Review of NBFC Categorisation by RBI: Potential Impact and Significance

Review of NBFC Categorisation by RBI: Potential Impact and Significance

Subject: Economy

Section: Monetary Policy

The Reserve Bank of India (RBI) is set to review the categorisation of Non-Banking Finance Companies (NBFCs) in 2024, nearly two years after introducing a revised regulatory framework.

This review has become necessary due to the growth of NBFCs, changes in their business models, and their evolving operations since the implementation of scale-based regulations.

Purpose of the Review:

• Evaluation of NBFC Growth: The review aims to assess the growth trajectory of NBFCs, especially those backed by large corporate houses and conglomerates.
• Adaptation to Changes: Given the significant changes in NBFC operations, the review seeks to ensure that regulatory categorisations align with current market dynamics.

Potential Implications:

1. Focus on Large NBFCs: The review might specifically focus on NBFCs backed by large corporate entities, considering them for potential re-categorisation.
2. Precursor to Bank Licences: There is speculation that the review could serve as a preliminary step towards granting bank licences to select NBFCs.

Potential Candidates for Upgradation:

• NBFCs such as Tata Capital, M&M Finance, L&T Finance, and Bajaj Finance are among the names speculated for upgradation to the top layer.
• Currently, 16 NBFCs are in the upper layer, with nine of them led by large business houses.

Basis of Upgradation:

• Nuanced Approach: The RBI is expected to adopt a nuanced approach, considering various parameters for upgradation.
• Key Parameters: Factors such as customer grievance handling, technology capabilities, asset quality, in-house operations, management quality, asset-liability management, and liability diversification may be assessed.
• Case-by-Case Review: The review process is likely to be case-specific rather than a blanket approach, evaluating each NBFC individually.

Significance of the Review:

• Alignment with Bank-like Operations: The review aims to address the perception among some NBFCs in the upper layer that they already function like banks.
• Regulatory Clarity: RBI Deputy Governor highlighted the existing differences between regulations for banks and NBFCs, suggesting the need for clarity in the categorization.

Current Regulatory Framework:

• Scale-Based Regulations: Implemented in October 2021 and fully enforced a year later.
• Four Layers: The regulatory framework includes four layers—base, middle, upper, and top.
• Asset Composition: As of September 30, 2023, NBFCs in the base, middle, and upper layers constituted 6%, 71%, and 23% of total NBFC assets, respectively.
• No NBFC in Top Layer: Presently, no NBFC is listed in the top layer of the regulatory framework.

The review of NBFC categorisation by the RBI signals a proactive approach to adapt regulatory frameworks to the evolving financial landscape.

By evaluating key parameters and potentially considering certain NBFCs for upgradation, the RBI aims to ensure a more effective and aligned regulatory environment for the non-banking finance sector in India. This move also underscores the RBI’s focus on maintaining the stability and integrity of the financial system amid changing market dynamics.

Non-Banking Financial Company (NBFC): Overview and Features

An NBFC is a company registered under the Companies Act, 1956 or 2013, engaged primarily in financial activities such as:

• Providing loans and advances
• Acquiring shares, stocks, bonds, debentures, and other securities issued by the government, local authorities, or other entities
• Engaging in leasing and hire-purchase activities
• Conducting insurance and chit fund businesses

Exclusions:

• An institution is not considered an NBFC if its primary business involves:
  • Agricultural activities
  • Industrial activities
  • Purchase or sale of goods (other than securities)
  • Providing specific services
  • Sale, purchase, or construction of immovable property

Types of NBFCs:

1. Asset Finance Company (AFC):
   • Mainly finances the purchase of machinery, equipment, and other assets
   • Leasing and hire-purchase activities are common
2. Investment Company (IC):
   • Primarily deals with acquiring securities
   • Invests in shares, stocks, bonds, debentures, etc.
3. Loan Company (LC):
   • Focuses on providing loans and advances
   • Often provides personal loans, business loans, and other forms of credit
4. Infrastructure Finance Company (IFC):
   • Specializes in financing infrastructure projects
   • Funds construction of roads, bridges, power plants, etc.
5. Systematically Important Core Investment Company (CIC-ND-SI):
   • A category of NBFCs that plays a crucial role in the financial system
   • Has a significant impact on the financial stability of the economy

Features of NBFCs:

1. No Demand Deposits:
   • Unlike banks, NBFCs cannot accept demand deposits from the public.
   • Demand deposits refer to funds that customers can withdraw on demand, like savings and current accounts.
2. Non-Participation in Payment System:
   • NBFCs are not part of the payment and settlement system.
   • They cannot issue checks drawn on themselves, unlike banks that facilitate check-based transactions.
3. No Deposit Insurance:
   • Depositors in NBFCs do not have the benefit of deposit insurance provided by institutions like the Deposit Insurance and Credit Guarantee Corporation (DICGC).
   • Deposit insurance protects depositors’ funds up to a certain limit in case of the institution’s failure.
4. Focus on Financial Services:
   • NBFCs primarily focus on providing financial services such as lending, leasing, investment, and insurance.
   • They often cater to specific segments of the market, offering tailored financial products.
5. Regulated by RBI:
   • The Reserve Bank of India (RBI) regulates and supervises NBFCs to ensure stability in the financial system.
   • NBFCs must comply with regulatory guidelines, capital adequacy norms, and reporting requirements set by the RBI.
6. Diverse Business Models:
   • NBFCs can have diverse business models, ranging from consumer finance to infrastructure financing.
   • They often fill gaps in credit availability, especially for small and medium-sized enterprises (SMEs) and individuals.

Classification of Non-Banking Financial Companies (NBFCs)

The regulatory and supervisory framework for Non-Banking Financial Companies (NBFCs) is based on a four-tiered structure. This classification aims to differentiate between NBFCs based on their systemic importance, potential risks, and impact on financial stability.

1. Base Layer: NBFC-Base Layer (NBFC-BL)

• NBFCs in the lower layer fall under the category of NBFC-Base Layer (NBFC-BL).
• Least regulatory intervention is warranted for NBFCs in this layer.
• These NBFCs are considered to have lower systemic risks and minimal impact on financial stability.

2. Middle Layer: NBFC-Middle Layer (NBFC-ML)

• NBFCs in the middle layer are designated as NBFC-Middle Layer (NBFC-ML).
• The regulatory regime for this layer is stricter compared to the base layer.
• Measures can be implemented to address adverse regulatory arbitrage compared to banks.
• This layer aims to mitigate systemic risk spill-overs from NBFCs falling within this category.

3. Upper Layer: NBFC-Upper Layer (NBFC-UL)

• NBFCs in the Upper Layer are known as the NBFC-Upper Layer (NBFC-UL) and will have a new regulatory superstructure.
• This layer includes NBFCs with a large potential for systemic risks and the ability to impact financial stability.
• The regulatory framework for NBFCs in this layer will be more akin to that of banks, with suitable modifications.
• NBFCs identified in the Upper Layer need to meet specific criteria to remain classified as such.
  • If an NBFC-UL does not meet the classification criteria for four consecutive years, it will move out of the enhanced regulatory framework.

4. Top Layer:

• Ideally, the Top Layer is supposed to remain empty.
• This layer serves as a buffer, where certain NBFCs from the Upper Layer can be placed if they pose extreme risks.
• If NBFCs in the Upper Layer are deemed to pose significant risks according to supervisory judgment, they can be subject to higher and tailored regulatory requirements.
• This Top Layer of the classification is intended to be a contingency for extreme risk scenarios and not a standard classification for NBFCs.

The four-tiered classification of NBFCs aims to create a structured and responsive regulatory framework that aligns with the varying degrees of systemic importance and risk posed by these financial institutions.