NBFC

Minimum Capital Requirements For NBFC

NBFCs, like banks, provide financial services to individuals and businesses throughout the nation. NBFCs in India have a significant objective of providing a diverse range of loan products and services to individuals and businesses all around country. The problem of NBFC systemic risk has been discussed, particularly in India, where there’s been a number of major NBFC collapses, and the subject of inter-connectivity between NBFCs and the rest of the financial sector has become apparent. The RBI has noted the necessity to reassess the regulatory framework in consideration of the evolving risk profile of NBFCs in its Statement on Development and Regulatory Policies dated December 4, 2020. In the last several years, the regulatory framework for NBFCs has undergone a number of modifications, making it all more comprehensive. Furthermore, the sector’s phenomenal expansion, along with the NBFCs’ regulatory arbitrage, has created a systemic danger. As a result, regulators have deemed it essential to strengthen regulatory standards for NBFCs that control a significant portion of the market. The proposed discussion paper’s goal is to reconsider the broad principles that underlie the existing regulatory framework and analyze the necessity to develop a scale-based approach of minimum capital requirements for NBFC, to regulate from the viewpoint of “systemic significance,” as well as to suggest suitable regulatory measures in support of a strong and determined financial system.

In response to the declaration mentioned above, the RBI issued a Discussion Paper on January 22, 2021, requesting comments from industry players. The present article examines the RBI’s main recommendations.

Existing minimum capital requirements for NBFC

There are minimum capital requirements for NBFC firms under Section 45-IA of the RBI Act, 1934. The RBI has set rigorous minimum capital criteria for such shadow banks to guarantee risk reduction in the event of a capital crisis or a lack of liquidity. This was also done with the customer’s best interests in mind and to help the market develop.

Highlights of the New Regulatory Framework of minimum capital requirements for NBFC

• Base layer (BL) to be systematically non-significant entities, with light touch regulation, i.e. 4 layers of regulatory intensity – progressively from bottom – BL, ML, UL, and TL. Some organizations, such as Type 1 NBFCs (those with no public interface or public funding), will appear to always be in the Base layer, regardless of their size. The systemically significant NBFCs will cover ML. Based on indications of higher systemic risk, 20-25 companies will be chosen for closer monitoring from ML. The TL field is left blank by default; however, it should be filled in only if supervisory discretion is exercised in the case of high risks.

• From Rs 500 crores to Rs 1000 crores, the monetary barrier for systematic importance would be raised.

• Aims to eliminate regulatory arbitrage at Layer 2 (ML) and higher, as well as to harmonise the ML regulatory framework with banks.

• Layer 3 (UL) is a new regulatory layer with rules that are expected to have been on par with those of banks.

• The NBFC will not be surprised by the UL categorization; the decision to be placed in the category will be notified beforehand, giving the NBFC time to operate and get out of the classification.

• The entry-point criteria for new NBFC registrations would be raised tenfold, from Rs 2 crores to Rs 20 crores. Current NBFCs will be given a deadline, perhaps 5 years, to demonstrate their worth.

• NPA standards for BL NBFCs (now the NSI subcategory) would be reduced to 90 days from 180 days.

• Not less than one of the NBFCs’ board members (directors) must have expertise in retail lending.

• ICAAP will apply to NBFC-ML and above.

• Auditor rotation every three years, the appointment of a Chief Compliance Officer, managerial remuneration controls, and a slew of new disclosure obligations for ML companies.

• Concentration limitations: suggested for ML companies are board-imposed sectoral exposure caps, IPO funding limits, and self-imposed real estate exposure.

• Adoption of the Core Banking Solution by NBFCs with ten or even more branches.

• The Upper Layer will be composed of 25-30 companies chosen from a sample of around 50 organisations depending on a scoring methodology that indicates distinct systemic risk. These organisations will be required to have a standard equity tier of 9%. Furthermore, leverage restrictions may well be set.

• UL organisations must have a distinct provision for standard assets.

• For UL entities, mandatory listing, managerial compensation restrictions, and other requirements will be imposed.

• In the case of banks, the top layer should be comparable to the protective structure: The Capital charge is higher, and there is a capital conservation buffer.

Regulatory arbitrage: the concern behind the present regulatory proposal of minimum capital requirements for NBFC

In an integrated financial system, the unrestricted development of the NBFC sector, combined with a poor regulatory environment, may create the conditions of systemic risk. In the current environment, the collapse of any big and deeply linked NBFC has the potential to send shocks across the financial system, disrupting even the operations of small and mid-sized NBFCs.

Classification of NBFCs by scale of activities, risks and size under the proposed framework of minimum capital requirements for NBFC

The suggested framework of minimum capital requirements for NBFC calls for a scale-based method of regulation. This basically implies that regulatory and supervisory resources will be concentrated mainly on firms that have become too-large-to-fail (TBTF) as a result of their systemic interconnectivity with other financial market players. The principle of proportionality will be used to determine the level of regulation.

The suggested classification for minimum capital requirements for NBFC from the research is summarised in the figure under:-

CICs, however, is expected to be scrutinised more closely, potentially as a result of a recent major NBFC default. CICs, together with NBFCs presently categorised as systemically important NBFCs (NBFC-ND-SI), deposit-taking NBFCs (NBFC-D), HFCs, IFCs, IDFs, and SPDs, are suggested to be considered Middle Layer NBFCs (NBFC-ML). Despite the fact that CICs and SPDs would go under the Middle Layer of the regulatory pyramid, the present regulations that apply to them will remain in effect.

Increased NOF & Harmonization of NPA Recognition under the proposed framework of minimum capital requirements for NBFC

The proposed framework of minimum capital requirements for NBFC also recommended that the NOF be increased to Rs. 20 crores. Furthermore, in attempt to guarantee a seamless transition, the RBI will set a well-defined timetable for current NBFCs, perhaps, covering 5 years. On the issue of instructions, the higher NOF requirements will be imposed instantly for new registrations.

All NBFCs, even the ones that are not strategically significant, would be eligible for NPA designation based on 90 DPD.

Recognition of NBFCs in Upper Layer

The classification of NBFCs is based on an annual assessment. The study characterises between 2 given parameters, i.e. quantitative and qualitative parameters:

• The quantitative characteristics will be weighted at 70%.
• The qualitative aspects will be weighted at 30%.

To calculate leverage, divide the NBFC’s individual score by the sample’s average leverage. Even if it fails to fulfil the parametric criteria the following year, an NBFC-UL will be exposed to increased regulatory obligations comparable to those imposed on banks for at least four years after its previous appearance in the category.

NBFC in Base Layer

NBFCs with assets of up to Rs 1000 crores would be covered under the base layer. The following table summarises the key proposals for this layer:

Proposals for NBFCs in Base Layers
1.	The present laws mandate NPA categorization of assets with more than 180 DPDs; however, this is recommended to be decreased to 90 DPDs to align with regulatory recommendations for other types of NBFCs.
2.	The Board must have the following qualifications: i.        A sufficient level of experience and education ii.      Not less than one director should have retail lending experience for a bank or a non-bank financial institution.
3.	For the Risk Management Committee, i.        the overall function and duties will be specified, ii.      The composition may be at the Board or Executive level, depending on the Board’s decision.
4.	Once the guidelines have been finalised, the laws for the sale of stressed assets will be aligned with those of banks.
5.	Further disclosures on risk types, linked party transactions, and consumer complaints will be prescribed.

NBFCs in Middle Layer

Along with the recommendations for the base layer, numerous new regulatory requirements are suggested for this category. For NBFC-ML, no modifications to capital requirements are suggested.

Proposals for NBFCs in Middle Layers
1.	Internal Capital Adequacy Assessment must be conducted according to a board-approved policy that considers all risks.
2.	It is recommended that the existing credit concentration limitations for NBFCs for lending and investment be combined into a single exposure limit of 25% for a single borrower and 40% for a group of borrowers linked to Tier 1 capital rather than Owned Funds.
3.	As per the proposed minimum capital requirements for NBFC, the auditors must be rotated on a regular basis. – Auditors will be ineligible for re-appointment for a period of 6 years upon completing a three-year continuous audit term (two tenures).
4.	•        Appointment of a Chief Compliance Officer who would be functionally independent. •        Additional CG and Disclosure Requirements, along with a Secretarial Audit Requirement
5.	It is suggested that no KMP of an NBFC holds office in any other NBFC-ML, NBFC-UL, or subsidiaries and that an Independent Director cannot be a director in more than 2 NBFCs (NBFC-ML and NBFC-UL) at the same time.
6.	Internal board-approved limitations and sufficient transparency would be needed to access sensitive exposures, and NBFCs will be obliged to conduct dynamic vulnerability assessments. Internally, a sub-limit within the commercial real estate exposure ceiling must be set for land acquisition finance.
7.	Loans and advances for/to the aforementioned are subject to limitations:      A.            Share/security buybacks      B.            Actions that result in Ozone Depleting Substances      C.            Directors & their relations      D.            Officers and the relatives of Senior Officers      E.            Real estate – only when project clearances and other permits have been obtained.
8.	NBFC IPO financing would be limited to Rs. 1 crore. There is currently no limitation for NBFCs; however, banks have a ceiling of Ts. 10 lakh for IPO funding.
9.	Core Banking Solution for NBFCs is required for NBFCs with more than 10 branches.

NBFCs in Upper Layer

A series of additional rules will be applicable to NBFC-UL supplementary to the laws that apply to NBFC-ML:

Proposals for NBFCs in Upper Layer
1.	Within Tier I capital, CET 1 might be prescribed at 9%. NBFCs would be subjected to a leverage requirement in addition to the CRAR regulations.
2.	Differential Provisioning is used in the same way as banks do for conventional assets.
3.	For Concentration standards-      A.            The Large Exposure Framework (LEF) will apply to banks with appropriate modifications.      B.            Implementation transition time
4.	Corporate Governance rules would be along with the same principles as those in place for private sector banks. Further governance rules include requiring members of the board to be qualified, as well as giving thorough information on group companies, which would include consolidated financial status and details of related party activities.
5.	Adequate phase-in time must be allowed for the required listing. Furthermore, as part of the overall implementation strategy for NBFC-UL, disclosure requirements will take effect prior to the actual listing.
6.	The removal of an Independent Director must be approved by the Board of Directors (supervisors).

NBFCs in Top Layer

The top layer is presently vacant and would be filled if the RBI determines that there’s been an unsustainable growth in systemic risk spillovers from individual NBFCs in the Upper Layer. This Layer’s NBFCs would be subject to greater capital charge, as well as Capital Conservation Buffers. The supervisory involvement with these NBFCs will be expanded and intensified.

The Monetary threshold for systemically essential NBFCs as per the new framework of minimum capital requirements for NBFC

On November 10, 2014, an asset size of Rs 500 crores was established to differentiate between SI and NSI NBFCs. The restrictions were set in accordance with the recommendations of the Working Group on Issues and Concerns in the NBFC Sector, which was led by Smt. Usha Thorat.

The RBI intends to raise the threshold from Rs 500 crores to Rs 1000 crores after more than 6 years.

The RBI’s statistics show that the number of NSI businesses will increase from 9133 to 9209, demonstrating this metric’s inherent scepticism. That is, just 76 companies would be moved from the SI category to the BL classification.

10-fold jump in entry point net worth requirement

The regulator proposes raising the NOF requirement for NBFCs from Rs 2 crores to Rs 20 crores, a tenfold increase. The fundamental objective is to create a slower entry barrier and to guarantee that NBFCs have sufficient initial capital to spend on technology, labor, and infrastructure. This steep increase in the entry point criterion, on the other hand, will keep smaller NBFCs out of the game. Smaller NBFCs, especially those with a geographic or industry emphasis, have played an essential role in financial inclusion.

Conclusion

The regulatory framework of minimum capital requirements for NBFC is being completely overhauled. Whereas the new legal framework should’ve been expected to keep smaller NBFCs out of the spotlight, it is worth noting that just 76 businesses are moving from SI to NSI classification as a result of the suggested modification. The whole point of scalar regulation would’ve been to have fewer entities to control to focus attention where required. Furthermore, the concept of scalar regulation implies that there should be more regulation at higher levels of the pyramid and less regulation at the bottom. There are no obvious signs of decreased regulation at the base level.

Read our article:Regulatory Framework for NBFCs: A RBI Revision