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India’s central bank (RBI) has released guidelines on 19th April, 2022 with respect to the Scale based regulations for the Non-Banking Financial Companies (NBFCs) and the necessary disclosures they are supposed to make under these new scale based regulations.
RBI has stated that the aggregate exposure of an upper layer NBFC which is in the top category should not exceed 20 per cent of its capital base in any case. However, this limit can be enhanced till 25 percent with the approval of Board. This means that the aggregate exposure for a group of connected entities cannot exceed the limit of 25 percent of the capital base for all the Upper Layer NBFCs.
There is an exception created for the Infrastructure Finance Companies (IFC) where the aggregate limit has been set at 30 percent for a single entity and 35 percent in case of a group of connected entities.
These Scale based Regulations shall be applicable to all the NBFCs who fall in the Upper Layer and Middle Layer.
The RBI clarified that these additional disclosure are in addition to the existing disclosures requirements and in no way substitute the disclosure requirements in other laws, regulations or financial and accounting standards.
The reason for releasing the scale based regulations for the NBFCs falls in the backdrop of financial crisis created after the systematic risks were exposed on the fallout of Dewan Housing Finance Corporation Ltd. and Infrastructure Leasing & Financial Services. These regulations have been released to tighten the regulatory hold on the NBFCs especially after the instances of defaults and bankruptcy.
The RBI has stated that NBFC sector has grown in leaps and bounds and evolved over time in terms of its sheer market size, its complexities and the interconnected with the segments of the financial sector. Many of the NBFCs have grown in size and have become an important part of the economy. Thus, a need arises for a regulatory framework for NBFCs taking into account the exposure of risks associated with their management and operations.
Essentially, the objective of these scale based regulations is to ensure that NBFCs have adequate funding and are effectively managed.
RBI classifies NBFCs into the following four categories based on their size, activities and the risks taken by them:
The segregations has been done keeping in mind the assets and liabilities that the NBFCs have and the kind of activities they are engaged in. RBI’s objective behind these guidelines is to protect the interests of the stakeholders and ensure that no risk accrues to the banks who are exposed to these NBFCs.
Experts are of a view that this scale based regulatory framework will limit the practice of arbitrage with banking institutions. Moreover, these regulations will ensure that smaller asset sized NBFCs serve the needs of low-income strata and such base layer NBFCs face less stress to continue effective funding of the lower-class economy.
However, some experts are of the view that increased standards of overall risk assessment will negatively affect the functioning of the Upper Layer NBFCs.
The RBI has brought these regulations in furtherance of promoting the practice of responsible lending and borrowing. These regulations will tighten norms and would require more disclosures from the borrowers’ end to bring greater transparency. Further, these regulations will certainly bring better customer service although they would be required to fulfill certain extra requirements.
One of the biggest risks the NBFCs have to face is the risk of Non-Performing Assets (NPAs) and bad loans. When compared to banks, the customers of NBFCs usually have longer period of time before their loan defaults are declared as NPAs. The new guidelines have made it compulsory that irrespective of the layer the NBFCs fall in, the asset norms will be applicable to all the NBFCs. Moreover, the asset classification norms will be the same as they are for the banks.
Experts are of the opinion that RBI has made very stringent rules and it will be felt specifically by the microfinance institutions belonging to the category of NBFCs. There are possibilities that this whole sector might collapse because of the change in risk factors. A collapse within this sector will further end up bringing a potential crash in the economy. The trust of the public within the microfinance sector will be negatively affected.
Moreover, the middle, upper and top layer NBFCs will undergo major changes when the regulations will be implemented within the NBFC sector to manage the risks better.
The disclosure requirements brought by the RBI shall become effective for the annual financial statements for the Financial Year 2023.
Elements of Common Equity Tier 1 capital
According to the newly released Scale based regulations the capital requirements for the NBFCs- Upper Layer require them to maintain an equity tier 1 capital of at least 9 percent of the risk weighted assets, wherein the common equity tier 1 capital shall comprise of paid up equity shares, capital reserves representing surplus arising out of asset sales, statutory reserves, other disclosed free reserves if any, revaluation of reserves arising out of change in the carrying amount of property consequent to its revaluation in accordance with the applicable accounting standards.
All the above shall be reckoned as CET1 capital at a discount of 55 percent instead of Tier 2 capital. However, this is subject to meeting the following conditions such as where the property is held for its own use by the NBFC and the same property can be sold by the NBFC at its own will without any legal impediment; where the revaluations reserves are disclosed/presented separately in the financial statements of the NBFC; where the revaluations presented are realistic and in accordance with the accounting standards; where such valuations are obtained from two independent valuers at least once in three years; in case the value of the property has been seriously impaired due to any event, then they are to be valued immediately and factored appropriately into capital adequacy computations and where the external auditors of the NBFC have not expressed a qualified opinion on the revaluation of the property.
It allows an NBFC to reduce the amount of accumulated losses from CET 1 while the profits in the current financial year may be included on the quarterly basis if the accounts have been audited or been subject to limited review by the statutory auditors. Consequently, such profits shall be reduced by the average dividend paid in the last three years.
Moreover, it allows deduction of entire losses in the current year from CET 1 (Common Equity Tier).
The application of the new regulatory adjustments/ deductions in the calculation of CET 1 capital can be done if it is deducted from the sum of items for goodwill and all other intangible assets should be deducted from the Common Equity Tier 1 capital.
The Deferred Tax Assets (DTAs) associated with accumulated losses and DTAs (excluding DTAs associated with accumulated losses) net of Deferred Tax Liabilities (DTL) shall be deducted in full from CET 1 capital.
In calculation of CET 1 capital, accounting of investment in shares of other NBFCs and shares, debentures, outstanding loans, bonds and advances including hire purchase and lease finance made to and deposit with subsidiaries and companies in the same group exceeding in aggregate 10 % of the owned funds of the NBFC will also be included.
However, the Impairment Reserve shall not be recognized in CET 1 capital. Further, exclusions/ deductions, required on unrealized losses and/or gains from regulatory capital read with circular on “Implementation of Indian Accounting Standards” shall also be reduced from CET 1 capital.
Full recognition of the Defined Benefit Pension Fund Liabilities, as included on the balance sheet, must be done in the calculation of CET 1 capital. For every defined benefit pension fund that is an asset on the balance sheet, that asset should be deducted while calculating CET 1. Since the investments in its own shares amounts to repayment of capital, therefore such investment, whether held indirectly or directly, shall be deducted from CET 1 capital. Moreover, this deduction will remove the double counting of equity capital which arises from direct holdings, indirect holdings via index funds and potential future holdings as a result of contractual obligations to purchase own shares.
It must be noted that the Total Risk Weighted Assets (RWAs) to be used while computing the ration of CET 1 shall be the same as the total RWAs computed under the relevant Directions of the concerned category.
Applicability of the NBFCs
From the above discussion it can be expected that the new scale based regulations are expected to make it mandatory for the NBFCs to make additional disclosures which can cause hiccups in the initial phases but in the long run it will be beneficial for the maintenance of trust in the NBFC sector.
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