In comparison to banks, non-banking financial companies (“NBFCs“) have always enjoyed higher net interest margins (“NIM“) which is the amount of money that it is earning in interest on loans compared to the amount it is paying in interest on deposits. One of the reasons for this is that banks must comply with higher capital requirements in line with Basel III norms, which in turn increases the cost of lending. NIM is an important indicator of profitability and growth. However, NBFCs have also suffered from higher non-performing assets (“NPA“) as compared to banks because they tend to lend to lower income segments and the informal sector, while banks do not prefer lending to such segments given that this increases the chances of a default. Today, as NIM drops and NPA classification norms for NBFCs are tightened, NBFCs will require a higher level of provisioning even though NBFCs in general are not well capitalized. NBFCs have also found it difficult to raise capital and subscription to their debt instruments has not seen much enthusiasm in the recent years. As NBFCs are now required to maintain a certain percentage of liquid assets and higher levels of capital, it is unlikely that they will be in a position to operate at the same level of profitability as they have in the past. The shadow banks who came under immense scrutiny since the collapse of IL&FS and DHFL, will now have to adhere to certain measures on the same lines as are being observed by banks. A recent introduction of a slew of norms by the RBI is a clear indication that the regulatory freedom enjoyed by NBFCs is now a thing of the past.
RBI set the ball rolling in a bid to tighten its grip over NBFCs in 2019 by introducing the requirement of a Liquidity Coverage Ratio (LCR). In October, 2021 and December, 2021, the RBI introduced the Scale Based Regulation (SBR) and Prompt Corrective Action (PCA) Framework for NBFCs, respectively. Both these regulations are to come into effect from October 1, 2022. RBI further issued two circulars on April 19, 2022, (i) to quantify the restrictions placed on lending by NBFCs and (ii) to provide adequate disclosures in the financial statements of NBFCs, as contemplated in the SBR. These circulars shall come into effect from October 1, 2022 and March 31, 2023 respectively.
RBI has been taking steps to bring NBFCs on a par with banks such as:
LCR1:All non-deposit taking NBFCs with asset size of ₹ 5,000 crore and above, and all deposit taking NBFCs irrespective of their asset size, shall maintain a liquidity buffer in terms of LCR. LCR refers to a requirement whereby NBFCs maintain a proportion of high-quality liquid assets that is adequate to meet the net cash outflows for a period of 30 calendar days. This measure ensures that in case the markets face a liquidity crisis then the NBFC is in a position to meet its short-term financial obligations. The moot point of introducing LCR appears to keep a check on the asset liability mismatch, as it was due to the borrowing undertaken by NBFCs for short term and lending by the NBFCs for long term which created a liquidity crunch. Defaults in repayment of bank loans, term and short-term deposits were inevitable as was the case with IL&FS . LCR is a step in the right direction towards NBFCs maintaining liquid funds which would be required for meeting its short-term financial obligations.
SBR2: The earlier classification of NBFCs into deposit taking and non-deposit taking has now been replaced with (a) NBFC Base Layer (NBFC- BL), (b) NBFC Middle Layer (NBFC – ML), (c) NBFC Upper Layer (NBFC- UL). There is also an NBFC Top Layer (NBFC- TL) which is expected to remain empty until the RBI feels it necessary to move NBFCs from the NBFC-UL. The intention behind this four-tier classification is to inter alia ensure that NBFCs not taking public funds will remain in the base layer since that warrants a lesser degree of scrutiny. All the deposit taking NBFCs and non-deposit taking NBFCs with an asset size exceeding Rs. 1000 crores have been placed in the middle layer which ensures more focus on those entities which are more likely to fail and, on whose failure, there would be a significant impact on the functioning of financial institutions. The upper layer is intended to be populated with those entities which in the opinion of the RBI require intense scrutiny.
Prior to the introduction of SBR, a loan account was classified as an NPA if the interest or principal remained unpaid for a period of 180 days. This NPA classification norm has been now changed and shall be gradually reduced to 90 days instead which is again in line with recognition of NPAs by banks.
Net owned fund requirements for certain NBFCs (investment and credit company, micro finance institution and factors) has been increased to Rs.10,00,00,000/- on a gradual basis. The increase in net owned fund requirements will firstly ensure that NBFCs have adequate capital to absorb NPAs and secondly will serve as an entry barrier to ensure lending is carried out only by serious and well capitalized NBFCs. This in turn would reduce the chances of failure of an NBFC.
Further, loans exceeding Rs.5,00,00,000/- cannot be granted by a NBFC-ML and NBFC-UL to their directors, relatives of the directors or any firm/company in which any of its director or their relative is interested, unless the same has been sanctioned by the board of directors of the NBFC. This restriction is similar to that under Section 20 of the Banking Regulation Act, 1949 which prohibits banks from advancing loans to directors or any firm in which any of its directors is interested.
PCA3: RBI has introduced PCA for NBFCs, which has been place since 2002 for Scheduled Commercial Banks. As NBFCs have been growing in size, PCA will enable supervisory intervention at appropriate time and require the Supervised Entity to initiate and implement remedial measures in a timely manner, so as to restore its financial health. PCA for NBFCs is, based on the financial position of NBFCs on or after March 31, 2022. It will be applicable to all deposit taking NBFCs excluding government NBFCs, primary dealers and housing finance companies and other non-deposit taking NBFCs in the middle, upper and top layers. There are three thresholds and on breach of each threshold, RBI shall restrict: (i) payment of dividend and introduction by promoters of capital and reduction of leverage, (ii) branch expansion and (iii) capital expenditure (except technological upgradation) and variable operating costs. Introduction of PCA will be instrumental to avoid a situation where an NBFC would have to close its operations completely, as once the thresholds are breached, RBI can enforce the abovementioned restrictions, which would provide for greater chances of survival of the NBFC.
The introduction of all these measures is a major step towards putting NBFCs on par with banks, pursuant to the growth of, especially the larger NBFCs, their increased role in the financial system and their interconnectedness between banks and other financial institutions. Collapse of a large NBFC as in the case of DHFL and IL&FS has a domino effect and imposes a systematic risk for the entire banking system. It would be a reasonable assumption to say that regulatory authorities intend on blurring the line between shadow lenders and traditional banks to such an extent that, that it would, in the near future, presumably not be correct to call an NBFC a shadow bank.
Footnotes
1 Liquidity Risk Management Framework for Non-Banking Financial Companies and Core Investment Companies RBI/2019-20/88 DOR.NBFC (PD) CC. No.102/03.10.001/2019-20
2 Scale Based Regulation (SBR): A Revised Regulatory Framework for NBFCs RBI/2021-22/112 DOR.CRE.REC.No.60/03.10.001/2021-22
3 PCA Framework for NBFCs- RBI/2021-22/139 DoS.CO.PPG.SEC.7/11.01.005/2021-22
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