RBI’s New and Stricter Approach to Regulate NBFCs
Regulating Non-Banking Financial Sector (NBFC) has always been at the top in the Reserve Bank of India’s (RBI) checklist as this sector has evolved manifold times in the recent years. As per RBI, NBFC’s are now more than a quarter of the size of banks and therefore, they act as a spare tyre to the Indian economy. However, weak regulatory framework can turn this sector into a catastrophe for the economy, and thus, RBI in its latest discussion paper dated 22.01.2021 titled Revised regulatory framework for nbfc’s- A scale-based approach”https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/DP220121630D1F9A2A51415B98D92B8CF4A54185.PDF has come out with a strong and tougher regulatory framework to govern theses institution. In its discussion paper, RBI has proposed a four-tier pyramid structure having progressive level of regulation based on the principle of proportionality. The principle as mentioned explicates that the degree of regulation of a financial entity should be proportionate with the perception of risk the entity poses to the financial system and the scale of its operation.
This concept of proportionality-based regulation will ensure that those entities which are generating higher systemic risk will be governed by stricter regulations as compared to those entities which are not a potent threat. The important factors that will decide the tier for an entity are firstly, comprehensive risk perception which will consist of different parameters like size, leverage, interconnectedness, complexity, etc. and once the entity crosses such threshold, it will be subject to proportionately higher regulation. Secondly, the size of operation of an institution will be an essential factor wherein an entity whose balance sheet crosses a particular mark, such entity would be regulated at a higher pedestal. The third and one of the critical factors in analysing the proportionality is the nature of activity that an institution performs. It means that those entities whose business model involves a certain level of systemic risk, they would fall under a category where regulations would be tighter.
As per the discussion paper, RBI has proposed pyramid like structure with four different layers according to scale-based framework. The four layers are as follows-
- Base Layer (NBFC-BL)
This layer is at the bottom of the pyramid indicating those institutions which require least regulatory intervention. As per RBI’s discussion paper, this layer can consist of those NBFCs which are currently classified as Non-systemically Important Non-deposit Taking NBFCs (NBFC-ND), NBFC Peer-to-Peer lending platforms (NBFC P2P), NBFC Account Aggregator (NBFC-AA), Non-Operative Financial Holding Company (NOFHC) and Type I NBFCs. Approximately 9209 NBFCs of an asset size upto Rs. 1000 Crore will be placed in this layer.
- Middle Layer (NBFC-ML)
This layer is just above the Base layer and accordingly the NBFCs in this layer will have stricter regulatory regime compared to the base layer. This layer consists of those NBFCs which are currently classified as Systemically Important Non-Deposit taking Company NBFCs (NBFC-ND-SI), Deposit Taking NBFCs (NBFC-D), Housing Finance Companies (NBFC-HFC), Infrastructure Finance Companies (NBFC-IFC), Infrastructure Debt-Fund (NBFC-IDF), Standalone Primary Dealers (SPD) and Core Investment Companies (CIC). Mostly, the regulatory structure will be broadly similar to the framework which is currently applicable to NBFC-ND-SI and NBFC-D.
- Upper Layer (NBFC-UL)
The third layer of NBFCs will be governed more or less like banks with suitable modifications in the regulations. In this layer, those NBFCs will be placed which are identified as systemically significant among all NBFCs. It certainly means that those NBFCs which have large potential of systemic spill-over of risks and have the ability to impact financial stability as compared to other NBFCs will occupy Upper Layer. A range of parameters including substitutability, complexity, nature of activity, etc. will be used in identifying those small set of NBFCs which possess systemic risk of spill-over and are in need of tighter regulations. It is expected that not more than 25-30 NBFCs will be placed in this layer.
- Top Layer
This top layer is scheduled to be kept empty unless a view is taken that some NBFCs out of the upper layer consisting of the systemically significant NBFCs require higher regulation and supervision than others present in this layer. Therefore, only those NBFCs will be positioned in this layer which as per the discretion of the supervisor poses extreme risks and requires significantly higher level of regulations.
Through the proposed regulatory framework, RBI is of the view that such sectoral classifications of NBFCs can result in minimizing the systemic risk keeping in mind the flexibility these institutions enjoy as compared to the banks. The problem of arbitrage induced due to less rigorous regulation would be solved as the proposed framework identifies the NBFC on different parameters and then proposes the kind of regulation that a particular NBFC is required to be governed with, thereby making the room available for threat elimination and maintaining financial stability.