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An overview on: Scale Based Regulation-NBFCs

Non-banking financial companies are scripting tale of success for many businesses in entrepreneur spirit of India, they have been providing the complementary services to the economy and competing with banks to reduce the gap in the supply of funds.

Introduction:

A Non-Banking Financial Company (NBFC) caters to the needs of society by engaging in the business of loans and advances, acquisition of shares, stock, bonds, hire-purchase insurance business or chit-fund business. It channelizes the funds to the business left out by the banking system.

NBFC plays a primary role in the development of MSME, Infrastructure development and keeping the entrepreneurial spirit alive by Providing loans: car, personal, education, home, micro-finance, and capital to start small business.

They are regulated and governed by the rules and regulations of RBI, registered under the provision of the Companies Act 1956. SEBI and IRDAI are two different supervising authorities in India.



Need for Regulation:

Over the time the industry has seen a gigantic growth, as of now there are more than Ten Thousand NBFC in India, and it covers 25% of financial system, it means a little disturbance in non-banking financial industry can bring crises in the economy. As happened during the fallout of Dahwan Housing Finance Crop. (DHFC) and IL&FC. The companies struggle to process new loans as their existing loans are turning into non-performing assets (NPAs).

Scale Based Regulation:

To strengthen NBFC RBI has proposed a tighter regulatory frame works by creating a Four Tier structure, they can be now classified into four different categories based on their size, activities, complexity, and risk associated with them:

  • Base Layer

  • Middle layer

  • Upper layer

  • Top layer

If we visualize a pyramid then the bottom part of it will represent the base layer of scale layer regulation, it has the least RBI intervention, the other parts of the pyramid will be represented by Middle, Upper and the Top layer which will have the most regulatory provisions. Along with the layer acuteness of the regulation increases. Scale base regulation (SBR) is set to be effective from October 2021.

Detail Explanation of Regulatory Structure

Base layer (NBFC-BL)

The base layer will be equivalent to the existing non-deposit taking non-systemically important NBFCs (NBFC-NDs) Systemically important, non-deposit taking NBFCs having asset size of INR500 crore and above but below INR1,000 crore will be part of NBFC-BL (Base Layer) it will specifically include:

• NBFC-P2P (NBFC-Peer to Peer lending platform)

• NBFC-AA (NBFC-Account Aggregator)

• NOFHC (Non-Operative Financial Holding Company), and

• NBFCs without public funds and customer interface

With an aim to establish a strong and resilient financial system RBI have increased the transparency requirements through additional disclosures and improved governance standards.

Previously BLs had 180 days to recognize NPA (Non-Performing Assets) but SBR have reduced it to 90 days

Middle Layer

The middle layer will be equivalent to the existing deposit taking NBFCs (NBFC-D) and systemically important non-deposit taking NBFCs (NBFC-ND-SI).

It will specifically include the SPD (i.e. Standalone Primary Dealers) and IDF (Infrastructure Debt Funds) (which will always remain in the middle layer). It will also include NBFC-D, irrespective of their asset size, NBFC-ND-SI with asset size greater than INR1,000 crore.

There will be a higher level of regulatory supervision in this layer, which aims to plug the areas of regulatory arbitrage between banks and NBFCs.


 Upper layer (NBFC-UL)

The upper layer will be specifically identified by the RBI through a scoring Methodology.

Which will be reviewed from time to time. Accordingly, entities that meet the specified criteria will move from the middle layer to the upper layer of the scale-based framework.

The top 10 eligible NBFCs in terms of their asset size will always reside in the upper layer, irrespective of any other factor. Higher prudential regulations and intensive supervision will be applicable for such entities proportionate to their systemic significance.

Once an NBFC is identified as NBFC-UL it will be subject to enhanced regulatory requirements for at least 4 years from its last appearance in the category.

In September 2023 RBI released a list of 15 Upper Layer NBFC, some prominent name in the list were Bajaj Finance, Tata sons Private limited and Muthoot Finance limited.

Top Layer (NBFC-UP)

The top layer would remain empty and NBFCs will be placed in this layer from the upper layer of the scale-based framework at the discretion of RBI if it is of the opinion that the entity is contributing.

Such entities would be required to comply with significantly higher regulatory and supervisory requirements.

How will this regulation impact the NBFC Industry?

This layered approach may sound like a magic wand, but it is very confusing and may create further damage. The Finance Industry Development Council (FIDC) fears that SBR poses a threat to the growth of the industry. The regulation does not promote the establishment of more NBFCs, as the RBI has taken a strict approach toward the sector. To make scale-based regulation more effective and easier to understand, the RBI released Master Directions in 2023. In the coming years, we may see a few new NBFCs, but they will become a more secure and risk-free industry.

FinTech and SBR

The emerging tech industry has found its position and need in the financial sector as well. Due to India's strict banking system, the tech industry is assisting individuals through NBFCs. After the introduction of SBC's layer-based approach, the RBI has banned many platforms that are unregulated and violate regulations. Nevertheless, SBR is a good way of policing the FinTech industry. The main objective of the regulations is to keep the bigger industry in check.

Conclusion

These new regulations will boost coordination between the RBI and NBFCs. They will further promote an environment of accountability by making the industry more trustworthy and transparent. However, the RBI should also keep the possibility of innovation in the financial sector alive because strict rules will discourage new, unconventional players from entering the industry. The repercussions of this will be faced by individuals who were ignored and denied financial assistance by the traditional banking system.

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