting into technical non-compliance. Instead of advancing stability, the framework converts compliance into a zero-sum exercise where group-level capital safety is pursued at the cost of subsidiary viability.

The squeeze reveals a fundamental deficit in coherence. Investment caps under Paragraphs 23 and 24 were calibrated for proportionate regulatory regimes, whereas the upper layer framework assumes unconstrained access to capital. Their unmediated convergence, absent transitional mechanisms or proportional calibration, exerts a tug-of-war pull on the overall regulatory framework. The pincer does not merely discipline risk; it legislates subsidiary obsolescence.

Conclusion and Recommendations

The Amendment functions as a structural foreclosure, rendering the bank-affiliated NBFC model economically obsolete. The regulatory signal is clear: diversification is viewed as arbitrage, and the era of the homogenized universal bank has returned.

To prevent the unintended erosion of financial inclusion, a regulatory recalibration is essential. Firstly, the Reserve Bank needs to introduce an ex-ante validation system for “proper rationale” for Paragraph 18(3) to bring forward investable certainty in place of ambiguity that is currently retrospective in nature. Secondly, the framework needs to harmonize with the capital framework, wherein the infusions mandated by regulatory re-categorization should be exempt from the investment limits stipulated in Paragraphs 23 and 24. Finally, to bring in the principle of proportionality, a graduated timeline for the smaller subsidiaries needs to be adopted. Without these adjustments, the framework risks sacrificing the institutional diversity essential for serving India’s heterogeneous credit markets in favour of administrative uniformity.