DBOD. No. FSD. BC.46 / 24.01.028/ 2006-07
December 12, 2006
All Scheduled Commercial Banks
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 MPD.BC.286/ 07.01.279/ 2006-07 dated October 31, 2006 (Copy of the paragraph
enclosed as Annex).
2. 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 was 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. Accordingly, a draft of the proposed guidelines were
issued vide letter DBOD.No.FSD.556/
24.01.02/ 2006-07 dated November 3, 2006, seeking feedback from banks and
NBFCs. Based on the feedback received, the draft guidelines were suitably revised
and second draft guidelines issued for further comments vide DBOD.No.FSD.5046/24.01.028/2006-07
dated November 30, 2006. On the basis of the feedback received, final guidelines
are now issued for implementation.
Current Status: Prudential Norms
3. 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.
4. 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 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) Unsecured borrowing by companies is regulated
by the Rules made under the Companies Act. Though NBFCs come under the purview
of the Companies Act, they are exempted from the above Rules since they come
under RBI regulation under the Reserve Bank of India Act. 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 and NBFC
5. 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.
6. NBFCs avail of bank finance for their operations
as advances or by way of banks’ subscription to debentures and commercial paper
issued by them.
7. 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;
i) Investments of NBFCs both of current and
long term nature, in any company/entity by way of shares, debentures, etc. with
ii) Unsecured loans/inter-corporate deposits
by NBFCs to/in any company.
iii) All types of loans/advances by NBFCs to
their subsidiaries, group companies/entities.
iv) Finance to NBFCs for further lending to
individuals for subscribing to Initial Public Offerings (IPOs).
v) 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).
vi) Should not enter into lease agreements departmentally
with equipment leasing companies as well as other Non-Banking Financial Companies
engaged in equipment leasing.
Current Status : Structural Linkages Between
Banks and NBFCs
8. 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.
9. 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.
10. 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, gives
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.
11. NBFCs - D may access public funds, either
directly or indirectly through public deposits, CPs, debentures, inter-corporate
deposits 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
12. 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
13. In terms of the provisions of the Banking
Regulation Act, a bank is not allowed to set up a banking subsidiary. This 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
14. 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
15. 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
(viz. NBFCs which are subsidiaries of banks or where banks have a management
control) 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
16. 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, the following modifications are being made in the regulatory framework
A. Regulatory Framework for Bank Exposures
to all NBFCs
(i) The exposure (both lending and investment,
including off balance sheet exposures) of a bank to a single NBFC / NBFC-AFC
should not exceed 10%/15% respectively, of the bank’s capital funds as per its
last audited balance sheet. Banks may, however, assume exposures on a single
NBFC/NBFC-AFC up to 15%/20% respectively, of their capital funds provided the
exposure in excess of 10%/15% respectively, is on account of funds on-lent by
the NBFC /NBFC-AFC to infrastructure sectors. This is in partial modification
of the current single/group borrower exposure ceilings prescribed for banks
in terms of Master Circular DBOD.
No. Dir. BC. 33 / 13.03.00/ 2006 -07 dated October 10, 2006, on exposure
norms. Further, banks may also consider fixing internal limits for their aggregate
exposure to all NBFCs put together. Infusion of capital funds after the published
balance sheet date may also be taken into account for the purpose of reckoning
capital funds. Banks should obtain an external auditor’s certificate on completion
of the augmentation of capital and submit the same to the Reserve Bank of India
(Department of Banking Supervision) before reckoning the additions to capital
B. Regulatory Framework for all NBFCs Forming
Part of a Banking Group
(ii) In terms of 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, NBFCs promoted by the parent / group of a foreign bank having presence
in India, which is a subsidiary of the foreign bank’s parent / group or where
the parent / group is having management control 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. These
foreign banks in India need not prepare ‘consolidated financial statements’
under Accounting Standard 21 – Consolidated Financial Statements (AS 21). They
may consolidate the NBFCs with the bank’s Indian operations on a line by line
basis for the purposes of consolidated prudential regulations by adopting the
principles of AS 21 as applicable to consolidation of subsidiaries. Where a
foreign bank is holding between 10% and 50% (both included) of the issued and
paid up equity of an NBFC, it will be required to demonstrate that it does not
have a management control in case the NBFC is to be kept outside the ambit of
consolidated prudential regulations.
(iii) 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 (viz. NBFCs which are subsidiaries
of banks or where banks have a management control) 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 the Department
of Banking Operations & Development, World Trade Centre, Mumbai- 400 005.
C. Ownership and Governance
(iv) 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.
Effective date and transition
17. Taking into account the likelihood that
some of the banks may not be in compliance with some of the elements of the
revised regulatory framework, it has been decided to provide for a transition
period up to end March 2007. Accordingly, banks should comply with all elements
of the revised framework with effect from April 1, 2007. In case any bank needs
more time for compliance, it should apply to the Department of Banking Operations
and Development of the Reserve Bank of India before the close of business on
January 31, 2007 clearly indicating the reasons for which they are not able
to ensure compliance within the above period and the time frame within which
they would be able to comply with all the relevant elements. This will enable
the Reserve Bank to take a view on the requests by end March 2007.
18. A separate circular
has been issued to NBFCs in this regard by Department of Non-Banking Supervision,
(P. Vijaya Bhaskar)
Chief General Manager
Extract of Paragraph 141 of the Mid-Term Review
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 3, 2006. After providing two weeks for comments,
the final circular will be issued before November 30, 2006.