Scale-Based Regulatory Frame(works)? Analysis of RBI’s Revised Regulatory Framework for NBFCs
[Mehak and Arush are students at Hidayatullah National Law University, Raipur.]
Non-banking financial corporations (NBFCs), also referred to as ‘shadow banks’, have historically played a major role in the financial community by channelizing investments and savings for the retail, small-scaled, unorganised sector and unbanked territory of the economy. There has been tremendous growth in this sector over the years in relation to its operations, size and technological evolution. Currently, there is a total of 9,651 NBFCs across India. As on 31 March 2021, the asset size of the NBFC sector crossed INR 54 lakh crore which made it equivalent to one-fourth of the banking sector.
The crisis of IF&LS and the crisis of DHFL had almost engulfed the entire NBFC sector and also dented the long-drawn trust. While the NBFC community was still recovering from the set-back of this bleak downfall, nation-wide lockdown aggravated the situation in 2020 which put a halt to economic activities and further impacted NBFCs. Due to these factors, it was necessary to restore the trust in this sector by bringing-in a stringent regulation. It is in this background that RBI released the Discussion Paper on Revised Regulatory Framework for NBFCs (Discussion Paper) on 22 January 2021 and the Scale-Based Regulation: A revised Regulatory Framework for NBFCs (Notification) on 22 October 2021 (applicable from 22 October 2022) with the motive of “calibrating the degree of regulatory prescriptions based on systemic importance of NBFCs”. Through this article, the authors aim to analyse the four main changes under the Scale-Based Regulations (SBR) (point 3.1 of the Notification) that would be applicable to all the NBFCs.
Understanding the Scale-Based Regulation Model
According to the new regulatory framework, NBFCs shall now be classified into four layers based on their size and complexity:
NBFC-BL (Base Layer) – All non-deposit taking NBFCs with asset size of less than Rs. 1000 crore and particular NBFCs based on their activities such as NBFC-P2P, NBFCs not having access to public funds, and others specified in point 1.2 of the Notification fall in this layer.
NBFC-ML (Middle Layer) – All deposit-taking NBFCs irrespective of their asset size, non-deposit taking NBFCs with asset size more than Rs. 1000 Crores, and particular NBFCs based on their activities such as infrastructure debt funds, housing finance companies, and others specified in point 1.3 fall in this layer.
NBFC-UL (Upper Layer) – Top 10 NBFCs in terms of their asset size and NBFCs specifically identified by the RBI on parameters listed in the Appendix to the Notification shall fall in this layer.
NBFC-TL (Top Layer) – This layer shall remain empty, unless RBI is of the opinion that an NBFC ought to be moved to this layer by virtue of its perceived riskiness.
The objective behind such a classification is to postulate different compliance requirements based on the riskiness of NBFCs; those in the Base Layer are subject to less regulatory intervention than those in the Middle Layer, and so on. The classification is based on the principle of proportionality and ensures more focus on those entities which are more likely to fail and thus need proper regulation to avoid impact on systemic stability.
Regulatory Changes under SBR and Comments
In addition to formulating a new model of classification, RBI has also made regulatory changes applicable to all layers, detailed in point 3.1 of the Notification. These changes and their impact are as follows:
IPO financing capped at INR 1 crore per borrower
With an intention of curbing risks in the financial sector, RBI has introduced a limit of INR 1 crore per borrower for IPO financing subject to more conservative limits that may be opted for by NBFCs.
IPO financing refers to the practice of borrowing funds for the sole purpose of applying for an IPO and is widely opted for by High Net-worth Individuals (HNIs). In IPO financing, lenders (usually banks and NBFCs) provide loans at a particular interest rate for applying for IPOs. The nature of transaction is such that it forces the investor to sell the shares as soon as they are listed. If this results in profit, the proceeds are used to repay the lender and the remainder amount is retained by the investor. If this results in loss, the investor is personally liable for repayment with interest.
Evidently, this practice jeopardizes the interests of genuine long-term investors and hinders fair price discovery. It creates a distorted image of demand for interested retail investors and makes the market prone to volatility. As per the Discussion Paper, such a ceiling is necessary to prevent abuse of the system.
It is relevant to note that while there is a cap of INR 10 lakh on IPO financing by banks, no such limit existed for NBFCs prior to this Notification. The IPO Financing ceiling is applicable to all layers of NBFCs as opposed to the proposed applicability to NBFC’s in the middle layer and top layer, thereby cementing RBI’s intent of prevention of abuse of funds.
Interestingly, the cap of INR 1 crore is per ‘borrower’ and not per ‘individual’, in contrast to what had been suggested by the Discussion Paper. This differentiates the Regulations from those applicable to banks, as banks are only permitted to lend to individuals for the purposes of IPO financing. Use of the term ‘borrower’ implies that corporates shall also be permitted to borrow funds for the purposes of IPO financing.
NPA classification norms changed from 180 days to 90 days
Prior to the Regulations, a loan account was classified as a non-performing asset (NPA) if the interest or principal remained unpaid for 180 days. This NPA classification norm has been now changed to 90 days instead.
In order to assess the impact of this move, it may be argued that owing to the difference in the type of NBFC-clientele with regards to the difference in cash flow and frequency, such a change was unnecessary. However, RBI in its Discussion Paper clarified that such unique cash flow aspects of business can be factored in by NBFCs while arriving at the due date. Thus, the end impact of the proposed 90-day NPA classification is unlikely to interfere with the business of NBFCs.
NOF limit increased from INR 2 crore to INR 10 crore
An NBFC cannot commence its business unless it has a minimum stipulated requirement of Net-Owned Funds (NOF). Prior to this Notification, the minimum NOF requirement was INR 2 crore.
NOF has been defined under the Explanation to Section 45-IA of the Reserve Bank of India Act,1934 and also under question 18 of the FAQs on the official website as an:
“aggregate of the paid-up equity capital and free reserves as disclosed in the latest balance-sheet of the company after deduction therefrom- accumulated balance of loss, deferred revenue expenditure and other intangible assets; which is further reduced by the amounts representing investments of such companies in shares of its subsidiaries, companies in the same group and all other NBFCs and the book value of debentures, bonds, outstanding loans and advances”.
RBI has made changes to the regulatory minimum stipulated NOF for NBFC-ICC (investment and credit company), NBFC-MFI (micro finance institution) and NBFC-factors. As per this change, the minimum NOF requirement for these three types of NBFCs shall be increased to INR 10 crore in contrast to the earlier limit of INR 2 crore, INR 5 crore and INR 5 crore respectively. Such a change shall be implemented in a phased manner and the INR 10 crore limit shall be applicable from 31 March 2027.
NBFCs with no public funds and no customer interface as well as NBFC-P2P (peer to peer lending platform) and NBFC-AA (account aggregators) shall continue to have the regulatory minimum NOF limit of INR 2 crore as before. Further, regarding the NBFCs with a higher regulatory minimum NOF (ranges from INR 20 crore to INR 300 crore), RBI has made no change in their NOF requirements.
In the Discussion Paper, RBI briefly discussed the rationale behind increasing the minimum stipulated NOF even further for the three types of NBFCs (as discussed above). The requirement of INR 2 crore contained a high possibility of failure for the non-serious players. For an NBFC to carry out its business in an appropriate manner, it must be adequately capitalised, financially resilient, and well-regulated. To inculcate such features for all the NBFCs, RBI intended to increase the entry norm for the other NBFCs to INR 20 crore (from the current INR 2 crore) as mentioned in the Discussion Paper; basing its contention on the increase in “real GDP” and “regulatory judgement”.
However, NBFCs and other market participants, in their feedback, mentioned that they were against such a high requirement. Therefore, the minimum requirement was cut-short by half and a comfortable transition period was provided to the requisite NBFCs. Nevertheless, this definitely comes in as a positive change to raise the entry barrier for NBFCs and makes sure that the business is carried on by serious participants only.
Changes to board member requirements
RBI has made it compulsory for one of the directors of the board to be a person with relevant experience of having worked in either a bank or an NBFC for all NBFCs.
The rationale behind this change is to implement the concept of corporate governance for all the NBFCs and in turn, keep an adequate mix of experience and educational qualification on the Board. This can be ascertained from point 4.2.3 (c) of Chapter 4 of the Discussion Paper where RBI proposed that one of the directors shall have retail lending experience in a bank/NBFC.
RBI’s intent of instilling corporate governance standards in all NBFCs is evident from its discussion of corporate governance guidelines for all four layers of NBFCs in point 3.2.3 of Section II of the Notification as well as from multiple points of the Discussion Paper such as point 126.96.36.199 dealing with corporate governance norms for NBFC-ML and point 188.8.131.52 dealing with corporate governance norms for NBFC-UL.
This additionally shows RBI’s intent to further the motive of the NBFC - Corporate Governance (Reserve Bank) Directions 2015. In the authors’ opinion, inclusion of a board member with prior experience can be seen as a small-step to gain corporate governance standards across all NBFCs.
Operational flexibility of NBFCs, in comparison to the banking sector, has enabled them to achieve a pivotal position in the financial ecosystem. It puts them at a position where their failure could impact systemic stability and create a domino effect resulting in the collapse of not just the NBFC community but also the entire financial sector. The NBFC sector needs to keep pace with the changing realities and the revised scale-based regulatory framework is a step forward in this regard. The Notification is indispensable in not only restoring the lost trust in the sector, but also rebuilding the confidence of investors and lenders over the longer-term.
Due to this reason, the revised scale-based regulatory framework is indispensable. It not only restores the lost trust in the sector, but also rebuilds the confidence of investors and lenders over the longer-term.