RBI Notification

RBI’s Ringfencing Approach to Safeguard Banking Operations

The Reserve Bank of India issued a draft circular, “Forms of Business and Prudential Regulation for Investments,” on October 4, 2024, as part of its regulatory modernization initiative. The circular aims to revise the existing guidelines provided under the Master Direction of Reserve Bank of India (Financial Services provided by Banks) Directions, 2016; comments are invited from banks and stakeholders until November 20, 2024.

The RBI’s draft circular is a crucial step in enhancing safeguards for banking operations. By revising the existing guidelines, the central bank aims to protect the sector against risks while inviting feedback from stakeholders to ensure comprehensive regulations.

This draft circular represents an important review of the regulations concerning banks’ business activities and investments in financial and non-financial sectors. The proposed rule’s principal objective is to ring-fence banks’ core business operations, particularly deposit-taking and lending, from risks presented by non-core activities.

While the main purpose is to give banks greater operational freedom to make strategic investments in the best interest of shareholders, in the case of Alternative Investment Funds, it also proposes stricter prudential norms to maintain the integrity of the banking sector. The following blog critically analyses the draft circular, its implications for banks, and how it seeks to strike a balance between operational flexibility and prudential safeguards.

Why is there a Need for Regulatory Revisions?

New financial services, alternative investment opportunities, and growing corporate exposure to international capital markets are some of the major factors that have recently altered the face of banking in India. Accordingly, banks have increasingly expanded into non-core operations, such as insurance, asset management, and venture capital investments. Similarly, while these new business ventures open new revenue sources for banks, associated risks may not align with the traditional form of banking through taking deposits and lending.

Recognizing this, RBI has proposed a regulatory framework that protects banks from potential risks arising from non-core activities while allowing them to take advantage of growth opportunities. The revision to the 2016 Master Directions aims to enhance the existing prudential limits on investments and business activities, clarify permissible activities for banks and their group entities, and propose new risk management and oversight requirements.

Know about the Core Business Protection and Ring-Fencing

The draft circular has focused on protecting banks’ core deposit-taking and lending business from risks that could arise in non-core activities. In other words, risk cannot overlap from one business unit to another within a banking group, which is a principle under the ringfencing approach. The RBI has stipulated that banks must conduct their core business activities departmentally, with the necessary insulation of the core functions from risks arising in other ventures.

Within the proposed framework, banks would be permitted to undertake other activities permitted under a department or subsidiary / associate group company, such as factoring, credit card issuing, housing finance, and equipment leasing activities, subject to the conditions provided in Chapter III of Master Direction.

However, the draft circular now introduces various new restrictions on risk-sharing activities, including mutual fund businesses, insurance, pension fund management, investment advisory, and portfolio management services. These activities entail a higher degree of risk and are now undertaken only through separate group entities rather than departmentally to protect the core business from volatility.

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Furthermore, the circular limits overlapping business activities within a banking group. No two entities within the same group will be allowed to undertake the same type of business or hold the same license or authorization from a financial sector regulator. This delineates the circles of business activities, reducing the chances of duplicative risks and conflicts of interest within a banking conglomerate.

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Enhanced Prudential Regulation for Investments

Besides protecting core business, the draft circular proposes revised prudential regulations for bank investments in financial and non-financial sectors. The RBI’s twin objectives here are to provide banks with operational freedom to pursue strategic investment opportunities while imposing prudential limits on such investments to ensure that they do not compromise the stability of their core operations. The draft circular consolidates the prudential regulations applicable to banks’ investments and provides several key limitations:

Equity Investment Limits

Banks cannot invest in more than a limit in any company or group entity; they are subject to restrictions regarding the investment limit. Equity investment in any single company and its group entities is restricted to 10% of the bank’s paid-up share capital and reserves, as per the latest audited or unaudited balance sheet. Aggregate equity investments in all companies go up to 20%, with the view that banks do not overextend themselves in risky ventures.

• Non-Financial Companies

The draft circular introduces a cap on banks’ investments in companies engaged in non-financial services. A bank’s equity holding in such companies is capped at 20%, with an allowance for up to 30% in specific circumstances, such as at the time of debt restructuring or for the protection of the bank’s existing loans or investments. This gives banks flexibility in managing their corporate exposure but ensures that such investments remain within reasonable bounds.

• Alternative Investment Funds (AIFs)

Banks shall be permitted to invest in Category I and II AIFs subject to prudential limits and with the prior approval of DoR. However, Category III AIFs typically bear higher risks. Investments in these would be precluded. This reflects several recent cautious measures the RBI has taken regarding high-risk investment vehicles amidst global market uncertainties and domestic financial sector vulnerabilities.

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• Group Entities and Holding Companies

When banks operate under a non-operative financial holding company (NOFHC) structure, some additional investment restrictions tend to apply. According to the draft circular, group entities of a NOFHC should not hold more than 10% of the equity capital in a financial or non-financial company. The circular has forbidden the use of group entities for regulatory arbitrage so that activities remain transparent and within the regulatory purview of the RBI.

Operating Flexibility with Safeguards

While the proposed framework imposed by RBI has been stricter regarding the prudential limits on banks’ investments, it gives more operation freedom in several areas. Banks can now, at their discretion, invest freely in financial services, non-financial services companies, and AIFs, attracting the provisions relating to value and capital without prior permission if their investment is below 20% of the equity capital of the investee company.

This relaxation of the prior approval requirement is expected to further facilitate and expedite the investment process by avoiding bureaucratic delays, enabling banks to seize emerging market opportunities more efficiently. However, the draft circular contains various safeguards against operational flexibility leading to undue risk-taking:

• Banks must ensure that their Capital to Risk-Weighted Assets Ratio (CRAR) remains above the minimum prescribed level, including the Capital Conservation Buffer, after making any new investment.
• Exemption condition for investment: The bank has to have a net profit in the previous two financial years.
• The aggregate equity investments made in a single financial year should not exceed the bank’s net profit from the earlier financial year.

These conditions are designed to ensure that banks remain well-capitalized and financially sound while continuing to expand a gamut of new investment opportunities. The main focus is balancing growth and risk management without over-leveraging or exposing themselves to risk in their non-core activities.

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Risk Management and Reporting Requirements

The draft circular, along with our important aspects, strongly emphasizes the risk management and reporting requirements for banks engaging in investment activities. Every bank must follow a comprehensive, group-wide risk management framework covering all equity investments, including those in AIFs and other service companies in the non-financial sector.

It also mandates that any violation of the prudential limit shall be reported to the Department of Regulation within seven working days. The reporting of the default underlines the need for constant monitoring and regulatory supervision so that the banks remain compliant with the prudential norms.

Banks must also furnish a detailed report about their present position and future plans for compliance with the new provisions within two months of the final circular’s issue. This would enable the Reserve Bank of India to track its compliance progress and intervene wherever necessary.

Implications for the Banking Sector

The draft circular issued by the RBI represents a significant shift in the regulatory environment in which Indian banks operate. Therefore, by tightening prudential regulations and imposing new restrictions on business activities, the RBI aims to balance two competing objectives: maintaining stability in the banking sector and permitting controlled growth in non-core activities.

The draft circular presents both a challenge and an opportunity for banks. The new regulations require banks to review their existing investments and business structures, primarily concerning group entities and non-core activities. Banks may have to divest certain businesses or reorganize their operations to comply with the new guidelines.

The draft circular, on the one hand, gives banks greater freedom in exploring new investment opportunities, especially in the financial services and AIF sectors. It allows the RBI to permit banks to diversify their revenue streams by streamlining the approval process and allowing for more operational flexibility.

Conclusion

The Reserve Bank of India’s draft circular on “Forms of Business and Prudential Regulation for Investments” is a significant step towards updating the regulatory regime governing banks’ business activities and investments. The draft circular strikes a commendable balance between protecting banks’ core functions and allowing them to explore new opportunities in the financial and non-financial sectors.

The banks and other stakeholders are invited to send their feedback on the draft circular; the key focus is to ensure that the final guidelines strike a proper balance between operational freedom and prudential oversight. The idea is to have a regime that will promote growth while safeguarding the stability and integrity of the Indian banking system.

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