RBI discussion paper proposes four-tier structure for NBFC regulations

A host of parameters such as size, leverage, interconnectedness, substitutability, complexity, nature of activity of the NBFC, etc. will be considered to identify such NBFCs who can be shifted to the top layer
The Reserve Bank of India (RBI) on Friday proposed to introduce a scale-based regulatory framework for non-banking financial companies (NBFC) to segregate larger entities and expose them to a stricter set of “bank-like” rules. This is aimed at protecting financial stability while ensuring that smaller NBFCs continue to enjoy light-touch regulations and grow with ease.

In a discussion paper released on its website, the central bank suggested a four-tier pyramid structure for the sector. There will be a base layer (NBFC-BL), which will have NBFCs with an asset size of up to Rs 1,000 crore, accommodating more than 95 per cent of the non-deposit taking shadow lenders. This layer will continue to enjoy regulatory arbitrage.

Above this base layer will sit a middle layer (NBFC-ML), where regulations will be stricter than now. On top of that, in the upper layer (NBFC-UL), 25-30 NBFCs can be accommodated. They will have bank-like regulations as they have swelled in their sizes and become the largest set of borrowers from the financial system with deep interconnectedness, which can threaten financial stability. The layer will be populated by NBFCs that have large potential for a systemic spillover of risks and have the ability to impact financial stability. 

“There is no parallel for this layer at present, as this will be a new layer for regulation. The regulatory framework for NBFCs falling in this layer will be bank-like, albeit with suitable and appropriate modifications,” the discussion paper said. 

At the very top, there will be a few NBFCs that will be subjected to the regulations proposed specifically for them. The top layer will essentially be those NBFCs in the upper layer that can pose extreme risks. Thus, they must be put to significantly higher and bespoke regulatory/supervisory requirements. 

The base layer will comprise non-deposit taking NBFCs, while the middle layer will be populated by non-deposit taking but systemically important NBFCs, deposit taking NBFCs, housing finance companies, and others. The regulatory regime for this layer shall be stricter compared to the base layer, and adverse regulatory arbitrage vis-à-vis banks can be addressed for NBFCs falling in this layer in order to reduce systemic risk spillovers, where required, the paper said. 

Considering that the RBI closely monitors the top 50 NBFCs, the upper and top layers will be scrutinised in a granular manner as these NBFCs alone can destabilise the entire financial system, as was seen when IL&FS started defaulting in 2018. 

A host of parameters such as size, leverage, interconnectedness, substitutability, complexity, nature of activity of the NBFC, etc, will be considered to identify NBFCs that can be shifted to the top layer. 

According to the paper, the top 10 NBFCs, in terms of their asset size, will anyway reside in the upper layer, irrespective of any other factor. A total of not more than 25 to 30 NBFCs will occupy this layer. All the regulations applicable to the middle-layer NBFCs will be applicable to the upper layer also. The regulations of the upper-layer NBFCs will be tuned on similar lines as those for banks, “though providing for the unique business model of NBFCs as also preserving flexibility of their operations”. 

 These upper-layer NBFCS will have to maintain 9 per cent tier-1 capital, and will have to maintain cash reserve requirements as well as other leverage requirements.  

Also, the large exposure framework that is applicable to banks, such as 25 per cent of tier 1 capital for single borrowers and 40 per cent of the capital for group borrowers must be introduced for the upper-layer NBFCs. There will be suitable transition time for the implementation for the existing NBFCs.

When it comes to corporate governance of these NBFCs, the paper says they need to maintain highest corporate governance standards and a diffused ownership structure to minimise the possibility of abuse of dominance. Also, they should fix sensitive sector exposures (SSE) ceilings based on internal board approved policy. 

“Apart from proposed framework for SSE suggested for NBFCs in this layer, the question considered is whether limits should be placed also on exposure to other specific sectors of the economy. Considering the unique nature of NBFCs, it will be incumbent upon the board of NBFCs to determine internal exposure limits on other important sectors,” the paper said. 

As far as the top layer is concerned, it is supposed to remain empty, but the RBI can populate it with upper-layer NBFCs if they are of the view that there has been unsustainable increase in the systemic risk spillovers from specific NBFCs in the upper layer. 

“NBFCs in this layer will be subject to higher capital charge, including capital conservation buffers. There will be enhanced and more intensive supervisory engagement with these NBFCs. This will offer a framework for any NBFC to grow in size and complexity, provided it is able to build up capital commensurate with the additional risks and subject itself to intense supervisory scrutiny”, it said. 

In other highlights, the discussion paper proposed that NBFCs with 10 or more branches should mandatorily be required to adopt core banking solution (CBS). It sought to increase the threshold for NBFCs to get classified systemically important from Rs 500 crore to Rs 1,000 crore. Out of the 9,425 non-deposit taking NBFCs, 9,133 NBFCs have asset size of less than Rs 500 crore. Hence, if the current threshold of systemic significance is raised to Rs 1,000 crore, the number of NBFCs in this layer would go up by 76 to 9,209, which would populate the base layer, the paper said. While this layer would continue to enjoy easy regulations, the NPA recognition norm would be reduced to 90 days from 180 days now.  

While the paper kept the capital adequacy ratio unchanged at 15 per cent, the paper proposed bank-like single exposure norms for NBFCs too in their lending operations. So, the paper said there should be single exposure limit of 25 per cent for single borrowers and 40 per cent for a group of borrowers anchored to the NBFC’s Tier 1 capital. 

The paper proposed that in the middle layer, statutory auditors can be kept for three years before they are rotated with other auditors. The same auditor cannot come back from another six years after their three-year contract ends. The NBFCs in this category have to appoint a functionally independent chief compliance officer. 

The compensation packages of the management should be like that of private banks where excessive risk taking is discouraged. 

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