RBI Notification

RBI’s New Scale-Based Regulation for NBFCs

The Reserve Bank of India (RBI), on October 22, 2021, introduced a ground-breaking regulatory framework for Non-Banking Financial Companies (NBFCs) known as Scale-Based Regulation (SBR). This framework categorizes NBFCs into different layers based on their size, activities, and perceived riskiness, ushering in a more nuanced and tailored approach to regulation. In this article, we delve into the details of this significant development, exploring its implications and providing clarity through examples.

Understanding the Background

The importance of NBFCs in the Indian financial landscape cannot be overstated. They serve as crucial intermediaries, supporting economic activities and expanding credit access beyond traditional banks. Over the years, the NBFC sector has grown substantially in terms of size, complexity, and interconnections with the broader financial system. As a result, some NBFCs have become systemically significant, necessitating a regulatory framework that evolves in tandem with their changing risk profiles.

Scale-Based Regulation (SBR) Unveiled

SBR is the RBI’s response to the evolving NBFC landscape. It divides NBFCs into four regulatory layers, each defined by specific characteristics. These layers enable a more granular and targeted regulatory approach, ensuring that regulatory requirements are proportional to an NBFC’s scale, complexity, and activities.

1. The Four Regulatory Layers

a. Base Layer (NBFC-BL)

• Definition: This layer comprises non-deposit-taking NBFCs with assets below Rs 1000 crore and specific activities, including NBFC-Peer Peer Lending Platforms (NBFC-P2P), NBFC-Account Aggregators (NBFC-AA), Non-Operative Financial Holding Companies (NOFHC), and NBFCs without public funds and no customer interface.
• Example: A small NBFC offering peer-to-peer lending services falls under the Base Layer.

b. Middle Layer (NBFC-ML)

• Definition: This layer encompasses all deposit-taking NBFCs (NBFC-Ds), non-deposit-taking NBFCs with assets of Rs1000 crore and above, and certain other categories.
• Example: A mid-sized NBFC accepting deposits and with assets exceeding Rs1000 crore is categorized in the Middle Layer.

c. Upper Layer (NBFC-UL)

• Definition: The RBI identifies NBFCs in this layer based on specific parameters and scoring methodology. The top ten eligible NBFCs, in terms of asset size, always reside in the Upper Layer.
• Example: Based on predefined criteria, an NBFC deemed to have a higher risk profile is placed in the Upper Layer.

d. Top Layer (NBFC-TL)

• Definition: Ideally, this layer remains empty but can be populated if certain NBFCs in the Upper Layer pose substantial systemic risks.
• Example: The Top Layer could be activated if the RBI identifies certain NBFCs as posing exceptional systemic risks.

2. Categorization by Activity

The regulatory structure also considers the specific activities of NBFCs, ensuring that they are categorized appropriately.

a. Base Layer Activities

• NBFCs engaged in activities such as peer-to-peer lending, account aggregation, NOFHC, and those without public funds and customer interface remain in the Base Layer.

b. Middle Layer Activities

• NBFCs in the Middle Layer continue to follow regulations applicable to their specific activities, such as deposit-taking, infrastructure financing, or housing finance.

c. Activity-Based Regulation

• Some NBFCs, such as Investment and Credit Companies (NBFC-ICC), Micro Finance Institutions (NBFC-MFI), NBFC-Factors, and Mortgage Guarantee Companies (NBFC-MGC), can fall into various layers based on the parameters of the scale-based regulatory framework.

d. Government-Owned NBFCs

• Government-owned NBFCs are placed in the Base Layer or Middle Layer, depending on their specific circumstances, and are not moved to the Upper Layer at this time.

3. Implementation Timeline

• The revised regulatory guidelines came into effect on October 1, 2022, with specific instructions on Initial Public Offering (IPO) funding taking effect from April 1, 2022.

Key Regulatory Changes under SBR

SBR introduces several key regulatory changes across all layers of NBFCs aimed at enhancing their stability and risk management capabilities.

a. Net Owned Fund (NOF) Requirements

• Change: Regulatory minimum NOF for NBFC-ICC, NBFC-MFI, and NBFC-Factors is increased to Rs10 crore.
• Example: An NBFC-MFI previously required Rs5 crore in NOF, but it must now raise its NOF to Rs10 crore, with a phased implementation plan.

b. NPA Classification

• Change: The NPA classification norm is changed to overdue periods of more than 90 days for all categories of NBFCs.
• Example: An NBFC that previously considered an asset as an NPA only after 150 days overdue must now follow the 90-day rule.

c. Director Experience

• Change: At least one director must have relevant banking or NBFC experience.
• Example: A newly formed NBFC board must include a director with significant banking or NBFC expertise.

d. IPO Financing Ceiling

• Change: A ceiling of Rs1 crore per borrower is introduced to finance Initial Public Offerings subscriptions.
• Example: An NBFC can now lend a maximum of Rs1 crore to an individual or entity for subscribing to an IPO.

4. Additional Regulations for Upper Layer (NBFC-UL)

For NBFCs in the Upper Layer, more stringent regulations are applied to manage their elevated risk profiles.

a. Internal Capital Adequacy Assessment Process (ICAAP)

• Change: Implementation of ICAAP to ensure adequate capital in line with risk profile.
• Example: An upper-layer NBFC must assess its capital needs based on its risk exposure.

b. Common Equity Tier 1 Capital

• Change: Maintenance of Common Equity Tier 1 capital at a minimum of 9% of Risk Weighted Assets.
• Example: An Upper Layer NBFC with Rs1000 crore in Risk Weighted Assets must maintain a minimum of Rs90 crore in Common Equity Tier 1 capital.

c. Leverage Requirements

• Change: Introduction of leverage requirements to monitor and limit excessive leverage.
• Example: An upper-layer NBFC must ensure its leverage ratio remains within specified limits.

d. Large Exposure Framework (LEF)

• Change: Introduction of a Large Exposure Framework to manage concentration risk.
• Example: An upper-layer NBFC must diversify its lending portfolio to comply with the LEF limits.

Governance Guidelines

The regulatory changes also emphasize governance enhancements to strengthen oversight and risk management.

a. Risk Management Committee (RMC)

• Change: Establishment of a Risk Management Committee.
• Example: An NBFC must form an RMC comprising experienced members to oversee risk management practices.

b. Disclosure Requirements

• Change: Expanded disclosure requirements to improve transparency.
• Example: An NBFC must provide more detailed financial information in its reports to the RBI and the public.

c. Loan Policies

• Change: Introduction of loan policies for directors, senior officers, and relatives of directors.
• Example: An NBFC’s board must define policies for loans granted to its directors and their family members.

d. Chief Compliance Officer (CCO)

• Change: Appointment of a Chief Compliance Officer.
• Example: An NBFC must designate an experienced individual to ensure compliance with regulations.

e. Compensation Guidelines

• Change: Guidelines on compensation practices for employees and directors.
• Example: An NBFC must align its compensation practices with regulatory guidelines.

f. Whistle-Blower Mechanisms

• Change: Introduction of whistle-blower mechanisms to report governance-related concerns.
• Example: An NBFC must establish channels for employees to report governance issues anonymously.

Transition Plan and Future Review

NBFCs transitioning to higher layers must adhere to enhanced regulatory requirements within specified timelines. The methodology for assessing NBFCs in the Upper Layer will also be reviewed periodically. NBFCs can only exit the enhanced regulatory framework if they do not meet classification criteria for five consecutive years.

Implications of Scale-Based Regulation (SBR)

5. Enhanced Financial Stability

One of the SBR approach’s primary objectives is to strengthen the NBFC sector’s financial stability. By categorizing NBFCs into different layers based on their scale and risk profiles, the RBI aims to identify and address potential systemic risks more effectively. This, in turn, can contribute to the overall stability of the financial system. For instance, larger NBFCs in the Upper Layer are subject to stricter capital adequacy requirements, reducing the likelihood of financial distress.

6. Improved Risk Management

SBR encourages NBFCs to adopt robust risk management practices tailored to their specific risk profiles. With potentially higher risk exposures, NBFCs in the Upper Layer are required to establish an Internal Capital Adequacy Assessment Process (ICAAP). This process helps NBFCs identify, measure, and manage risks more effectively. These institutions can better weather economic downturns and unforeseen challenges by aligning capital with risk.

7. Greater Financial Inclusion

While imposing stricter regulations on larger NBFCs, SBR also acknowledges the importance of smaller NBFCs in promoting financial inclusion. The Base Layer comprises smaller NBFCs, including peer-to-peer lending platforms and microfinance institutions, which play a crucial role in reaching underserved segments of the population. By minimizing regulatory burdens on these entities, the framework aims to encourage their growth and continued contribution to financial inclusion.

8. Investor Confidence

The revised regulatory framework enhances investor confidence by promoting transparency and governance within NBFCs. Investors are more likely to trust NBFCs that adhere to stringent regulatory standards, particularly in terms of risk management, disclosure requirements, and corporate governance. This confidence can attract more capital inflows into the sector, supporting its growth.

Challenges and Considerations

9. Compliance Costs

While SBR aims to strike a balance between regulatory rigour and financial inclusion, there are concerns that compliance costs may rise for NBFCs, especially those transitioning to higher layers. Smaller NBFCs may face challenges in meeting enhanced regulatory requirements, potentially impacting their profitability. Therefore, careful planning and resource allocation are crucial for NBFCs as they navigate this regulatory landscape.

10. Monitoring and Enforcement

Effective monitoring and enforcement of the SBR framework pose challenges for regulators. The RBI needs to ensure that NBFCs adhere to their designated layers and comply with the prescribed regulations. Continuous oversight is essential to prevent regulatory arbitrage and maintain the integrity of the framework.

11. Periodic Review

The RBI has committed to periodically reviewing the methodology for assessing NBFCs’ placement in the Upper Layer. This review process is critical to ensure that the criteria remain relevant and reflective of evolving risk profiles. Stakeholder engagement and feedback mechanisms will be vital in this ongoing evaluation process.

12. Exiting the Enhanced Regulatory Framework

NBFCs placed in the Upper Layer can exit the enhanced regulatory framework if they do not meet the classification criteria for five consecutive years. While this provision offers flexibility, it also underscores the need for consistent risk management practices. Exiting the framework should not be the primary goal; NBFCs should focus on maintaining strong risk governance over the long term.

Conclusion: A Paradigm Shift in NBFC Regulation

The RBI’s Scale-Based Regulation (SBR) for NBFCs represents a paradigm shift in the regulatory approach. It recognizes the dynamic nature of the NBFC sector and strives to strike a balance between promoting financial inclusion and safeguarding financial stability. As NBFCs adapt to the new regulatory landscape, they must view compliance not merely as a regulatory requirement but as an opportunity to enhance their governance, risk management, and investor appeal.

SBR underscores the RBI’s commitment to maintaining a resilient and inclusive financial system, ensuring that NBFCs remain key contributors to India’s economic growth. Stakeholders, including NBFCs, investors, and regulators, must collaborate to address challenges and harness the potential benefits of this transformative regulatory framework. In doing so, the Indian financial sector can look forward to a future marked by greater stability, inclusivity, and resilience.

Please note that the information provided in this extended article is based on the RBI’s notification as of October 22, 2021. Subsequent updates or changes may have occurred, and stakeholders need to stay informed about the evolving regulatory landscape in the NBFC sector.

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