BRACE FOR REVOLUTIONARY AMENDMENTS IN NBFCs (NON BANKING FINANCIAL COMPANIES) REGULATIONS BY RESERVE BANK OF INDIA (RBI)

Usha Thorat Committee report regarding the NBFC Companies was recently made public and its recommendation shall be applicable shortly. This committee was a high powered committee which undertook very detailed study of the NBFC sector looking deeply at its contribution, positioning and impact in the economy. Over the years NBFC companies has grown and taken a significant position in economy and there is emergence of larger NBFCs and suitable changes in regulation were made by RBI in time to time. However, in recent time looking a the possibility of risk transferring from more lightly regulated NBFC to Banking sector. This growing significant position and possibility of transfer of risk to banking sector coupled with the importance of role played by NBFC has called for the need to evolve better regulation without curbing its dynamism.

These recommendations will result in huge change in the present regulations and conditions. We are reproducing some of the significant portions of the report which will require immediate attention of the management and professional engaged in the NBFC sector.

 We had reproduced following items from the report. These are selected for ease of understanding and we recommend that one must read the actual report after going through these selected items for forming a clear understanding:

• NBFCs would henceforth be classified under two categories - exempted NBFCs and registered NBFCs.

• Registered NBFCs: Registered NBFCs are those which have been registered and issued a CoR by RBI and are under the purview of RBI regulation.

• All deposit taking companies, irrespective of size, would continue to be registered NBFCs with RBI and as such would fall under the purview of RBI regulations. In other words, no deposit taking company is exempt from registration and thereby RBI regulation.
• Foreign owned companies will however require the CoR from the Bank before commencing any non-banking financial activity. They will also continue to follow the minimum capitalization norm as under FEMA.

• Exempted NBFCs- Exempted NBFCs are those which are exempted from registration by RBI. The Bank reserves the right to bring exempted NBFCs under regulation, should the need arise thereof at a later date.

• The following categories of NBFCs are exempted from registration with the Reserve Bank
• NBFCs with asset size below Rs. 25 crore whether accepting public funds or not.
• NBFCs with asset size below Rs. 500 crore and not accepting public funds, directly or indirectly.

• The provisions of Chapter IIIB of the RBI Act 1934, except Section 45N, will not apply in respect of the above exempted category of NBFCs. These NBFCs will have the option of surrendering the CoR on a voluntary basis.

• Position Relating to Existing NBFCs -

• Existing NBFCs-ND with asset size below the threshold of Rs. 25 crore but which intend to continue to be registered are required to notify the Bank within three months from the date of these Directions, with a road map for increasing their asset size to Rs. 25 crore or above within a period not exceeding 2 years. Notwithstanding the fact that any such company has obtained a Certificate of Registration under Section 45IA of the RBI Act 1934, it shall be required to apply for a fresh COR within a period of 6 months from the date of achieving the asset size threshold.

• Further, NBFCs-ND which de-register would need to approach the Bank afresh for CoR if

1. individually the asset size exceeds Rs. 25 crore or
2. the asset size exceeds Rs. 500 crore, even if such NBFC does not access public funds.

• Entry Point Norms - New companies having NOF not less than Rs. 2 crore and minimum asset size of Rs. 25 crore, fulfilling the revised PBC as given below are required to obtain registration.

• Principal Business Criteria (PBC)

• A company not accepting deposits, will qualify for registration as NBFC if and when its financial assets1 aggregate Rs 25 crore and constitute 75 per cent and above of its total assets (net of intangible assets) and financial income constitutes 75 per cent or above of its gross income.
• Financial entities having asset size of Rs.1000 crore or above, holding financial assets which constitute 50% of the total assets OR generate financial income which as a proportion of the gross income is at least 50%, will need to be registered and regulated by the Bank.

• Roadmap for existing NBFCs to comply with revised Principal Business Criteria

• Existing NBFCs will be given a period of 2 years with the following milestones for achieving the minimum threshold of Rs. 25 crore of financial assets:

31/03/2014 – 65%

31/03/2015 – 75%

• NBFCs-ND unable to comply with the threshold within the two year period, will be deregistered by the Reserve Bank through a public notification and shall no longer be eligible to carry out such activity and must exit the business within a given time frame.
• Existing NBFC-D failing to achieve the 75 % threshold in financial assets and income by March 2015 will not be allowed to accept fresh deposits or renew deposits thereafter. They will be required to repay deposits within a given timeframe as decided by the Bank and be deregistered thereafter.
• Principal business for AFCs has been redefined in alignment with that of the revised principal business criteria for NBFCs. Accordingly, a minimum of 75 per cent of the assets of AFCs (as against 60 per cent at present) should be in asset financing activities and at least 75 per cent of total income (as against 60 per cent at present), should be from these asset financing activities. Existing AFCs would be allowed to conform to the revised principal business criteria within a period of two years from the date of this Direction, in two stages as per the milestones given above.

• Multiple NBFCs

• There are groups in the sector which have floated multiple non-deposit taking NBFCs for different reasons. However, such entities that are part of a corporate group or are floated by a common set of promoters will not be viewed on a standalone basis and instead their total assets will be aggregated to determine if such consolidation leads to the cut off limit prescribed for a systemically important NBFC i.e. Rs. 100 crore of assets. For this purpose, the definition of the word “group” will be the same as per Accounting Standards2.
•  “Companies in the Group”, shall mean an arrangement involving two or more entities related to each other through any of the following relationships: Subsidiary – parent.
• For the purpose of regulation, the total assets of all NBFCs in a group will be taken together to determine the cut off limit of Rs. 100 crore for application of prudential norms. All provisions of the NBFC Prudential Norms, 2007 will be applicable to each NBFC in the group. For this purpose, Statutory Auditors would be required to certify the asset size of all the NBFCs if the Group has more than one NBFC.
• In case there is a deposit accepting NBFC within the group, it would be supervised on a solo basis and all regulations prescribed for registered NBFCs would apply.

• Captive NBFCs

• It has been observed that a number of manufacturing groups have been floating NBFCs which are captive to their requirements to facilitate the sale of their products or services. A captive NBFC is defined as one which holds receivables generated on account of its parents activities at least to the extent of 90% of its total assets, net of intangible assets. The business franchise of such captives is inextricably linked to the parent’s fortunes. As a result, credit underwriting standards could be weaker in such entities and the recall, if any, of parental assets could further stress the captive NBFC. Consequently, risks in the captives are much higher and warrant a higher Tier I capital, if not a different start-up NOF requirement.
• It has, therefore, been decided that captive NBFCs shall maintain Tier I capital at 12 per cent, as against 7.5 per cent at present. Existing captive NBFCs that do not fulfill the requirement would be given a period of three years from the date of this notification to comply, upon which they shall produce a statutory auditor’s certificate of compliance.

• Prior Approval of RBI in cases of Change in Control or Transfer of Shareholding

• It has been decided that all registered NBFCs both deposit taking and non-deposit taking should take prior approval from the Reserve Bank where there is a change in control and / or increase of shareholding to the extent of 25 percent or in excess thereof, of the paid up equity capital of the company by individuals or groups, directly or indirectly. Acquisitions in the ordinary course of business by an underwriter, a stock broker and a merchant banker are not covered by this requirement.
• For any acquisitions and for all mergers under Section 391-394 of the Companies Act, 1956 by or of an NBFC, the NBFC involved should approach the Reserve Bank (even before filing for the same in the Courts) to ensure adherence to the basic tenets of corporate governance and overall health of the sector. Non-adherence to these guidelines will result in cancellation of the CoR of the concerned NBFC.

• Prior Approval for Appointment of CEO and Related Matters

• Appointment of CEOs of NBFCs with asset size of Rs. 1000 crore and above would require the Reserve Bank’s prior approval. In the interest of good governance and the sensitivities associated with NBFCs, the number of Directorships held by a single director of any NBFC, public or private, may not exceed the maximum number prescribed under Section 275 of the Companies Act 1956. In addition, suchcompanies, whether listed or not, will need to comply with Clause 49 of SEBI’s listing agreement on corporate governance including induction of Independent Directors.

• Fit and Proper Criteria for Directors

• All NBFCs-ND-SI and NBFCs-D shall ensure that there is a policy in place for ascertaining the fit and proper criteria for appointment of directors. To ensure continuing due diligence on directors, the Nomination Committee of all NBFCs with asset size Rs. 100 crore and above shall certify annually to RBI on ‘fit and proper’ status of directors. Guidelines for NBFCs to ascertain fit and proper criteria of directors are given in Annex 2. Annex 3 contains the draft of the declaration and undertaking to be given by the Director and Annex 4 gives draft Deed of Covenant to be signed between the Director and the company. All NBFCs-ND-SI and NBFCs-D shall also furnish to the Reserve Bank a quarterly statement on change of directors certified by the auditors and a certificate from the Managing Director that fit and proper criteria in selection of directors has been followed.
• NBFCs with assets of Rs. 100 crore and more but less than Rs. 1000 crore are encouraged to adopt Clause 49 principles in their governance practices.

• Disclosures in Financial Statements – Notes to Account

• At present, balance sheet disclosures by NBFCs are largely guided by those laid down by accounting standards and the Companies Act 1956, SEBI regulation on disclosures for listed companies, and a few items mandated by the Reserve Bank. The disclosures mandated by the Bank require all NBFCs (irrespective of whether they hold public deposits or not) to attach a schedule to their balance sheet containing additional particulars of assets and liabilities and details of their non-performing assets. NBFCs-ND-SI have to, in addition, disclose their Capital to Risk Asset Ratio, their exposure (both direct and indirect) to the real estate, and the maturity pattern of their assets and liabilities.
• The above disclosures are far from comprehensive. NBFCs being financial entities are exposed to risks arising out of counterparty failures, funding and asset concentration, interest rate movements and risks pertaining to liquidity and solvency. Besides, they are highly leveraged entities, deeply interconnected with the financial markets and now increasingly into offering complex products. There is therefore need for greater transparency and greater rigor in disclosure norms.
• Consequently, all registered NBFCs should disclose their registration with other regulator(s) such as SEBI, IRDA, Stock Market and Commodity Exchanges, as well as any credit ratings assigned by rating agencies. In addition, all registered NBFCs should disclose penalties, if any levied by any regulator.
• NBFCs with asset size of Rs. 1000 crore and above will need to comply with mandatory disclosures under Clause 49 of the SEBI listing agreement, irrespective of whether they are listed or not. Additionally, they will need to disclose their provision coverage ratio, liquidity ratio, asset liability profile, extent of financing of parent company products, NPAs and movement of NPAs, details of all off-balance sheet exposures, structured products issued by them as also securitization/assignment transactions and other disclosures as given in Annexure 5. Further, in the case of unlisted NBFCs with asset size of Rs.1000 crore and above, these disclosures should be made available on their websites.

• Remuneration and Compensation

• It will be mandatory for registered NBFCs with assets of Rs. 1000 crore and above to constitute a Remuneration Committee to decide on the compensation payable to the Executives. NBFCs with asset size below Rs. 1000 crore are encouraged to adopt such practices. Guidelines on Compensation to management of NBFCs will be issued separately.

• Liquidity Management

• It has been decided that, henceforth, all registered NBFCs - deposit taking and non-deposit taking, should maintain high quality liquid assets in cash, bank deposits available within 30 days, money market instruments maturing within 30 days, investment in actively traded debt securities (valued at 90 per cent of the quoted price) and carrying a rating not lower than AA or equivalent, equal to the gap between total net cash inflows and outflows over the 1 to 30 day time bucket as a liquidity coverage requirement. In other words, there should not be any liquidity gap in the 1-30 day bucket.
• For deposit taking NBFCs, the extant requirement of SLR will continue.

• Prudential Regulatory Framework

• It has been decided that Tier l capital be raised to 12% for all captive NBFCs (90 per cent and above of total assets (net of intangibles) are on financing parent company’s products/services), and for NBFCs that are into lending to / investment in sensitive sectors namely, capital market, commodities and real estate, to the extent of 75% or more of their total assets net of intangible assets. Other NBFCs including IFCs, shall maintain Tier l capital at 10%. Existing NBFCs that do not fulfill the requirement would be given a period of three years from the date of this notification to comply, upon which they shall produce a statutory auditor’s certificate to the effect.

• Risk weights for Capital Market Exposures (CME) and Commercial Real Exposures (CRE)

• The risk weights on exposure to capital market and real estate, for NBFCs in a bank group shall be the same as specified for banks. Further, the risk weights for NBFCs that are not sponsored by banks or that are not part of a group that contains a bank may be raised to 150 per cent for capital market exposures and 125 per cent for CRE exposures.

• Asset Classification and Provisioning Norms:

• It has been decided that the asset classification and provisioning norms (including standard asset provisioning norms) should, in a phased manner, be made similar to that of banks for all registered NBFCs irrespective of size. The same will be implemented in phases, viz; a 120 day norm shall be applied from April 01, 2014 to March 31, 2015 and a 90 day norm thereafter. A one-time adjustment of the repayment schedule which shall not amount to restructuring will, however, be permitted.
• Further, it is proposed to raise the provisioning for standard assets from 0.25 per cent to 0.40 per cent of the outstanding amount w.e.f. March 31, 2014 for all NBFCs.

• Deposit – Taking NBFCs

• It has been decided that all existing NBFCs-D, including AFCs, should be credit rated and that unrated NBFCs, including AFCs, should not be permitted to accept deposits. Existing unrated NBFCs-D will be given a period of one year to get themselves rated if they wish to continue to accept deposits. Thereafter, they would not be allowed to accept any fresh deposits or renew existing deposits, till they get themselves rated.
• Further, the limit for acceptance of deposits for rated AFCs is reduced from 4 times to 2.5 times NOF. AFCs presently exceeding the limit of 2.5 times NOF shall not renew or accept fresh deposits till such time they reach the revised limit. Each of such AFCs would be given specific time period within which they should comply with the norm of 2.5 times the NOF.