Regulate NBFCs, the banking channel
In a strategic move, the RBI has extended the framework of Prompt Corrective Action (PCA) to non-bank financial corporations (NBFC), thus bringing their regulations closer to banks. Considering the fragility of NBFCs and their collateral risks to financial stability observed in recent years, the RBI has gradually upgraded the regulatory architecture to strengthen their risk management practices as they utilize the expanded scope of their role in l financial intermediation.
NBFCs play a vital role in connecting people to the formal financial system. But their internal risk governance may not be able to cope with the nuances of the diversity of risks to which they are now exposed. Unless the gap in risk management practices is closed, it will not be possible to close them against the proliferation of risks.
Realizing the depth of connection of NBFCs with consumer segments, the RBI has calibrated regulations to align them with banks that are at a better regulatory angle. The RBI has simultaneously worked on harnessing the potential of NBFCs by giving them more operational freedom to accelerate their growth, while calibrating their regulatory rigor.
In October 2021, the RBI introduced Scale-Based Regulations (SBR) – a revised regulatory framework for NBFCs that aligns supervisory measures based on their size and direct connection of customers by classifying them into four pools. . Long before, risk-based internal audit (RBIA) was also extended to some NBFCs based on the size of their operations and the spillover risks they may present to the financial sector.
The need to appoint a Chief Risk Officer (CRO) was also mandated to better regulate the institutionalized risk governance processes and its interface with the board of directors so that they can provide safe and secure services to consumers on a sustainable.
The digital lending operations of fintechs, peer-to-peer (P2P) lenders and neobanks are also under the regulatory prism of the RBI. In November, the RBI introduced stricter asset classification standards for NBFCs to bring them in line with the banking system. Key points included classifying Special Mention Accounts (SMAs) and NPAs based on end-of-day position and moving from NPA category to standard category only after clearing all delinquencies.
While these measures can cause problems in the short term, in the long term they can strengthen the roots of risk management systems.
According to the RBI, the objective of the BCP framework is to enable timely prudential intervention and to require the supervised entity to initiate and implement corrective actions in a timely manner, in order to restore its financial health. With this decision, the RBI added another regulatory step to increase the strength, stability and robustness of regulated entities to proactively rule out any emerging risks to their stability.
The BCP will apply to: all NBFCs accepting deposits (excluding Crown corporations); and (ii) all NBFCs not accepting deposits in the middle, upper and upper layers (excluding NBFCs not accepting / not intending to accept public funds; companies of State;) primary dealers; and housing finance companies).
The critical applicability of PCA will be for non-governmental entities that manage “public funds”. They include funds raised directly or indirectly through public deposits, commercial paper, bonds, intercompany deposits and bank financing, but exclude funds raised through the issuance of debt securities. instruments that must be converted into shares within five years from the date of issue.
The format and parameters of the PCA for NBFCs are close to those prescribed for banks although the target parameters may be different. It has Risk Weighted Capital (CRAR) parameters. Category I capital, ratio of net non-productive assets (NNPA) calibrated in three thresholds of increase risk – threshold – I (early sign); threshold-II (risk of aggravation); and threshold III (serious risk endangering livelihood).
The trigger points are shown in the table.
This PCA framework for NBFCs will be implemented from October 2022 based on the March 2022 financial statements for all depository NBFCs and other large entities that are grouped by the RBI under the middle, top and top layers of the SBR. Those who do not accept deposits with an asset size of less than 1,000 crore, major brokers, government-owned NBFCs, and housing finance companies are exempt from this framework.
Rigor beyond the parameters
The CPA framework has a single integrated regulation of “mandatory and discretionary” conditions. While mandatory conditions accompany the invocation of the PCA, discretionary conditions are aligned with the entity’s risk and threshold levels. Restrictions on distribution of dividends, remittance of profits, need for stakeholders to inject additional capital, etc. at the discretion of the RBI.
If they fall into higher risk thresholds, they may face more stringent restrictions such as an embargo on opening branches and changing the structure of the board composition to ensure that regulations are improving.
These conditions could limit the autonomy of the NBFCs but, at the same time, they could function as a systemic control to make them work on specific strategies to exit the CPA as quickly as possible. In addition, whenever PCA is invoked, it will be in the public domain, which could damage the reputation of the entity. Thus, it can work as a control tool for NBFCs not to invite PCA by proactively guiding the entity to better manage risk.
Out of the three key metrics – CRAR, Tier I capital, and NNPA – some NBFCs, experts say, could exceed the 6% NNPA mark, and the RBI may be asked to invoke the PCA. Since NBFCs have until March 31, 2022 to redress their stance on asset quality, they can improve performance and stay away from PCA.
It is a tool capable of making NBFCs more sensitive to risk management.
The transparency of the CPA framework should be a powerful tool for NBFC boards to proactively monitor key metrics and implement best business and risk management practices to stick to the gap.
The author is adjunct professor, Institute of Insurance and Risk Management, Hyderabad. Views are personal