Explained: What scale-based regulation means for NBFCs

The RBI circular is applicable to all commercial banks other than regional rural banks, local area banks and payments banks.

The Reserve Bank of India issued guidelines on April 19 for loans and advances by non-banking financial companies and the disclosures they are required to make under what it called a scale-based regulatory framework.

The RBI said the aggregate exposure of an upper layer NBFC, which is in the top category, to any entity must not exceed 20 percent of its capital base, although this limit can be enhanced to 25 percent with board approval. The aggregate exposure to a group of connected entities will be limited to 25 percent of the capital base for all upper layer NBFCs.

For infrastructure finance companies, the aggregate limit will be 30 percent to a single entity and 35 percent for a group of connected entities.

These norms would apply to NBFCs in the middle and upper regulatory layers. While the middle layer would include all deposit-taking and non-deposit taking NBFCs with assets of Rs 1,000 crore and above, the upper layer would comprise those identified by the RBI for enhanced regulatory requirement.

“These disclosures are in addition to and not in substitution of the disclosure requirements specified under other laws, regulations, or accounting and financial reporting standards,” the RBI said in a statement.

Why scale-based regulation has been introduced

The RBI aims to tighten the regulatory noose on NBFCs, especially after the systemic risks posed by the fallout of the Infrastructure Leasing & Financial Services and Dewan Housing Finance Corporation Ltd. crises.

“In light of these defaults and bankruptcy, the RBI issued these guidelines,” said Karamveer Singh Dhillon, cofounder of Perpetuity Capital, an NBFC.

According to the RBI, the NBFC sector has undergone considerable evolution in terms of size, complexity, and interconnectedness within the financial sector over the years. Many entities have grown and become systemically significant and hence there is a need to align the regulatory framework for NBFCs keeping in view their changing risk profile, the central bank said in October last year.

What will be the impact of scale-based regulation on NBFCs?

NBFCs will be classified into four categories – base, middle, upper and top layers. The regulatory structure for NBFCs comprises four layers based on their size, activity, and perceived riskiness, the RBI said.

The segregation is based on the liabilities and assets an NBFC has and the kind of activities it has been engaged in, experts said. The RBI’s main objective is to preserve the sector and ensure there is no systemic risk to banks, which have exposure to NBFCs.

“These regulations will reduce arbitrage with banking institutions,” said HP Singh, the chairman and managing director of Satin Creditcare Network. “The RBI has kept into account that various smaller asset-sized NBFCs cater to the low-income people and ensured that the base layer witnesses less stress so as to continue effectively funding the lower-class economy.”

The experts said raising the standards of overall risk assessment will negatively affect the functioning of the upper layer. The primary focus of the scale-based regulation is to ensure that NBFCs are well-funded and effectively managed.

How will it affect customers?

The regulations are likely to bring better customer service, although they may have to fulfil some extra requirements.

“With the tightening of norms, more disclosures may be needed from borrowers. The RBI is trying to inculcate the practice of responsible borrowing and lending,” said Dhillon of Perpetuity Capital.

What are the risk factors addressed?

As experts pointed out, one of the major risks of NBFCs was their level of non-performing assets or bad loans. Unlike in banks, NBFC customers get a longer period of time before loan defaults were classified as NPAs.

“Regardless of the layer they are in, the asset norms will be applicable to NBFCs as well. Asset classification norms will also be same for NBFCs like that of banks,” said Dhillon.

What does it mean for the NBFC sector?

Given the stringent regulations, microfinance institutions belonging to the category of NBFCs may face some heat.

“With the changing risk factors, there is a huge possibility of a collapse within the sector. With a fall within this sector, there would be a potential crash in the economy, and it will negatively harm the trust of the public within the microfinance sector,” said Singh.

Middle, upper, and top layer NBFCs will experience major changes as the regulations are implemented to better manage risks within the sector.