NBFC Compliance

How can NBFCs Avoid Being Subject to RBI Warnings?

In India, NBFCs are important in appropriately distributing credit across the country. Especially to the underserved segments of society such as rural areas, MSMEs (Micro, Small and Medium Enterprises), and other individuals or entities to whom traditional banking systems are inaccessible.

Around 25% of the total credit provided to the MSMEs was supplied by NBFCs. Also, around 18-20% of the total financial assets of the country are held by NBFCs. Essentially, NBFCs act as the interface between the traditional banking system and the parties and individuals to whom those systems are inaccessible for any number of reasons. Especially for developing countries such as India with a large rural population, NBFCs are extremely important.

However, their special nature makes them liable to certain special provisions and extra monitoring by the government. Every year, NBFCs come under fire from the RBI due to their aggressive lending practices and their lack of standards and qualifications for loan dealings. To understand how NBFCs can be more compliant and navigate regulations more effectively, we will first see what exactly an NBFC is.

Shedding Light on the NBFCs in Brief

NBFC stands for Non-Banking Financial Company. An NBFC is a financial services company that provides services like loans, credit facilities, leasing, hire purchase, and investment services. The main difference between an NBFC and a normal bank is that NBFCs cannot accept demand deposits.

This should not be confused with the ability to accept deposits in general, as NBFCs (specifically NBFC-Ds) can accept deposits, but they cannot accept deposits that are repayable on demand. Thus, although they provide many of the services banks do, NBFCs do not need a banking license to operate.

Examples of large NBFCs in India would be Bajaj Finance Ltd., Aditya Birla Finance Ltd, and Tata Capital Ltd.

Some Prominent Types of NBFCs

The main types of NBFCs are mentioned below-

• Asset Financing NBFCs (NBFC-AFC): This type of NBFCs is engaged in financing physical assets like automobiles, industrial machinery, houses, etc.

• Investment and Credit Companies (NBFC-ICC): Engaged in the acquisition and management of securities of securities such as stocks, bonds, debentures, etc. They handle and undertake investment ventures for both individuals and corporations.

• Infrastructure Finance Companies (IFC): Focus on lending to the infrastructure sector, with at least 75% of funds loaned out being to the infrastructure sector, with a minimum net-owned fund of INR 300 crore.

• Microfinance Institutions (MFIs): Microfinance companies extend microloans to low-income individuals, forming the backbone of rural and semi-urban economies.

Major Functions of an NBFC

NBFCs serve many functions in their overall presence as a market intermediary between traditional banking and the sectors less touched by the traditional banking systems. The main functions of NBFCs in India are:

Loan lending and other credit facilities: NBFCs extend loans to individuals and corporations that traditional banks need to focus on more. Examples of such individuals would be people in rural and suburban areas, thus bridging the gap in the economic and geographic distribution of lending services. This microfinancing function is especially important for MSMEs (Micro, Small, and Medium-sized Enterprises).

Insurance services: NBFCs are also involved in lending out insurance plans and services either directly or by extending credit facilities to insurance companies through strategic partnerships. Insurance services are also hard to get in rural and sub-urban areas, where banking systems are weak, and insurance awareness is low. NBFCs, again, bridge this gap and help strengthen the insurance system.

Wealth management and asset management services: NBFCs can also provide wealth management and asset management services for individuals and corporations. Asset management is the practice of managing assets and wealth over time to increase their value, such as handling their investment.

Venture capital: Some NBFCs also extend loans and advances to emerging businesses and startups, making the market more symmetrical in terms of capital opportunities.

Leasing and hire purchase: NBFCs also engage in leasing services of machinery, equipment, land, and other assets to businesses so that they don’t have to purchase the items fully paid out. Additionally, NBFCs also offer hire purchase credit facilities where ownership of assets is transferred after the final payment.

A Brief Outlook on RBI Regulations for NBFCs

NBFCsin India are governed under Chapter III-B of the RBI Act 1934, which grants the RBI authority to regulate, supervise, and issue guidelines for NBFCs. NBFCs do not need a banking license to operate, but they need to undergo compulsory NBFC registration with the RBI.

Other than this, there are certain compliance and minimum requirements that NBFCs need to adhere to at all times to maintain their validity as NBFCs and ensure that they have the RBI permit to perform their functions.

An overview of the main regulations is:

Minimum Net-Owned Fund: Net owned fund is defined as the total of paid-up equity capital and free reserves and is net of the accumulated losses, deferred expenditure, intangible assets, etc. RBI has specified different minimum NOF requirements for different classifications of NBFCs.

• NBFC-ICC – 10 Crore
• NBFC – MFI – 10 Crore
• NBFC-P2P (Peer-to-Peer Lending), NBFC-AA (Account Aggregator), and NBFCs without public funds or customer interface – ₹2 crore
• NBFC- IFC- 300 Crore

Fair Practices Code: The RBI has established a Fair Practices Code (FPC) outlining the NBFC’s appropriate behaviour in lending out loans and advances, such as handling loan applications, their processing, appraisal and terms, and collection activities.

RBI mandates that NBFCs not collect any late payment of early closure charges. The loan taker should get a loan card outlining their interest and terms, which cannot change for the duration of the loan. It also outlines compliance and reporting standards and stresses appropriate behaviour by recovery agents and staff in loan handling.

KYC and AML Guidelines: While dealing with lending and investment services, NBFCs must follow Know-Your-Customer (KYC) guidelines and the AML (Anti-Money Laundering Guidelines) set forth by the RBI.

Early Warning System by the RBI:  The RBI has also established an early warning system specifically for the middle and upper layers of NBFCs, aimed at detecting credit risks early and preventing the defaulting of loans and controlling losses. The EWS specifies operational requirements, reporting obligations, and various monitoring indicators that need to be observed to detect credit risks.

Capital Adequacy Requirements: All NBFCs must maintain a CAR (Capital Adequacy Ratio) of 15% of their aggregate risk-weighted assets. The certificate of registration of an NBFC also states that financial activities should be the principal business of NBFCs, with over 50% of total assets employed in financial activities.

Common Triggers for RBI Warnings to NBFCs

Because NBFCs are the interface between a more robust and traditionalist banking system and the parties that cannot access the said system, they are often found to be engaging in more risky and unsustainable practices that can be risky for both the NBFCs themselves and the credit infrastructure of our country. Hence, the RBI sends warnings to the NBFCs that are engaging in such practices, which are then given time to come up with an explanation and means to resolve the risky behaviour within a specified Turnaround Time (TAT) not exceeding 30 days for presenting.

The most common triggers for RBI warnings to NBFCs are:

Unsustainable Growth Practices: Recently, the Governed of the RBI, Shaktikanta Das, while acknowledging the impressive growth of NBFCs in recent years, remarked that some NBFCs are chasing a “growth-at-any-cost” strategy without adequate measures for financial stability and interests of the economy. He warned the outliers that they had been flagged and that RBI would take prompt action if self-correction was not done. Unsustainable practices include high interest rates, unsecured loans, lack of proper background verification and credit checks, etc.

High Interest Rates: In the same remark by the RBI governor, he also claimed to have taken note of very high interest rates being charged by some NBFCs, bordering on usury. The purpose of NBFCs is to make credit facilities more accessible to parties to whom regular credit is not accessible, and high interest rates defeat this purpose, making NBFCs just like another exploitative off-the-market loan shark. High interest rates are not in favour of the borrowers and increase the risk of defaults greatly, which in turn destroys the financial stability of the credit system.

Borrower Over Leverage: In recent years, some NBFCs have adopted aggressive lending behaviour, especially when discussing unsecured loans. Unsecured loans are relatively riskier for the lender since they are only based on the borrower’s creditworthiness and do not involve collateral. Hence, the lender cannot recover the amount if the borrower defaults on the loan by any other means.

Aggressive lending of unsecured loans leads borrowers to seek excess credit that may not be payable based on their income level, thus leading to huge losses for the lender and posing a huge systemic risk to the financial system since NBFCs themselves depend on banks for credit; leading to broader financial instability.

Non-Compliance: The Fair Practices Code (FPC), mentioned earlier in this article in the RBI regulations for NBFCs section, is a critical component of the RBI’s oversight of the functioning of NBFCs in our country. Hence, all NBFCs are required to adhere to compliance, reporting, and FPC standards.

Non-compliance with any of the above regulations is a frequent source of warnings sent to NBFCs by the RBI. These regulations specify appropriate lending behaviour, collection guidelines, and financial stability protocols.

Poor Governance: Poor oversight mechanisms, lack of proper standardized risk assessment measures, and absence of effective governance, visible from recent losses or complaints, are also a trigger for RBI warnings. NBFCs are supposed to keep a check on their lending practices and should not be money-motivated in the traditional sense, as they are a crucial component of the financial system.

Poor governance and greedy practices may put the entire financial and credit system of our country at risk, including the propagation of exploitative practices that harm borrowers. Hence, NBFCs should ensure that they have a foolproof risk auditing infrastructure.

Fraudulent and exploitative lending practices: The RBI closely monitors NBFCs for signs of fraud, such as misappropriation of funds or manipulation of accounts. Any increase in fraud incidents can trigger regulatory scrutiny and warnings.

 Digitization of lending facilities and their access via technologically adverse people has led to a rampant increase in the frauds and scams associated with NBFCs. The RBI keeps a tab on the scams initiated by the NBFCs themselves and the scams resulting from any of their policies and behaviour. Exploitation by recovery agents is another big no-no in the RBI books.

Best Practices for NBFCs in Crucial Operational Aspects

One can get a functional understanding of the things to stay away from an NBFC perspective by reading about the common triggers that result in warnings from the RBI. However, the best practices for NBFCs should result in a safer financial environment for both NBFCs themselves and the parties that deal with them.

Strong risk management framework: NBFCs should implement stringent credit appraisal measures to ensure that their lending services have appropriate oversight and they do not lend to financially dangerous and low-credit individuals and corporations.

NBFCs should also implement strong operational measures and internal procedures to ensure that no internal fraudulent activities are going on. Also, NBFCs should ensure that they have enough liquidity to cover surprise short-term liabilities. This means ensuring compliance with the Liquidity Coverage Ratio (LCR) as per RBI guidelines.

Regular reporting and compliance checks: NBFCs shouldensure timely and accurate submission of financial reports to the RBI. This includes filing annual returns, balance sheets and reports on asset quality and NPAs (Non-Performing Assets).

Maintain transparency with investors and stakeholders by providing clear information about the company’s performance, growth strategy, and risk profile. All information regarding the allocation of financial assets should be kept transparent.

Cyber data risk management: Information about the borrowers and their finances is sensitive. NBFCs should ensure that their cyber data is secured properly and third parties cannot access it. In our country, we hear of frequent scams that result in the loss of personal data by third parties, which can later be used for malicious reasons. Cyber data management vulnerability assessments and audits to identify potential weaknesses in your digital infrastructure are strongly recommended.

Fair and transparent lending practices: Lending by the NBFCs should never appear to be usury. Their interest rates, lending terms, and other financial lending details should be made clear before any contracts are signed or any loans are disbursed. Also, the collection of loans should not be seen as a source of money, and NBFCs should ensure that they do not charge late payment and early closure charges, thereby exploiting the borrowers.

In the Nutshell

NBFCs are a crucial component of India’s financial infrastructure. They are complimentary to the function of banks, and increase the reach of financial services greatly. These entities have emerged as vital conduits for credit delivery, particularly in underserved and rural areas where conventional banking infrastructure remains limited.

NBFCs excel in their ability to cater to niche markets, offering specialized financial products and services made especially to cater to the diverse needs of a growing nation’s various stakeholders. Traditional banks are far too occupied with the maintenance of credit facilities and serving the needs of the mainstream to offer specialized services, making NBFCs vastly important.

Their flexibility and innovative approach to lending have significantly contributed to financial inclusion, fostering economic growth in sectors often overlooked by mainstream banks.

The Reserve Bank of India (RBI), recognizing the critical function of NBFCs, has implemented a robust regulatory framework to ensure their stability and effectiveness. This oversight mechanism encompasses stringent checks and balances, including mandatory registration, capital adequacy norms, and regular reporting requirements.

The RBI, in its recent regulations and mandates, has shown an increased emphasis on the performance of NBFCs and their compliance with safety and stability mandates by the RBI, and the NBFCs have also been praised for their fast growth statistics. Only a few outliers have been reprimanded for their aggressive tactics.

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