NBFC

Capital adequacy norms for NBFCs in India

Addressing the risk that Non-Banking Financial Companies confront and improving their ability to absorb that risk have been major factors taken into account while developing the Scale Based Regulations (SBR) for NBFCs. The SBR also aims to reduce the regulatory arbitrage available to very big NBFCs with activities that are roughly comparable to those of banks in terms of size.

RBI has divided the Non-Banking Financial Companies into four layers, the base, middle, upper, and top layers, to address the issues. Only when the RBI believes there has been a significant increase in the potential systemic risk from a particular NBFC will the Top layer be filled in. The NBFCs in the Upper Layer would be made up of the top ten qualified NBFCs in terms of asset size as well as those NBFCs that have been expressly designated as necessitating increased regulatory requirements based on a set of criteria and scoring system. A small number of significant NBFCs, from the perspective of systemic spill overs, would make up the upper layer, and they would be subject to stricter rules as a result.

Regulatory Measures of Capital Requirements by the RBI 

According to the SBR framework, the RBI^[1] mandates that all Non-Banking Financial Companies in the upper layer except Core Investments Companies maintain a Common Equity Tier 1 ratio of at least 9% of risk-weighted assets on an ongoing basis. The new requirement came into effect on October 1, 2022. The RBI has offered specific guidelines in this respect.

Capital requirements for NBFC-UL under Scale-Based Regulation. For more details regarding scale-based regulation, refer to the RBI’s official circular dated October 22 2021. As per the RBI guidelines, NBFC-UL must maintain Common Equity Tier 1 capital equal to at least 9% of Risk Weighted Assets. NBFC-UL shall maintain, on an ongoing basis, a Common Equity Tier 1 ratio of at least 9%.Below are the specific guidelines in this regard.

Calculation of Common Equity Tier 1 Ratio

CET 1 – Ordinary and retained earnings are included in the Tier 1 Capital component known as Common Equity Tier 1. As part of the Basel III Regulations pertaining to protecting a local economy from the financial crisis, CET 1 implementation began in 2014.

Calculation CET 1 ratio – The common equity tier 1 ratio will be calculated by dividing common equity tier 1 capital by total risk-weighted assets.

Risk-Weighted Assets – The bank’s assets and some off-balance sheet exposures are weighted according to the risk weights that have been allocated to the various kind of exposures in accordance with regulatory standards. Higher weights are given to riskier exposures, indicating a greater need for capital to protect against losses and vice versa.

The total risk-weighted assets (RWAs) to be used in the calculation of the CET1 ratio must match the total RWAs estimated in accordance with the applicable NBFC category-specific relevant directives.

Common Equity Tier 1 Capital

Common Equity Tier 1 Capital will make up of the following elements:

• Share premium resulting from the issuance of equity shares 
• Paid-up equity share capital issued by the NBFC 
• Capital reserves that represent surplus from asset sale proceeds 
• Statutory reserves 
• Revaluation reserves that result from a change in an NBFC’s property’s carrying value following a revaluation in accordance with the relevant accounting standards may, at the NBFC’s discretion, be counted as CET1 capital at a discount of 55% rather than Tier 2 capital under the current regulations, provided that they satisfy the following requirements:
  1. The property is kept by the NBFC for its own use.
  2. There are no legal restrictions on the NBFC’s ability to sell the property at its own will.
  3. Revaluations are reasonable and as per the applicable accounting standards.
  4. Valuations of two independent valuers are obtained at least once every three years. 
  5. Where the property value has been substantially diminished by any event, these are to be revalued immediately and factored appropriately into capital adequacy computations. 
  6. And the external auditors of the Non-Banking Financial Companies have not expressed an opinion on the property that is revalued. 
  7. The revaluation reserves have to be separately disclosed or presented in the financial statement of NBFC.

• Any further disclosed free reserves.
• The remaining balance in the Statement of Profit & Loss Account at the conclusion of the previous financial year, or retained earnings. Losses that have accumulated from CET 1 must be reduced.
• If the current financial year’s profits have undergone an audit or a restricted review by the NBFC’s statutory auditors, they may be included on a quarterly basis. Additionally, the average dividend paid over the previous three years will be deducted from such profits to arrive at the amount that can be considered as under:
• The regulatory adjustments/deductions listed below must be taken into account for calculating CET1 capital [i.e., they must be subtracted from the total of items.

Regulatory Adjustment or deduction applied in the calculation of CET 1 Capital

a) Intangible assets such as goodwill

• The Common Equity Tier 1 capital should be reduced by goodwill and all other intangible assets.
• Any associated deferred tax liabilities that would be eliminated if the intangible assets were to lose value or be derecognised under the applicable accounting standards are to be subtracted from the total amount of the intangible assets. Intangible assets would be defined for this purpose in accordance with the applicable accounting standards. If not previously deducted, losses in the current period and losses carried forward from previous years should also be subtracted from Common Equity Tier 1 capital.

b) DTAs (Deferred Tax Assets)

The following DTAs must be fully subtracted from CET1 capital: 

• DTAs for accumulated losses.
• DTAs net of Deferred Tax Liabilities (DTL), excluding DTAs related to Accumulated Losses

The excess shall neither be adjusted against the item nor contributed to CET1 capital where the DTL exceeds the DTA (excluding DTA related to cumulative losses).

c) Investments that exceed, in the aggregate, 10% of the NBFCs owned fund in shares of other non-banking financial companies, shares, bonds, debentures, outstanding advances and loans, including hire purchase and lease finance made to, and deposits with subsidiaries and companies in the same group.

d) Impairment Reserve will not be recorded as capital by CET1.

e) The deductions or exclusions from regulatory capital that are unrealised gains and/or losses in accordance with the computation of regulatory capital and regulatory ratios read with the circular dated July 24, 2020, on the title “Implementation of Indian Accounting Standards.”

f) Securitisation Transactions: In this regard, Non-Banking Financial Companies must abide by the Master Direction dated September 24, 2021, titled “the Reserve Bank of India (Securitization of Standard Assets) Directions, 2021.”

g) Defined Benefit Pension Fund Assets and Liabilities: Defined Benefit Pension Fund Liabilities must be fully acknowledged in the calculation of CET1 capital, as they are shown on the balance sheet. The asset should be subtracted from CET1 for each defined benefit pension fund that appears as an asset on the balance sheet.

h) Investments in an NBFC’s own shares (Treasury Stock) amount to capital repayment. Thus all such investments, whether held directly or indirectly, shall be subtracted from CET1 capital. The double counting of equity capital that results from direct holdings, indirect holdings through potential future holdings and index funds as a result of contractual commitments to buy own shares would be removed by this reduction.

Applicability

• All Non-Banking Financial Companies designated as NBFC-UL are subject to this circular, with the exception of Core Investment Companies (CICs).
• CICs designated as NBFC-UL must continue to maintain their Adjusted Net Worth as per the extant direction (i.e.) Core Investment Companies (Reserve Bank) Directions, 2016, dated August 25, 2016.

Conclusion 

For NBFCs-UL and NBFCs-TL, the RBI has specified how the CET 1 capital is to be calculated. The way the computation is done is mostly in line with what banks are obligated to do, which was also incorporated from Basel III Guidelines. The establishment of two layers within Tier-1 as a result of the prescription of CET-1 capital would be CET-1, which primarily consists of common stock and retained earnings, and additional Tier-1, which consists of PDIs and CCPS. However, the applicable NBFCs would not be significantly impacted by the requirement to maintain CET-1 because the majority of the larger and systemically important NBFCs in India are adequately capitalised.

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