RBI ending the party for dividends

By Sawant Singh and Aditya Bhargava, Phoenix Legal

Acting on its deserved reputation for hawk-eyed vigilance, in April 2020, the Reserve Bank of India (RBI) directed banks to refrain from making dividend payouts for the financial year ending 31 March 2020. This had the effect of preserving capital buffers in testing times when it was feared that banks might be saddled with significant non-performing assets. While the economy and the financial markets appear to be recovering, consistent with its orthodoxy, the RBI on 4 December directed banks to not make dividend payouts for the financial year 2020 to strengthen their balance sheets and “to conserve capital to support the economy and absorb losses”.

Sawant Singh,Phoenix Legal
Sawant Singh

In this vein and recognizing the growing significance of non-banking financial companies (NBFCs) and their “interconnectedness” with other parts of the financial system, in its 4 December statement, the RBI announced that it would prescribe directions for dividend distribution by NBFCs. The statement proposed that different “categories of NBFCs would be allowed to declare a dividend as per a matrix of parameters, subject to a set of generic conditions”. The RBI issued draft directions for the declaration of dividends by NBFCs on 9 December with the aim to “infuse greater transparency and uniformity”. The draft directions have been placed on the RBI’s website for stakeholder feedback. The draft directions also prescribe that these would apply to the dividends to be declared for the financial year 2020.

The tone of the draft directions emphasizes consistency in governance and appears to reward discipline over a continuous period of time. Deposit taking NBFCs and systemically important non-deposit taking NBFCs must have a capital adequacy ratio of 15% over a period of three years. Non systemically important non-deposit taking NBFCs must have a leverage of below seven times for the previous three years including the year in which dividends are proposed to be declared. Net non-performing assets should be less than 6% for the previous three years including the year in which dividends are proposed to be declared. The draft directions require NBFCs to pay dividends only out of the current year’s profit. It is possible that the RBI intended that NBFCs should declare dividends only out of actual receipts rather than unrealized profits. This provision could be further clarified in the final form of the directions.

Aditya Bhargava,Phoenix Legal
Aditya Bhargava
Phoenix Legal

The draft directions prescribe the manner of calculation of dividends by various categories of NBFCs. For any year for which dividends are proposed to be declared, an NBFC’s dividend payout ratio must be determined as a percentage of the dividend payable in a year relative to the NBFC’s net profit during the year. In calculating dividends for a particular period, an NBFC would need to exclude “any extraordinary profits/income”. Financial statements of the year for which dividends are proposed to be declared should be free of any auditors’ qualifications that could have an adverse impact on profit, failing which the net profit calculated to determine the dividend would have to be adjusted suitably. From a monitoring perspective, NBFCs would have to submit detailed reports in a prescribed format to the RBI within 15 days of the declaration of dividends.

To strengthen governance, the draft directions prescribe that a copy of the directions should be placed before its board, and that the board should take into account the interests of all stakeholders while considering proposals to pay dividends. This appears to be one of the first instances of the RBI hinting at a move towards the stakeholder-model of governance rather than the hyper-capitalist shareholder model of governance, which sometimes prioritizes profits over long-term stability. While considering proposals to pay dividends, an NBFC’s board of directors would need to consider supervisory findings made by the RBI on divergence in the identification of non-performing assets and the shortfall in provisioning, auditors’ qualifications and the NBFC’s long-term growth plans.

The draft directions are a step in the right direction. This does not appear to be an isolated step and the RBI’s statement on regulatory policies proposes revisiting the regulatory framework for NBFCs to make oversight proportional to the risk profile relative to the financial system. The importance of NBFCs to the financial system has gradually increased, and NBFCs are critical to providing access to financial services in areas unreached by banks. These moves towards systematizing governance for NBFCs are crucial to enable their growth and to minimize regulatory arbitrage.

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

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