The Reserve Bank of India, in the middle of October 2021, with an objective to create a better financial system so as to increase transparency with greater disclosures to improve good governance, prescribed a 'scale-based regulation’ for the NBFCs sector. This scale-based regulation highlights the rules and regulations along with the supervision of NBFCs to operate according to their size, activity, and associated possible risks. Moreover, RBI has further clarified different provisions of scale-based regulations, which have been implemented since 1 October 2022, along with an amendment related to the ceiling on IPO funding. However, The Apex Bank aims to create a regulatory guidelines structure without altering certain existing provisions along with some specific revisions. Non-Banking Financial Companies (NBFCs) in the dynamic financial landscape played an important role, catalyzed economic growth, and promoted small businesses. NBFCs, in recent years, have achieved massive growth in the market. However, in recent years, NBFC associated with other entities and imparted certain risks within the financial system. In fact, it was needed to safeguard the invested sum of investors, and the financial market duly depends on NBFC; thus, the RBI revised Scale-Based Regulations and provided a new guideline for its sustainable growth in finance. Role of NBFCs in the Indian Economy: The Emergence and Growth of NBFCs in India A Non-Banking Financial Company (NBFC) is registered under the company law, and as per the RBI, it is mainly engaged in those businesses to provide advances and loans, acquisition of shares, stocks, bonds, securities issued either by the government or local authority instead related with that institution whose primary business relates to agriculture, industrial, etc. NBFCs evolved in the finance sector to provide loan credit for MSMEMs and the rural, small-scale, informal sector within India. NBFCs ended the financial gaps left by the banks, which were reluctant to provide loans to these sections just because of their perceived risk. Recently, in a report published by the RBI, the NBFC's shares contribution to the Indian economy increased to 29.1% in Feb 2023 from 16.4% in December 2022. Types of NBFCs NBFC works as a financial intermediate and competes with banks through efficiency in the financial system. Although NBFC is regulated by the RBI (Reserve Bank of India) and the Securities and Exchange Board of India (SEBI), it plays efficiently in providing loans to MSMEs. The two types of NBFCs, based on their nature of activity and deposits, are as follows- Asset Finance Company An asset finance NBFC offers funds for acquiring assets to companies engaged in manufacturing or other related economic activities. Such assets may be industrial machinery, automobiles, etc. Investment NBFCs Company These investment NBFCs are specifically related to investments as they are making investments on the client's behalf, and the client is hereby bound to share the profits or loss of the investments with the same investing NBFCs. Infrastructure Finance NBFCs Such NBFCs offer loan facilities based on infrastructural developments, especially in energy, transport, water, and other commercial projects related to infrastructure etc. Loan NBFCs Company This type of NBFC generally facilitates financial loan support in the form of financial products like Business loans, personal loans, capital loans, etc. Micro- Finance Company Such NBFCs are involved in providing financial support in the form of credit or savings to those unbanked residents of rural and semi-rural areas on a small scale level. Not only this, NBFCs as financial intermediation significantly played a vital role in diversifying the financial landscape through providing a range of services such as credit provision, investment in assets like stocks, bonds, and mutual funds, offers leasing and hire of assets, and provides bill discounts to manage the cash flow in management; also NBFC offers insurance services in rural areas and offers forex exchange services, microfinance, vehicle finance along with advisory, and mortgage services, etc. The Importance of NBFCs in Supporting Financial Inclusion. NBFCs are at the forefront of financial inclusion within India and work as financial intermediation and have significantly played a vital role in diversifying the financial landscape by providing a range of lending services to those undeserving groups living in rural parts of India especially those small companies in forecasting the business growth. Nowadays, digital lending with high demands for smaller loans with the easiest application requests has widened the scope of NBFCs. However, the NBFCs are flexible in providing loans to MSMEs comparably faster than the banks with flexibility in payment plans with low-cost EMIs. Additionally, the increase in the usage of Artificial intelligence and other block chain financial services has improved NBFC's portfolio. RBI Scale-Based Regulation & Structure for NBFCs RBI in its Scale Based Regulation (SBR): namely A Revised Regulatory Framework for NBFCs RBI/2021-22/112 DOR.CRE.REC.No.60/03.10.001/2021-22 has differentiated and revised the different layers and further the NBFCs will be identified according to these based layers. The revisions will be applicable upon each NBFC falling in appropriate base layers. Why Changes Required in the NBFCs Sector? Recent years' reports in the NBFCs sector emphasize the crisis of IL&FS, along with many other NBFCs, a huge financial crisis that seized the financial market with a debt involved approx. 1 lakh crores, out of which only 62% were unresolved. There was rapid growth in the NBFC sector in the previous 10 years, but recent years have been worse for the NBFCs. NBFCs cater significant complements to the mainstream banking system, and those markets are inherently presumed to be higher in risk as per big financial banks. Customers easily approach NBFCs for loans just because of easy reach out and quick decision with less paper formalities, financial services, etc. So RBI felt, with the essence of the regulations for NBFCs, that they are regulated according to their asset value, nature of the activity, and possible risk exposures. Key Points Following are the key points of the scale-based regulation framework adopted by the RBI to revise and create differences between NBFCs based on the asset value, activities, and involved market risks. Re-classified Non-Banking Financial Companies- Existing different categories of NBFCs like as Core Investment Companies, Microfinance Institutions, Systemically Important/ Non-Systemically Important, Deposit-taking/Non-deposit taking, etc., The RBI has re-classified the NBFCs into a 3-level scale system. Classification based on layer into 4 tiers- Base Layer, Middle Layer, Upper Layer, and Top Layer Classified as per Asset valuation and possible market risk Based on activities taken into consideration while classifying NBFCs. Enhanced Governance Accordingly, the requirement in NBFCs financial world, RBI formulated and amended a unified governance structure which will comply according to different layer-wise- The governance among different layers will be varied and will based on NBFC meetings. Constitution for internal committees and their assessments. RBI formulated Disclosure required additionally for both the upper and middle-layer NBFCs. Internal Capital Adequacy Assessment Process – Under this proviso, NBFCs are duly required to keep an internal assessment of their capital in proportionate to business risk like-wise the banks compete under Master Circular- Basel III Capital Regulations. NBFCs are required to develop and use the best-skilled management risk techniques, etc. The Regulatory Structure of NBFCs RBI structured a 4 tier, tighter regulatory system for NBFCs or shadow banking with a progressive increase in the regulations. Now, NBFCs will be supervised and monitored according to their size, nature of activity, and risk exposures. They will be further designated under the base, middle, upper, and top layers. With each progressive layer, the regulations will become stricter. Base layer (NBFC-BL) RBI clarified under the Base layer includes such NBFCs parallel with those existing non-deposit-taking non-systemically important NBFCs (NBFC-NDs) Systemically important. NBFCs under this base layer must hold an asset valuation of INR 500 crores, less or more. The valuation of such NBFCs under the base layer will be less than INR 1000 crores, excluding those NBFCs that significantly are featured under the middle layer, also included under the base layer NBFC-BL. Under the Base layer, NBFCs include like-wise NBFC-P2P (NBFC-Peer to Peer lending platform) NBFC-AA (NBFC-Account Aggregator) NOFHC (Non-Operative Financial Holding Company) and NBFCs without public funds and customer interface1. Under this base layer, NBFCs will not attract a high level of prudential regulations, and there will be an increase in the transparency requirements through additional disclosures and improved governance standards. Middle layer (NBFC-ML) Under the Middle Layer of NBFCs, the deposit-taking NBFCs (NBFC-D) along with systemically important non-deposit-taking NBFCs (NBFC-ND-SI) will be included accordingly. This layer will also include the SPD (i.e. Standalone Primary Dealers) and IDF (Infrastructure Debt Funds) that will be in the middle layer itself. This layer will also include those NBFCs taking deposits beyond their asset size valuation, NBFC-ND-SI with asset size greater than INR1,000 crore, CIC, IFC, and HFCs. The NBFCs owned by the government will not be included in the upper layer without any further notice or instructions from the government. Such government NBFCs will be more likely to be kept in either the base layer or middle layer NBFC-BL or NBFC-ML. The NBFCs under the Upper layers need to comply with the high level of regulations, which is similar to a bank. Upper layer (NBFC-UL) Under the Upper Layer tier, considering those NBFCs that are significantly systemic NBFCs specially recognized by the RBI using different parameters to analyze a few qualitative and quantitative standards that RBI will review over a period of time. If some of the existing NBFCs fulfil the established standard, then those NBFCs will get shifted from the middle to the upper layer. In this layer, at least the top 10 existing NBFCs will be listed according to the asset valuation. As the NBFCs significantly increase in their value and attach high risks, they will comply with higher regulations and be under the intensive supervision of RBI. The identification of NBFCs within the upper layer will be calculated on the basis of RBI set parameters and scoring methods having 70% and 30%, respectively, reflected in their balance sheet. Recently, in 2023, on September 14th, RBI issued a list of NBFCs on the basis of new base scale regulation figuring for the upper layer (NBFCs-UL). These listed entities must comply with significantly high regulations based on the possible risks for a minimum of 5 years. The list of NBFCs is as follows- Name of the NBFCCategory of the NBFCLIC Housing Finance LtdDeposit-taking HFCBajaj Finance LimitedDeposit-taking NBFC-ICCShriram Finance Limited (formerly Shriram Transport Company Limited)Deposit-taking NBFC-ICCTata Sons Private LimitedCore Investment Company (CIC)L&T Finance LimitedNon-deposit taking NBFC-ICCPiramal Capital & Housing Finance LimitedNon-deposit taking HFCCholamandalam Investment and Finance Company LimitedNon-deposit taking NBFC-ICCIndiabulls Housing Finance LimitedNon-deposit taking HFCMahindra & Mahindra Financial Services LimitedDeposit-taking NBFC-ICCTata Capital Financial Services LimitedNon-deposit taking NBFC-ICCPNB Housing Finance LimitedDeposit-taking HFCHDB Financial Services LimitedNon-deposit taking NBFC-ICCAditya Birla Finance LimitedNon-deposit taking NBFC-ICCMuthoot Finance LimitedNon-deposit taking NBFC-ICCBajaj Housing Finance LimitedNon-deposit taking NBFC-ICC TMF Business Service Limited, previously known as Tata Motors Finance Limited, has not been listed in the upper layer scale despite being qualified and eligible for the list. This is because of their ongoing business re-organization. Transition/Conversion Path to the Upper Layer The Reserve Bank of India has provided some guidelines regarding the conversion or passage of NBFCs listed in the middle layer and further converted into the upper layer NBFC. RBI Will Suggest Concerned Eligible NBFCs Failing in the Category of Upper Layer After scrutinising its assets, the Reserve Bank of India identifies or recognizes any NBFCs from the middle layer, and possibly attached market risk is getting high. There is a requirement for the NBFCs to comply with high regulations to safeguard interests. Then, under such a situation, RBI will apply upper layer-based regulations on those NBFCs and provide a timeline to comply with other basic documentation required- Create a policy duly approved by the board within a period of 3 months. The RBI suggests such NBFCs for their allotment in the upper layer UL. Then, those eligible NBFCs, within the next 3 months from the date of RBI suggestion, need to comply and create a board-approved policy to adopt the enhanced regulatory framework and formulate an implementation layout to comply with this new set of regulations. This formulated board-approved policy will be submitted to the RBI for its review and suggested changes if required. Adherence with stipulations for NBFCUL within 24 months: There is a requirement from the end of the Board of Directors, such as advising NBFC to follow the regulations of NBFC-UL, and the implementation plan duly approved by the board must be subsumed within a timeline of 24 months from the RBI advice date. Transition of NBFCs in the upper layer In case any NBFCs are recognized and allotted in the NBFCs-UL, then such NBFCs need to comply with those regulatory regulations for at least a period of the next 5 years, even if the NBFCs are not complying with the required eligibility of the upper layer in the next coming years. Moreover, if it is found that an NBFC is classified for the upper layer and seems to be a voluntary strategic movement either specifically stated by its board of directors, then such NBFCs will be allowed to leave the upper layer regulatory framework. In case any NBFCs under the Upper layer slow down their business operations due to the opposite circumstances, then such NBFCs will not be allowed to be listed under the below regulatory scale-based framework, etc. RBI Intimation to NBFCs close to the NBFC-UL Parameters NBFCs who are eligible under the specified standards and established parameters will most probably entitled to be classified as NDFCs-UL and will be informed about such classification in advance from the end of RBI's concerned department so as to start complying with the measures and re-adjust their business operations, in case they wish to continue the operation in the NBFC-ML on a long term basis and do not wish to be featured under the upper layer. Top layer NBFCs upper layer is also known as the top layer. Now, this top layer is empty. No other existing NBFCs are allotted under this layer. The top layer is specifically for those NBFCs that contribute significantly higher risk and could further impact the financial market. According to the new scale base regulation, in case RBI found that existing NBFCs from the upper layer are enhancing more risk, then such NBFCs are allotted the top layer to supervise and comply with the tightened regulations, etc. Regulatory Changes under the Scale-Based Regulations for Base Layer The scale-based regulatory framework will be applicable to the lower-level NBFCs and those residing at the top layers of NBFCs. The specified regulatory revision will accordingly applicable specified below- NBFCs in the Base Layer (NBFC-BL) currently comply with the regulations duly applicable to Non-Deposit Non-Banking Financial Companies – Non- Non-Deposit Companies (NBFC-ND), excluding under these provisions- Minimum Net Owned Fund Requirements: NBFC-Peer to Peer Lending Platform (NBFC-P2P), NBFC-Account Aggregator (NBFC-AA), and NBFCs with no public funds and no customer interface shall continue to adhere to the Net Owned Fund (NOF) requirements of ₹2 crores. No changes are made to the existing regulatory minimum Net Owned Fund (NOF) requirements for Infrastructure Debt Fund – Non-Banking Financial Companies (IDF-NBFCs), Infrastructure Finance Companies (NBFC-IFCs), Mortgage Guarantee Companies (MGCs), Housing Finance Companies (HFCs), and Standalone Primary Dealers (SPDs). A Regulatory minimum Net Owned Fund (NOF) requirement for NBFC – Investment and Credit Companies (NBFC-ICC), NBFC – Micro Finance Institutions (NBFC-MFI), and NBFC-Factors shall be increased to ₹10 crores. The following glide path is provided for the existing NBFCs to achieve the NOF of ₹10 crore: NBFCsCurrent NOFBy March 31, 2025By March 31, 2027NBFC-ICC₹2 crore₹5 crore₹10 croreNBFC-MFI₹5 crore (₹2 crore in NE Region)₹7 crore (₹5 crore in NE Region)₹10 croreNBFC-Factors₹5 crore₹7 crore₹10 crore Non-Performing-Asset Modifying the classification norm of the Non-Performing Assets to the overdue period of more than 90 days for all categories of NBFCs. NBFC-BL shall follow the glide path so as to adhere to the NPA classification provided as follows: NPA NormsTimeline>150 days overdueBy March 31, 2024>120 days overdueBy March 31, 2025> 90 daysBy March 31, 2026 Qualification of Director: NBFCs are required to have at least one director experienced with banking work/considering the requirement of professional experts to manage the affairs of the NBFCs. Ceiling on Subscription through IPO: NBFCs are allowed only for the Application of the ceiling of ₹1 crore per borrower for financing subscription to Initial Public Offer (IPO). Further, NBFCs can fix limits accordingly. Grant of Loans to Directors and Senior Officers: Putting in place a Board Approved Policy for granting loans to the Directors, Senior Officers, and Relatives of Directors and to entities where directors or their relatives have a major shareholding Risk Management Committee: Constitution of a Risk Management Committee either at the Board or Executive level for evaluating the overall risks faced by the NBFC, including liquidity risk, and such Committee shall report to the Board. Disclosure Requirements: Base Layer NBFCs are required to make certain additional disclosures in Annual Financial Statements, such as Related Party Transactions, Exposure to the Real Estate Sector, Exposure to the Capital Market, Sectoral Exposure, etc. RBI proposed some regulatory changes applicable for both the NBFC middle layer and NBFCs- in the upper layer segments Internal Capital Adequacy Assessment Process NBFCs under this regulation are more likely to prepare their internal assessment of their capital need corresponding with the business risks. The internal assessment must be prepared parallel to ICAAP duly prescribed for commercial banks under pillar 2 (Master Circular- Basel III Capital Regulations published dated 1st July 2015). It is mandated for NBFCs to prepare a realistic assessment of their risks, including the associated factors in credit, operational, and all existing residual risks, using their own internal methodology to calculate. The assessment will be done in accordance with the scale and complexity of business operations prescribed in their Board approval policy. The intent of ICAAP behind NBFC's capital assessment is to ensure and make available an appropriate amount of capital to support business risks and encourage them to create and develop a good internal risk management technique to monitor and manage those business risks. Additional Regulatory changes applicable to NBFC upper layer Common Equity Tier 1 To improve the NBFC-UL regulatory capital quality, it is supposed to retain Common Equity Tier 1, at least 9% risk-weighted assets. Leverage NBFCs under the upper layer also require leverage to guarantee their growth, which depends on adequate capital along with other factors. RBI will determine the ceiling for leverage according to the need for hours. Differential Standard Asset Provisioning NBFCs under the upper layer must hold differential provisioning against their various standard asset classes. Concentration of credit/ investment – RBI proposed an extant credit limit for NBFCs independently for both lending and investment purposes as it further into a single merged exposure limit for single borrower and single group of borrowers at 25% and 40%, respectively. Further, it will be determined according to the NBFCs Tier 1 rather than being from those owned funds. Revised Norms are listed in the Table. Existing limit (as a percentage of Owned Funds)Revised limit (as a percentage of Tier I Capital) LendingInvestmentTotal ExposureSingle borrower/ party151525Single borrower/ party25A single group of borrowers/ parties252540A single group of borrowers/ parties40 Sensitive Sector Exposure (SSE) Exposure to direct and indirect capital markets and real estate must be computed as sensitive exposure for NBFCs. Thus, NBFCs are required to secure their Board's internal approved limits, especially for SSE under capital markets with real estate commercial exposures. NBFCs should assess different sectors periodically to determine the impact on business and the limits of such internal exposure. Meanwhile, the board can determine different sub-limits in SSE internal limits as follows- A sub-limit under the commercial real estate exposure ceiling will be fixed internally to finance land acquisition. The ceiling on IPO funding will be INR 1 crore per borrower. Regulatory restrictions on loans- NBFCs must comply with the regulatory restrictions in accordance with- In the case of Granting loans and advances to directors and their relatives or those entities where either relatives or director holds the majority of shareholdings. Granting loans to senior NBFC officers. In the case of real estate loan proposals, NBFCs must check out whether the borrower has taken any grant of permission for projects either from local/central/or any other concerned authorities if required. NBFCs need to comply with such rulings and only disburse the loan to the borrower. Additional regulatory changes under SBR applicable to NBFC-UL Large Exposure Framework LEF (Large Exposure Framework) duly decided for the NBFCs under the upper layer block that Concerned all counterparties along with the associated group of counterparties are to be considered for ceiling exposure. Further, a simplified with separate guild lines will be issued consisting of the definitions related to large exposure, reporting, and their exposure limits. Regulatory changes under SBR applicable to NBFC-ML and NBFC-UL Key Managerial Personnel The key managerial personnel, except for directorship in a subsidiary, cannot occupy any office in the upper or middle layer NBFCs. RBI provided a time frame of 2 years from the effective date 1st October 2022 in order to comply with the norms. The Key Managerial is allowed to hold the directorship in base layer NBFCs. Independent Director- According to the company law, at the same time, an independent director will not be on the board of more than 3 NBFCs (especially the middle and upper layer). They are also required to ensure that they have no dispute because their independent directors are available for the other NBFCs at the same time. This mandate is not required for the independent directorship of the base layer NBFCs. A time period of 2 years has been specified by the law to comply with such norms. Disclosures – NBFCs are required to disclose their annual financial disclosures effectively from dated 31st March 2023 in terms of- Corporate governance reports consist of its composition and directors, their shareholdings of non-executive directors, etc. NBFCs need to disclose their modified point of view, in the case expressed by any auditors, including those reported impacts on different financial items and management views, etc. Exceptional nature items' income and their expenditure need to be specified by NBFCs. Their loan availed breaches or any issued securities related to debts. Chief Compliance Officer It is mandated for the NBFCs to make an appointment for a Chief Compliance Officer (CCO) equivalent to hold a senior position among the organization who can easily comply with their risk management framework and improvise NBFCs in better functioning so as to create a good work culture within the organization. Compensation guidelines NBFCs are required to keep a board-approved compensation policy rather than misaligned compensation packages. Such compensation guidelines include the remuneration committee's constitution, the principle for a fixed or variable pay structure, etc. Other Governance Matters- NBFCs are required to comply with various other governance matters, such as The NBFC board should delineate the functions of different committees in order to formulate a calendar review. NBFCs should opt for a whistle-blowing mechanism, especially for directors along with employees, to report genuine and specific concerns. The board must check and comply that a good corporate governance culture is followed in the subsidiaries of NBFCs. Additional regulatory changes under SBR applicable to NBFC-UL Eligibility of Board Members Board members of NBFCs must be capable of managing the internal and external affairs of the concerned NBFC. Their composition should be done in accordance with educational qualifications along with the years of experience within the board. Listing & Disclosure It is mandatory for NBFCs to be listed for a period of the next 3 years to be recognized as NBFCs under the upper layer. Further disclosure will be performed per a listed company's applicability even required before its actual listing, etc., by duly board-approved policy basis. Independent Director’s Removal- NBFCs within the layer level must be liable to report about the removal of its independent director or about its resignation just before the normal completion of director tenure within the concerned NBFCs. Conclusion Although taking necessary steps, the Reserve Bank of India has duly categorized NBFCs into 4 tiers of layers: base, middle, upper, and topmost layer. The base layer will attract a very light touch of regulations under the RBI, while progressive NBFCs towards the next layers, such as the middle and upper, will aggregate tightened regulations. The intent is to safeguard the interest of investors involved and create a stable-based market. This change will provide the customer with a digital interface to get access to financial products and helps in keeping records for internal or regulatory purpose, etc.