NBFCs are now subject to prompt corrective action

By Sawant Singh and Aditya Bhargava, Phoenix Legal

In October 2021, the Reserve Bank of India (RBI) released a scale-based regulatory framework for non-banking financial companies (NBFC) to tackle systemic risks posed by the sector. Continuing its steady march forward in aligning the regulatory frameworks applicable to banks and NBFCs, the RBI issued the prompt corrective action (PCA) framework for NBFCs to enable supervisory intervention on breach of certain risk thresholds. The framework requires NBFCs to initiate and implement remedial measures to restore their financial health in a timely manner. Simultaneously with the scale-based regulatory framework for NBFCs, the PCA framework will become effective from 1 October 2022, and will apply on the basis of the financial position of NBFCs on or after 31 March 2022.

Sawant Singh
Phoenix Legal

The PCA framework applies only to certain categories of NBFCs, such as deposit-taking NBFCs, non-deposit-taking NBFCs in the “middle layers”, “upper layers” and “top layers”, and NBFCs conducting the activities of investment and credit companies, core investment companies (CICs), infrastructure debt funds, infrastructure finance companies, microfinance institutions and factors. NBFCs that are government companies, primary dealers and housing finance companies are exempt from the PCA framework.

The PCA framework bifurcates the risk thresholds for NBFCs other than CICs, and CICs. The risk thresholds are prescribed in respect of the capital adequacy ratio, the tier 1 capital ratio, and the net non-performing assets (NNPA) ratio for NBFCs (other than CICs), and in respect of the adjusted net worth and aggregate risk weighted assets ratio, the leverage ratio and the NNPA ratio for CICs. Such risk thresholds are divided into three levels depending on the severity of non-compliance. For instance, for both NBFCs and CICs, the first level of the risk threshold for the NNPA ratio is between 6% to 9%, the second level is between 9% to 12%, and the third level is more than 12%.

Aditya Bhargava,Phoenix Legal
Aditya Bhargava
Phoenix Legal

PCA will apply to an NBFC on breach of the prescribed risk thresholds, and such NBFCs must take appropriate remedial steps depending on the level of the breach. The PCA framework prescribes certain mandatory actions, as well as certain discretionary actions that may be implemented by the RBI. Mandatory actions following a first-level breach include restrictions on the distribution of dividends and the requirement of its promoters and shareholders to inject equity to reduce the leverage ratio. Further, a CIC is restricted from issuing any guarantees or accepting any other contingent liabilities on behalf of its group companies. If a second level breach occurs, branch expansion will be restricted, and on a third level breach the NBFC must establish appropriate restrictions on capital expenditure, other than for technological upgrading within limits approved by its board of directors, and reduce or restrict its variable operating costs. The RBI may, in its discretion, also take any actions in respect of the NBFC’s business strategy, governance, capital, profitability, or operations, and may increase its supervisory oversight of such NBFC or initiate insolvency and winding-up proceedings.

An NBFC can be placed under the PCA framework following any supervisory assessment made by RBI or on the basis of the financial position in its audited annual financial results. Once an NBFC is placed under PCA, withdrawal of the imposed restrictions will be considered based on the “supervisory comfort” of the RBI, and provided no breach of any risk threshold has occurred in four continuous quarterly financial statements, including one annual audited financial statement.

The PCA framework applies from October 2022, which provides NBFCs with adequate time to address any non-compliance. Unlike the Insolvency and Bankruptcy Code, 2016, which applies to non-NBFCs, the PCA framework does not contain any provision enabling creditors of NBFCs to initiate action. The PCA framework also does not contain any whistleblower-related provisions. The inability of any person other than the RBI to seek corrective actions in respect of NBFCs is holding back the development of NBFCs and their further integration with the financial markets.

Sawant Singh and Aditya Bhargava are partners at Phoenix Legal. Sristi Yadav is a senior associate

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