Proposed scale based governance frameworks for NBFCs

By Sawant Singh and Aditya Bhargava, Phoenix Legal
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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 on systemic risks they pose. The ongoing liquidity crisis and the covid-19 pandemic has brought into focus the need for an updated governance framework for NBFCs. The 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.

Sawant Singh,Phoenix Legal
Sawant Singh
Partner
Phoenix-Legal

Compared to shadow banks elsewhere, NBFCs are subject to greater regulation by the RBI. However, this is light touch regulation as compared to 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”.

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 (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.

Base layer NBFCs (NBFCs-BL) which are unlikely to pose systemic risk; middle layer NBFCs (NBFCs-ML) which may pose systemic risks and require stricter regulation; upper layer NBFCs (NBFCs-UL) which have greater potential to pose systemic risks and impact financial stability, and top layer NBFCs which represent the greatest risk. Each layer will be separately regulated, with NBFCs-BL the least regulated, and NBFCs-UL the most.

Non-systemically important, non-deposit taking NBFCs (with an asset size of 5 billion 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 categorization as systemically important NBFCs.

Aditya Bhargava,Phoenix Legal
Aditya Bhargava
Partner
Phoenix Legal

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 categorization 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 fulfills the NBFC-UL criteria after such categorization.

The RBI may cherry-pick certain NBFCs-UL for classification as top layer NBFCs with higher regulation and supervision. The RBI may thus create a category equivalent to domestic systemically important banks (DSIB), 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.

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 recognizes 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.

Sawant Singh and Aditya Bhargava are partners at Phoenix Legal. Sristi Yadav, an associate, also contributed to this article.

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