RBI proposes scale and risk based regulation of NBFCs

Reserve Bank of India (RBI) has proposed to introduce a scale-based regulatory framework, anchored on proportionality, for non-banking financial companies (NBFCs). 

RBI said the proposed regulatory and supervisory framework of NBFCs shall be based on a four-layered structure – Base Layer, Middle Layer, Upper Layer and a possible Top Layer. 
If the framework is visualised as a pyramid, the bottom of the pyramid, where least regulatory intervention is warranted, can consist of NBFCs, currently classified as non-systemically important NBFCs (NBFC-ND), NBFCP2P lending platforms, NBFCAA, NOFHC and Type I NBFCs.
Moving up, the next layer can consist of NBFCs currently classified as systemically important NBFCs (NBFC-ND-SI), deposit taking NBFCs (NBFC-D), HFCs, IFCs, IDFs, SPDs and CICs. The regulatory regime for this layer shall be stricter compared to the base layer. Adverse regulatory arbitrage vis-à-vis banks can be addressed for NBFCs falling in this layer in order to reduce systemic risk spill-overs, where required.
Going further, the next layer can consist of NBFC, which are identified as systemically significant among NBFCs. This layer will have NBFCs that have large potential of systemic Issues for discussion.
RBI is seeking wider opinion on whether the proposed triggers adequately capture the basis for determining the degree of proportionality or whether there is a need to add any other or remove any of the proposed triggers.
While the considered supervisory judgment might push some NBFCs from out of the upper layer of the systemically significant NBFCs for higher regulation/ supervision and such NBFCs will occupy the top of the upper layer as a distinct set. Ideally, RBI said, this top layer of the pyramid will remain empty unless supervisors take a view on specific NBFCs. 
It only means that if certain NBFCs lying in the upper layer are seen to pose extreme risks as per supervisory judgement, they can be put to significantly higher and bespoke regulatory/ supervisory requirements, RBI pointed out.
The regulatory framework envisages a progressive increase in the intensity of regulation. The extant regulatory framework for NBFC-NDs will now be applicable to Base Layer NBFCs while the extant regulatory framework applicable for NBFC-NDSI will be applicable to Middle Layer NBFCs. NBFCs residing in the Upper Layer will constitute a new category.
RBI also proposed a revision in the current threshold for systemic importance to Rs1,000 crore from Rs500 crore at present. The upward revision is based on the increase in general price levels as well as increase in real GDP since 2014, it added. 
RBI noted that out of 9,425 non-deposit taking NBFCs, 9,133 NBFCs have asset size of less than Rs500 crore. If the current threshold of systemic significance is raised to Rs1,000 crore, the number of NBFCs in this layer would go up by 76 to 9,209. NBFCs featuring in this layer will be known as NBFC Base Layer (NBFC-BL).
RBI had, in April 1999, fixed the minimum stipulated net owned funds (NOF) for NBFCs at Rs2 crore. Based on increase in prices, real GDP and regulatory judgement, the entry point norms will be revised from Rs2 crore to Rs20 crore. In order to ensure non-disruptive transition, a well-defined timeline will be prescribed for existing NBFCs, spanning over a period of, say, five years. For new registrations, the higher NOF norms will get implemented immediately on issue of instructions.
NBFC-BL shall largely continue to be subjected to regulation as is currently applicable for NBFC-ND. However, as the threshold is being increased to Rs1,000 crore, the regulatory framework can be supplemented by enhanced governance and disclosure standards. The specific changes in regulation will be:
  • The extant NPA classification norm of 180 days will be brought down to 90 days; 
  • The overall role and responsibilities of the Risk Management Committee will be prescribed for these NBFCs; 
  • It is proposed to prescribe that the board will have adequate mix of experience and educational qualification among its members. At least one of the directors shall have experience in retail lending in a bank/ NBFC;
  • Disclosure requirements will be widened by including disclosures on types of exposure, related party transactions, customer complaints, etc.
The Middle Layer shall consist of all non-deposit taking NBFCs classified currently as NBFC-ND-SI and all deposit taking NBFCs. This layer will exclude NBFCs which have been identified to be included in the Upper Layer. Further, NBFC-HFCs, IFCs, IDFs, SPDs and CICs, irrespective of their asset size, will be populated in this layer.
NBFCs featuring in the Middle Layer will be known as NBFC-Middle Layer (NBFC-ML). These NBFCs   shall broadly be subjected to regulatory structure as applicable for NBFC-ND-SI and NBFC-D at present. Further, regulations applicable to NBFC-BL will also become applicable to NBFC-ML, unless there is a conflict or otherwise stated.
At present, NBFCs are on a Basel I type framework (ie, uniform risk weights for counterparties, no capital for market risk or operational risk) and are required to maintain a minimum capital to risk weighted assets ratio (CRAR) of 15 per cent with minimum Tie r I of 10 per cent (12 per cent for NBFCs lending predominantly against gold).
RBI has proposed no changes in capital requirements for NBFC-ML.
At present, separate (but identical) limits are specified for lending and investment exposures on any single borrower (SBL) and a group of connected borrowers (GBL) linked to owned funds. In the case of banks, under the Large Exposure Framework (LEF), the limits are linked to Tier 1 capital. 
The extant credit concentration limits prescribed for NBFCs for their lending and investment can be merged into a single exposure limit of 25 per cent for single borrower and 40 per cent for group of borrowers anchored to the NBFC’s Tier 1 capital. In other words, exposure ceilings will apply to the overall exposure, whether lending or investment. Further, the denominator is proposed to be changed from owned funds to Tier I capital, as is currently applicable for banks.
RBI has proposed to introduce an Internal Capital Adequacy Assessment Process (ICAAP) - As in banks, NBFCs shall be subject to the requirement of having a board approved policy on Internal Capital Adequacy Assessment Process (ICAAP). Internal capital can be assessed based on it by factoring credit, market, operational, and all other residual risks. The objective of ICAAP is to ensure availability of adequate capital to support all risks in the business as also to encourage NBFC to develop and use better risk management techniques for monitoring and managing their risks. This will also include an active dialogue between the Reserve Bank and the NBFCs, wherein the supervisor will have the freedom to review and evaluate the NBFCs’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure compliance with the regulatory capital ratios. Supervisors can take appropriate supervisory action if they are not satisfied with the result of this process, which may include prescription of additional capital to be maintained. This would be of significance as NBFCs have different business models and hence one-size-fits-all approach may not be feasible, and, here, supervisory judgment will play an important role. The paper points out.
RBI has proposed rotation of auditors with a uniform tenure of three consecutive years (subject to the firms satisfying the eligibility norms each year. The SA/firm after completion of continuous audit tenure of three years, shall not be eligible for re-appointment as SA of the same NBFC for a period of six years (two tenures).
An NBFC should have a chief compliance officer (CCO) to oversee regulatory compliance to ensure a compliance culture within the organisation. The compliance function has to be adequately enabled and made sufficiently independent so that it can ensure strict observance of all statutory and regulatory provisions. 
The CCO shall have direct reporting lines to the MD & CEO and/or board/board committee (ACB) of the NBFC. In case the CCO reports to the MD & CEO, the Audit Committee of the board shall meet the CCO quarterly on one-to-one basis, without the presence of the senior management, including MD & CEO. The CCO shall not have any reporting relationship with the business verticals of the NBFC and shall not be given any business targets. Further, the performance appraisal of the CCO shall be reviewed by the Board/ACB.
RBI has proposed that compensation guidelines for NBFCs along the lines of banks can be considered to address issues arising out of excessive risk taking caused by misaligned compensation packages. Further, the compensation policy may also give due consideration to the financial soundness and performance of the NBFC. The guidelines may be suitably calibrated for NBFCs in the Middle Layer by prescribing, at the minimum, a) constitution of a Remuneration Committee, b) principles for fixed/ variable pay structures, and c) malus/ claw back requirements. The Nomination and Remuneration Committee will ensure that there is no conflict of interest in appointment of directors and their independence is not subject to potential threats.
Key managerial personnel (whole time employee in the nature of CEO, CFO, CS and WTD) will not hold any office (including directorships) in any other NBFC-ML or NBFC-UL. In order to ensure that there is no conflict arising out of independent directors being on the board of various NBFCs at the same time, including those of competing NBFCs, it is proposed that an independent director shall not be on the board of more than two NBFCs (NBFC-ML and NBFC-UL) in total. The onus of ensuring that there is no conflict, will lie with the board of the NBFC.
Additional disclosures which are proposed to be made applicable to NBFC-ML are:
  • Corporate governance report like composition and category of directors, relationship between directors, shareholding of non-executive directors, etc;
  • Disclosure on modified (ie, non-clean) opinion expressed by auditors, its impact on various financial items and views of management on audit qualifications;
  • Items of income and expenditure of exceptional nature;
  • Breach in terms of covenants, incidence/s of default; and
  • Divergence in asset classification and provisioning based on inspection findings.
Over and above the current disclosure requirements prescribed for NBFC-ND-SI, there are certain disclosures prescribed for banks, which would be equally relevant for NBFCs in this lay er. Making some of these disclosure requirements applicable to NBFCs would bring greater transparency and at the same time provide a better understanding of the entity to the stakeholders.