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11 May 2021
On 22 January 2021 the Reserve Bank of India (RBI) issued a discussion paper which proposes a significant overhaul of its approach to the regulation of non-banking financial companies (NBFCs), commonly referred to as 'shadow banks'. Recent events – in particular, defaults at certain storied NBFC groups and the effect thereof on the sector and financial markets as a whole – have brought the need to further tighten NBFC regulation into sharper focus.
The discussion paper, read in conjunction with a 20 November 2020 RBI working group report,(1) is consistent with the regulator's previous statements on the subject – namely, that larger NBFCs should either convert into banks or, in the absence of such conversion, that the regulatory arbitrage between larger NBFCs and banks should be bridged. The discussion paper is well thought out in its recognition of the fact that uniform tighter regulation for all NBFCs, or even all NBFCs currently classified as systemically important, may be disproportionate and impractical. Accordingly, the discussion paper tries to further nuance the regulatory requirements using a scale-based framework. The scale-based approach seeks to match the level of regulation to the perceived level of significant systemic risk spillovers which apply to a particular NBFC or class of NBFCs.
This article provides a brief snapshot of the proposed regulation framework and articulates certain practical issues that may arise for NBFCs regarding the proposed regulations.
The discussion paper proposes the following NBFC classes, each of which have a different regulatory framework:
Figure 1: proposed NBFC classes
It is proposed that existing NBFCs will be categorised into the various layers based on their size, scale of significance and nature of activities. The determination of which NBFCs to classify as NBFC-ULs will be driven by a parametric analysis of both quantitative and qualitative factors. The key regulations proposed for each layer are set out below.
Increase in net owned fund (NOF) requirements from Rs20 million to Rs200 million.
Harmonisation of non-performing asset classification norms with non-deposit-taking NBFCs (from 180 days to 90 days).
Stipulation of improved governance standards and higher disclosure requirements.
Merging of applicable credit concentration norms into a single exposure limit (as opposed to different limits for lending and investment) and calculation of exposure norms with reference to Tier 1 capital rather than owned funds.
Introduction of an internal capital adequacy assessment process (ICAAP), which would require NBFC-MLs to assess the adequacy of capital in light of an analysis of the various risks associated with the business. Authority is also granted to supervisors to review such process and take necessary supervisory action (including providing for additional capital).
Requirement to rotate audit firms after completion of a continuous audit tenor of three years.
Requirement to appoint a chief compliance officer.
Requirement to ensure that key NBFC-ML managerial personnel do not hold office in any other NBFC-ML or NBFC-UL and that no person is an independent director on the boards of more than two NBFC-MLs or NBFC-ULs.
Requirement to implement a core banking solution for NBFC-MLs with 10 or more branches.
Extension of applicability of all regulations that apply to NBFC-MLs to NBFC-ULs.
Applicability of enhanced capital requirements in line with Basel III requirements regarding the maintenance of Common Equity Tier 1 of 9%.
Alignment of standard asset provisioning requirements with those that apply to banks.
Applicability of large exposure frameworks for banks to NBFC-ULs (with modifications).
Requirement to maintain a diffused ownership structure and mandatory listing requirement.
Requirement of higher capital charge, including capital conservation buffers.
Introduction of enhanced and more intensive supervisory engagement.
Enhanced NOFs for NBFC-BLs
The discussion paper requires all NBFC-BLs to maintain NOFs of at least Rs200 million, instead of the existing requirement of Rs20 million. A 10-fold increase in the minimum NOF requirement could affect the continuation of smaller NBFCs and specialised NBFCs (eg, peer-to-peer NBFCs and account aggregator NBFCs), which are inherently not capital intensive.
However, a possible benefit of this requirement is the weeding out of shell NBFCs, which – despite having a registration certificate – are thinly capitalised and undertake little or no business activity as an NBFC.
Introduction of ICAAP for NBFC-MLs and NBFC-ULs
The introduction of an ICAAP could result in NBFCs having to maintain regulatory capital beyond the RBI minimum capital requirements to factor in the various risks identified. This could be burdensome for the sector, especially considering that NBFCs sometimes face challenges raising capital in normal times, let alone in turbulent circumstances with the added effect of the COVID-19 pandemic on asset quality.
Further, given that no objective criteria exist and that the supervision of ICAAP implementation would be scrutinised based on the subjective satisfaction of the relevant supervisory officer, NBFCs may have to carry out additional capital basis supervisory reviews.
Requirement of auditor rotation every three years for NBFC-MLs and NBFC-ULs
The discussion paper requires NBFCs to comply with additional rules regarding auditor rotation (ie, rotation every three years) that effectively impose a stricter standard than that of the Companies Act 2013, which requires rotation (if the auditor is an audit firm) after two terms of five years. The corporate governance rules which apply to systemically important NBFCs(2) require such NBFCs to rotate the partner of the chartered accountant firm which conducts the audit every three years, which arguably already addresses the proposed requirement's objective.
Given the differentiated business model of NBFCs, demand already exceeds supply for audit firms, particularly for individuals within audit firms who have the necessary sectoral expertise and knowledge. Therefore, this requirement could potentially exacerbate the situation and make it challenging for NBFCs to identify and appoint audit firms.
The proposal that an independent director cannot be on the boards of more than two NBFCs, while laudable in its objective, could again pose practical challenges by reducing the pool of candidates who have the sectoral know-how and ability. This could lead to NBFCs having to engage independent directors who do not have such know-how and may not be equipped to ask the right questions and perform their role effectively, which would be counterintuitive. Accordingly, this proposal may be reconsidered.
Requirement for mandatory listing of NBFC-ULs
Companies usually evaluate and proceed with an initial public offering (IPO) when the underlying business has reached optimum levels of volume and profitability. A mandatory requirement for NBFC-ULs to list their equity shares based on an ad hoc timeline – similar to the requirement imposed on banks at the time of licensing – could result in IPOs being required during inopportune times, thus potentially losing opportunities to realise maximum value for all stakeholders. Given that a parallel path exists for large NBFCs to potentially convert into banks, this proposal may be revisited and restricted to only those NBFCs which propose to convert to banks.
Diffused ownership structure
The discussion paper requires NBFC-ULs and NBFC-MLs to maintain a diffused ownership structure. While similar requirements apply to banks, challenges may arise when transplanting the same requirement to the NBFC sector for the following reasons:
The discussion paper's key objective – particularly in the context of NBFC-ULs – is to eliminate or significantly reduce the arbitrage between banks and NBFCs. Banks, as part of their business, enjoy two key advantages compared with NBFCs – namely, the ability to:
Only deposit-taking NBFCs may accept deposits from the public; all other NBFCs depend purely on institutional borrowing. Therefore, the imposition of regulatory requirements on NBFCs akin to banks without extending benefits to NBFCs similar to those that are available to banks is an area which may be worth reconsidering. Similarly, the discussion paper makes no distinction between deposit-taking and non-deposit-taking NBFCs and does not list this as a criterion to be specifically considered for classifying an NBFC as an NBFC-UL. Given that retail deposits, by their very nature, increase the systemic risk of an NBFC failing, this factor should be given due weight as part of the parametric analysis for classifying NBFCs as NBFC-ULs.
Overall, the discussion paper is a step in the right direction; it is well reasoned and articulated. However, certain areas may be worth considering further. The revised framework set out in the discussion paper should also be synchronised with a parallel framework that may be released based on the RBI working group report, such that NBFCs – especially those that may be classified as NBFC-ULs or top-layer NBFCs – can consider the alternative pathways that are available to them holistically.
For further information on this topic please contact Gautam Ganjawala or Karthik Mudaliar at AZB & Partners by telephone (+91 22 4072 9999) or email (firstname.lastname@example.org or email@example.com). The AZB & Partners website can be accessed at www.azbpartners.com.
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