DBOD.No.FSD. /556 / 24.01.02/
All Scheduled Commercial Banks (Excluding RRBs)
and NBFCs (deposit taking and non deposit taking)
Mid-Term Review of Annual Policy Statement for
the Year 2006-07- Financial Regulation of Systemically Important NBFCs and Banks'
Relationship with them
Please refer to paragraph 141 of the Mid-Term
Review of Annual Policy Statement for the year 2006-07 enclosed to Governor's
letter No.MPD.BC.286/07.01.279/2006-07 dated October 31, 2006. (copy of the
paragraph enclosed as Annex 1).
2. An Internal Group was constituted by the
Reserve Bank to study the issues relating to regulatory convergence, regulatory
arbitrage and to recommend a policy framework for level playing field in the
financial sector. Based on the recommendations of the Internal Group and taking
into consideration the feedback received thereon, it has been decided to put
in place a revised framework to address the issues pertaining to the relationship
between banks and NBFCs and the systemically important NBFCs. A draft of the
proposed guidelines have been prepared and furnished as Annex
2. The revised framework will not be applicable to the Residuary Non Banking
Companies (RNBCs), which are governed by a separate set of regulations.
3. Banks and NBFCs are requested to forward
their comments and feedback on the draft guidelines to the undersigned by close
of business on Friday, November 17, 2006.
Chief General Manager-In-Charge
Paragraph 141 of the Mid-Term Review of Annual
Policy Statement for the year 2006-07
(f) Banks' Exposures to Systemically Important
141. An Internal Group was constituted by the
Reserve Bank to study the issues of regulatory convergence, regulatory arbitrage
and to recommend a policy framework for level playing field in the financial
sector. The report of the Group was placed on the Reserve Bank's web-site for
wider dissemination and comments. In the light of the recommendations of the
Group and the feedback received, and in view of the importance of this segment
of the financial sector, a draft circular will be put in the public domain to
invite further feedback by November 2, 2006. After providing two weeks for comments,
the final circular will be issued before November 30, 2006.
DRAFT CIRCULAR - FOR COMMENTS
November 03, 2006
DBOD. No. FSD. BC. / /2006-2007
All Scheduled Commercial Banks (excluding
and NBFCs (deposit taking and non-deposit taking)
Financial Regulation of Systemically Important NBFCs and Banks’
Relationship with them
Non Banking Financial Companies (NBFCs) play
a crucial role in broadening access to financial services, enhancing competition
and diversification of the financial sector. They are increasingly being recognised
as complementary to the banking system, capable of absorbing shocks and spreading
risks at times of financial distress. The application of different levels of
regulations to the activities of banks and NBFCs, and even among different categories
of NBFCs, has given rise to some issues arising out of this uneven coverage
of regulations. The Reserve Bank of India had, therefore, set up an Internal
Group to examine the issues relating to level playing field, regulatory convergence
and regulatory arbitrage in the financial sector. Based on the recommendations
of the Internal Group and taking into consideration the feedback received thereon,
it has been decided to put in place a revised framework to address the issues
pertaining to the overall regulation of systemically important NBFCs and the
relationship between banks and NBFCs. The revised framework will not be applicable
to the Residuary Non Banking Companies (RNBCs), which are governed by a separate
set of regulations.
Current Status: Prudential Norms
2. The Reserve Bank put in place in January
1998 a new regulatory framework involving prescription of prudential norms for
NBFCs which are deposit taking to ensure that these NBFCs function on sound
and healthy lines. Regulatory and supervisory attention was focused on the ‘deposit
taking NBFCs’ (NBFCs – D) so as to enable the Reserve Bank to discharge its
responsibilities to protect the interests of the depositors. NBFCs - D are subjected
to certain bank –like prudential regulations on various aspects such as income
recognition, asset classification and provisioning; capital adequacy; prudential
exposure limits and accounting / disclosure requirements. However, the ‘non-deposit
taking NBFCs’ (NBFCs – ND) are subject to minimal regulation.
3. The application of the prudential guidelines
/ limits, is thus not uniform across the banking and NBFC sectors and within
the NBFC sector. There are distinct differences in the application of the prudential
guidelines / norms as discussed below:
i) Banks are subject to income recognition,
asset classification and provisioning norms; capital adequacy norms; single
and group borrower limits; prudential limits on capital market exposures; classification
and valuation norms for the investment portfolio; CRR / SLR requirements; accounting
and disclosure norms and supervisory reporting requirements.
ii) NBFCs – D are subject to similar norms as
banks except CRR / SLR requirements and prudential limits on capital market
exposures. However, even where applicable, the norms apply at a rigour lesser
than those applicable to banks. Certain restrictions apply to the investments
by NBFCs – D in land and buildings and unquoted shares.
iii) Capital adequacy norms; CRR / SLR requirements;
single and group borrower limits; prudential limits on capital market exposures;
and the restrictions on investments in land and building and unquoted shares
are not applicable to NBFCs – ND.
iv) The extent to which all companies can resort
to unsecured borrowings is restricted under the Companies Act. Though NBFCs
come under the purview of the Companies Act they are exempted from the requirement
under this Act since they are under RBI regulation. While in the case of NBFCs
– D, their borrowing capacity is limited to a certain extent by the CRAR norm,
there are no restrictions on the extent to which NBFCs – ND may leverage, even
though they are in the financial services sector.
Current Status: Financial Linkages Between Banks
4. Banks and NBFCs compete for some similar
kinds of business on the asset side. NBFCs offer products/services which include
leasing and hire-purchase, corporate loans, investment in non-convertible debentures,
IPO funding, margin funding, small ticket loans, venture capital, etc. However
NBFCs do not provide operating account facilities like savings and current deposits,
cash credits, overdrafts etc.
5. NBFCs avail of bank finance for their operations
as advances or by way of banks’ subscription to debentures and commercial paper
issued by them.
6. Since both the banks and NBFCs are seen to
be competing for increasingly similar types of some business, especially on
the assets side, and since their regulatory and cost-incentive structures are
not identical it is necessary to establish certain checks and balances to ensure
that the banks’ depositors are not indirectly exposed to the risks of a different
cost-incentive structure. Hence, following restrictions have been placed on
the activities of NBFCs which banks may finance:
(i) Bills discounted / rediscounted by NBFCs,
except for rediscounting of bills discounted by NBFCs arising from the sale
(a) commercial vehicles (including light commercial
(b) two-wheeler and three-wheeler vehicles, subject to certain conditions;
(ii) Investments of NBFCs both of current and
long term nature, in any company/entity by way of shares, debentures, etc. with
(iii) Unsecured loans/inter-corporate deposits
by NBFCs to/in any company.
(iv) All types of loans/advances by NBFCs to
their subsidiaries, group companies/entities.
(v) Finance to NBFCs for further lending to
individuals for subscribing to Initial Public Offerings (IPOs).
(vi) Bridge loans of any nature, or interim
finance against capital/debenture issues and/or in the form of loans of a bridging
nature pending raising of long-term funds from the market by way of capital,
deposits, etc. to all categories of Non-Banking Financial Companies, i.e. equipment
leasing and hire-purchase finance companies, loan and investment companies,
Residuary Non-Banking Companies (RNBCs) and Venture Capital Funds (VCFs).
(vii) Should not enter into lease agreements
departmentally with equipment leasing companies as well as other Non-Banking
Financial Companies engaged in equipment leasing.
(viii) Lend against lease rental receivables
arising out of sub-lease of an asset by a Non-Banking Non Financial Company
(undertaking nominal leasing activity) or by a Non-Banking Financial Company
as these should be excluded for the purpose of computation of permissible bank
finance for such company. This is because banks can only support lease rental
receivables arising out of lease of equipment/machinery owned by the borrowers.
Current Status: Structural Linkages Between
Banks and NBFCs
7. Banks and NBFCs operating in the country
are owned and established by entities in the private sector (both domestic and
foreign), and the public sector. Some of the NBFCs are subsidiaries/ associates/
joint ventures of banks – including foreign banks, which may or may not have
a physical operational presence in the country. There has been increasing interest
in the recent past in setting up NBFCs in general and by banks, in particular.
8. Investment by a bank in a financial services
company should not exceed 10 per cent of the bank’s paid-up share capital and
reserves and the investments in all such companies, financial institutions,
stock and other exchanges put together should not exceed 20 per cent of the
bank’s paid-up share capital and reserves. Banks in India are required to obtain
the prior approval of the concerned regulatory department of the Reserve Bank
before being granted Certificate of Registration for establishing an NBFC and
for making a strategic investment in an NBFC in India. However, foreign entities,
including the head offices of foreign banks having branches in India may, under
the automatic route for FDI, commence the business of NBFI after obtaining a
Certificate of Registration from the Reserve Bank.
9. NBFCs can undertake activities that are not
permitted to be undertaken by banks or which the banks are permitted to undertake
in a restricted manner: for example, financing of acquisitions and mergers,
capital market activities etc. The differences in the level of regulation of
the banks and NBFcs, which are undertaking some similar activities, give rise
to considerable scope for regulatory arbitrage. Hence, routing of transactions
through NBFCs would tantamount to undermining banking regulation. This is partially
addressed in the case of NBFCs that are a part of banking group on account of
prudential norms applicable for banking groups.
10. NBFCs - D may access public funds, either
directly or indirectly through deposits, CPs, debentures and bank finance and
NBFCs – ND may access public funds through all of the above modes except through
public deposits. The application of marginal regulation to NBFCs – ND that are
large and systemically important and also have access to public funds can be
a potential source of systemic risk through contagion even though these entities
are not members of the payment and settlement systems.
11. At present, there are no prudential norms
or guidelines on the intra-group transactions and exposures (ITEs) between the
NBFCs and their parent entities. From the perspective of consolidated supervision
of a banking group/ financial conglomerate, it is necessary to have some norms
/ limits on the ITEs to ensure that the activities of the banking group / financial
conglomerate are undertaken in a prudent manner so that they would not be a
threat to financial stability. Internationally, some regulators prescribe a
ceiling on the level of transactions that a bank can have with its affiliates.
These limits may operate either at a single entity level and / or at an aggregate
12. In terms of the provisions of the Banking
Regulation Act, a bank is not allowed to set up a banking subsidiary. This ensures
that more than one entity in a banking group would not be undertaking similar
activities for example, accepting deposits. This also eliminates the scope for
more than one entity within a group competing for public deposits. However,
this aspect is not well addressed under the existing framework where a bank
operating in India may set up an NBFC – D as a subsidiary or where they have
/ acquire substantial holding in such an entity i.e., say more than 10 per cent.
13. Foreign direct investment in NBFCs is permitted
under the automatic route in 19 specified activities subject to compliance with
the minimum capitalization norms. Once an NBFC is established with the requisite
capital under FEMA, subsequent diversification either through the existing company
or through downstream NBFCs is undertaken without any further authorisation.
This could give scope for undertaking those activities which do not qualify
for FDI through the automatic route.
Underlying Principles for a Revised Framework
14. Thus the regulatory gaps in the area of
bank and NBFC operations contribute to creating the possibility of regulatory
arbitrage and hence giving rise to an uneven playing field and potential systemic
risk. In this backdrop, the related issues have been examined and as recommended
by the Group, a review of the existing framework of prudential regulations for
bank and NBFC operations was undertaken. The broad principles underlying the
review are as under.
i) Entities offering financial services should
normally be within the ambit of financial regulations. However, all NBFCs –
ND were largely excluded from the scope of financial regulation in view of the
state of development of the financial sector at that time and as a matter of
prioritisation of regulatory focus. In the light of the recent developments
in the financial sector and its growth, as a first step, all systemically relevant
entities offering financial services ought to be brought under a suitable regulatory
framework to contain systemic risk. The definition of what is considered systemically
relevant will be as determined from time to time.
ii) The IMF publication, "Financial Sector
Assessment - A Handbook" mentions that, "Similar risks and functions
should be supervised similarly to minimize scope for regulatory arbitrage"
and that, "Bank-like financial institutions should be supervised like banks."
Similarly, the ‘Report of the Committee on Fuller Capital Account Convertibility’
has also identified that "modifications to regulation to discourage or
eliminate scope for regulatory arbitrage, focusing on activity-centric regulation
rather that institution-centric regulation will be needed" to enhance the
strengthening of the banking system. Hence, the focus will be to reduce or eliminate
the scope for regulatory arbitrage by ensuring that regulations are activity
specific – irrespective of the medium through which the activity is undertaken.
iii) The ownership of NBFCs, which are subjected
to a relatively less stringent regulatory and prudential framework, should be
subjected to certain norms which will encourage improved governance so that
regulatory arbitrage or circumvention of bank regulations are not resorted to.
Further, the ownership pattern should be such that more than one entity in a
Group does not compete for public deposits. Additionally, the principle of ‘holding
out’ will operate in a situation where an NBFC is within a bank group. Hence,
the eventual fall out of the holding out principle will have to be factored-in
while banks decide on the extent to which they would like to be involved in
iv) Consequent upon certain adverse events in
the banking sector in the early 1990s, banks are not permitted to offer discretionary
portfolio management scheme (PMS). As a corollary, the NBFCs sponsored by banks
are also not permitted to offer discretionary PMS. Whereas, other NBFCs are
allowed to offer this product. Hence, ownership structure of the NBFC should
not be determining factor to decide on the products that NBFCs may offer.
v) Foreign entities can undertake certain permitted
activities in India under the automatic route for FDI. However, it might not
be appropriate to allow a foreign entity to set up a presence through the automatic
route and later expand into activities which are not permitted under the automatic
route, without going through a further authorisation process.
vi) The over arching principle is that banks
should not use an NBFC as a delivery vehicle for seeking regulatory arbitrage
opportunities or to circumvent bank regulation(s) and that the activities of
NBFCs do not undermine banking regulations. In case it is observed that any
bank has not complied with the spirit of these guidelines, such non compliance
should be viewed very strictly by the Reserve Bank.
Modifications to the Regulatory Framework
15. In the light of the concerns that arise
out of the divergent regulatory requirements for various aspects of functioning
of banks and NBFCs and keeping in view the broad principles for the proposed
revision in the regulatory framework, the following modifications are being
made with immediate effect.
A. Regulatory Framework for Systemically
(i) Leverage Ratio
All NBFCs – ND with an asset size of Rs. 100
crore and more will be considered as a systemically important NBFC – ND (SI
– NBFC – ND) and shall be governed by a leverage ratio whereby they shall
be able to raise borrowings only up to 10 times of their net owned funds. The
net owned funds for this purpose shall be as per the last audited and published
(ii) Capital Adequacy Ratio for SI – NBFCs
All SI – NBFCs – ND will be required to maintain
a minimum Capital to Risk-weighted Assets Ratio (CRAR) of 10%. Those SI – NBFCs
– ND which presently do not have a CRAR of 10% would have to approach the Reserve
Bank (Department of Non-Banking Supervision, Central Office) with a clear indication
of the time-frame within which they would be able to comply with the required
CRAR. The present minimum CRAR stipulation at 12 % or 15%, as the case may be,
for NBFCs – D shall continue to be applicable.
(iii) Single / Group Exposure norms for SI –
NBFCs – ND
No SI – NBFCs – ND, as defined above, shall
a) lend to
i) any single borrower exceeding fifteen per
cent of its owned funds; and
ii) any single group of borrowers exceeding twenty five per cent of its
b) invest in
i) the shares of another company exceeding
fifteen per cent of its owned funds; and
ii) the shares of a single group of companies exceeding twenty five per
cent of its owned funds;
c) lend and invest (loans/investments taken together)
i) twenty five per cent of its owned funds
to a single party; and
ii) forty per cent of its owned funds to a single group of parties.
The above ceiling on the investment in shares
of another company shall not be applicable to an NBFC in respect of investment
in the equity capital of an insurance company up to the extent specifically
permitted, in writing, by the Reserve Bank. Further, the SI – NBFCs – ND are
advised to have a policy in respect of exposures to a single entity / group.
The SI – NBFCs – ND which are holding companies, which do not access public
funds, both directly and indirectly, and which invest only in the group entities
may apply to the Reserve Bank for exemption from the above requirement.
B. Regulatory Framework for Bank Exposures
(iv) Bank Exposures to NBFCs
The exposure (both lending and investment, including
off balance sheet exposures) of a bank to a single NBFC should not exceed 5%
of the bank’s net worth as per its last published balance sheet. Further, the
aggregate exposure of a bank to all NBFCs should not exceed 40% of the bank’s
net worth, as computed above. This is in partial modification of the current
single/group borrower exposure ceilings prescribed for banks in terms of our
Master Circular DBOD. No. Dir. BC. 33 / 13.03.00/ 2006 -07 dated October 10,
2006, on exposure norms.
C. Regulatory Framework for NBFCs Forming
Part of a Banking Group
(v) In terms of our circular DBOD. No. BP. BC.
72/ 21.04.018/ 2001-02 dated February 25, 2003 on consolidated accounting, among
other things, capital adequacy, single and group exposure, and capital market
exposure norms have been laid down for a consolidated bank. These norms cover
NBFCs which are part of a consolidated Indian bank. Henceforth, initially, wholly
owned and majority owned NBFCs promoted by the parent / group of a foreign bank
having presence in India, would be treated as part of that foreign bank’s operations
in India and brought under the ambit of consolidated supervision. Consequently,
the concerned foreign banks should submit the consolidated prudential returns
(CPR) prescribed by the above guidelines to the Department of Banking Supervision
and also comply with the prudential regulations / norms prescribed therein to
the consolidated operations of that bank in India.
(vi) NBFCs which do not belong to any banking
group are currently permitted to offer discretionary portfolio management as
a product, as permitted by their respective regulators. However, due to historical
reasons, as banks are aware, banks are not allowed to offer discretionary portfolio
management as a product; thus bank sponsored NBFCs are also not allowed to offer
discretionary portfolio management as a product. Henceforth, bank sponsored
NBFCs will also be allowed to offer discretionary PMS to their clients, on a
case to case basis. Applications in this regard should be submitted to DBOD,
World Trade Centre, Mumbai.
D. Ownership and Governance
(vii) Banks in India, including foreign banks
operating in India, shall not hold more than 10 % of the paid up equity capital
of an NBFC – D. This restriction would, however, not apply to investment in
housing finance companies. Banks which at present exceed the above limits should
approach the Reserve Bank, within a period of two months from the date of this
circular, supported by a plan for complying with the proposed regulatory requirement
within a specified time frame.
E. Expansion of activities of NBFCs through
(viii) NBFCs set up under the automatic route
will be permitted to undertake only those 19 activities which are permitted
under the automatic route. Diversification into any other activity would require
the prior approval of FIPB. Similarly a company which has entered into an area
permitted under the FDI policy (such as software) and seeks to diversify into
NBFC sector subsequently would also have to ensure compliance with the minimum
capitalization norms and other regulations as applicable.
Chief General Manager