India: proposed scale-based governance frameworks for NBFCs

Introduction
Classification of NBFCs
Regulation of NBFCs
Comment


Introduction

Non-banking financial companies (NBFCs) have grown rapidly, and are increasingly interconnected to capital markets and other components of the financial system. The dominance of NBFCs in the fintech space and the reliance that retail users place on payments systems that NBFCs manage and operate has led to increasing concern about the systemic risks they pose. The ongoing liquidity crisis and the covid-19 pandemic have brought into focus the need for an updated governance framework for NBFCs. The Reserve Bank of India (RBI) saw "a need to review the regulatory framework in line with the changing risk profile of NBFCs" and issued a discussion paper for feedback.

Compared to shadow banks elsewhere, NBFCs are subject to greater regulation by the RBI. However, this is light touch regulation in contrast with banks. The discussion paper notes that the prevailing regulatory arbitrage favouring NBFCs is "by design rather than by default" to provide them with operational flexibility and to assist them to "develop sectoral and geographical expertise, extending variety and ease of access of financial services".

Classification of NBFCs

The current framework classifies NBFCs on the basis of asset size and ability to take deposits. Systemically important NBFCs (NBFCs with assets greater than 5 billion rupees (US$68.6 million)), and deposit-accepting NBFCs are more rigorously regulated than other NBFCs. The discussion paper proposes a pyramidical framework "anchored on proportionality", of four layers:

  • the base-layer NBFCs (NBFCs-BL), which are unlikely to pose systemic risk;
  • the middle-layer NBFCs (NBFCs-ML), which may pose systemic risks and require stricter regulation;
  • the upper-layer NBFCs (NBFCs-UL), which have greater potential to pose systemic risks and impact financial stability; and
  • the top-layer NBFCs, which represent the greatest risk.

Each layer will be separately regulated, with NBFCs-BL being the least regulated, and NBFCs-UL being the most regulated.

Non-systemically important, non-deposit-taking NBFCs (with an asset size of 5 billion rupees or less) will be classified as NBFCs-BL; systemically important non-deposit-taking NBFCs, deposit taking NBFCs, housing finance companies and core investment companies will be classified as NBFCs-ML, and NBFCs which are identified as systemically significant based on criteria such as size, leverage, interconnectedness, complexity and nature of activity will be classified as NBFCs-UL. The RBI may adjust the thresholds for categorisation as systemically important NBFCs.

Regulation of NBFCs

NBFCs-BL will be regulated similarly to the current framework for non-deposit-taking, non-systemically important NBFCs. NBFCs-ML will be regulated similarly to the current framework for non-deposit-taking systemically important NBFCs and deposit-taking NBFCs. These frameworks will incorporate enhanced thresholds, governance and disclosure standards. The RBI will prescribe directions to counter systemic risks posed by NBFCs-ML, including credit concentration, internal capital adequacy assessment, corporate governance and restrictions on lending.

NBFCs-UL will be regulated in a manner similar to banks. The enhanced framework will provide for higher standards on capital requirements, credit concentration and corporate governance. An NBFC-UL will be allowed a period of eight weeks following categorisation as an NBFC-UL to plan for the implementation and adoption of the enhanced regulatory framework. Once identified as NBFC-UL, it will be subject to the enhanced regulatory framework for at least four years, irrespective of whether it fulfils the NBFC-UL criteria after such categorisation.

The RBI may cherry-pick certain NBFCs-UL – such as those with significant cross-linkages across payments and lending streams with other parts of the economy and whose failure could cause a "domino effect" – for classification as top layer NBFCs with higher regulation and supervision. The RBI may thus create a category equivalent to domestic systemically important banks, which are subject to greater regulation, including provisioning. This may align regulatory frameworks for banks and NBFCs on the basis of objective criteria such as size, interconnectedness and impact on the financial system.

Comment

While the light touch regulatory framework created some regulatory arbitrage and allowed NBFCs to grow rapidly, the introduction of a scale-based regulatory framework according to systemic risk recognises the maturity of the NBFC sector and its importance to the financial system. This is a move in the right direction, and if well implemented, will foster rather than stifle growth.

For further information on this topic please contact Sawant Singh, Aditya Bhargava or Sristi Yadav at Phoenix Legal by telephone (+91 22 4340 8500) or email ([email protected], [email protected] or [email protected]). The Phoenix Legal website can be accessed at www.phoenixlegal.in.

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