Opinion

Regulating NBFCs, the banking way

K Srinivasa Rao | | Updated on: Dec 21, 2021

RBI extending the PCA framework to shadow banks will prompt them to implement best business, risk-management practices

In a strategic move, the RBI has extended the framework of Prompt Corrective Action (PCA) to non-banking financial companies (NBFCs), bringing their regulations closer to banks. Looking at the fragility of NBFCs and their collateral risks to the financial stability witnessed in recent years, the RBI has been gradually upgrading the regulatory architecture to strengthen their risk management practices as they use the expanded scope of their role in financial intermediation.

NBFCs have a critical role in connecting people to the formal financial system. But their internal risk governance may not be able to cope with the nuances of diversity of risks to which they are now getting exposed. Unless the gulf in risk management practices is bridged, ring fencing them against the proliferation of risks will not be possible.

Realising the depth of connect of NBFCs with consumer segments, the RBI has been calibrating regulations to align them with banks that are under better regulatory lens. The RBI has been simultaneously working on harnessing the potential of NBFCs by allowing them more operational freedom to step up growth, but at the same time calibrating their regulatory rigour.

During October 2021, the RBI introduced scale-based regulations (SBRs) — a revised regulatory framework for NBFCs that aligns measures of supervision in line with their size and direct customer connect by classifying them into four pools. Way before, the risk based internal audit (RBIA) was also extended to select NBFCs depending upon their size of operations and spillover risks that they can pose to the financial sector.

The need to appoint a chief risk officer (CRO) was also mandated to better regulate the institutionalised processes of risk governance and its interface with the board so that they can provide safe and secure services to consumers on a durable basis.

The digital lending operations of fintechs, peer-to-peer (P2P) lenders and neo-banks are also under the regulatory lens of the RBI. In November, the RBI introduced more stringent asset classification norms for NBFCs so as to align them to the banking system. The key points included classification of special mention accounts (SMAs) and NPAs on a day-end position basis and upgrade from the NPA to standard category only after clearance of all outstanding overdues.

Though these measures could cause near-term pain, in the long run they can strengthen the roots of risk management systems.

PCA framework

According to the RBI, the objective of the PCA framework is to enable supervisory intervention at appropriate time and require the supervised entity to initiate and implement remedial measures in a timely manner, so as to restore its financial health. With this move, the RBI added another regulatory milestone to increase the soundness, stability and sturdiness of regulated entities to proactively ward off any incipient risks to their stability.

The PCA will apply to: all deposit taking NBFCs (excluding government companies); and (ii) all non-deposit taking NBFCs in middle, upper and top layers (excluding NBFCs not accepting/not intending to accept public funds; government companies;) primary dealers; and housing finance companies).

The critical applicability of the PCA will be for non-government entities handling “public funds". They include funds raised either directly or indirectly through public deposits, commercial paper, debentures, inter-corporate deposits and bank finance but excludes funds raised by issue of instruments compulsorily convertible into equity shares within five years from the date of issue.

The format and parameters of PCA for NBFCs is close to the one prescribed for banks though the target parameters could be different. It has parameters of capital to risk weighted assets (CRAR). Tier-I capital, net non-performing asset (NNPA) ratio calibrated into three heightening risk thresholds — threshold–I (early sign); threshold–II (deepening risk); and threshold–III (serious risk jeopardising sustenance).

The trigger points are shown in the Table.

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This PCA framework for NBFCs will be implemented from October 2022 based on the financials of March 2022 for all deposit-taking NBFCs and other large outfits that are grouped by the RBI under middle, upper and top layers of SBR. Those not taking deposits with an asset size of less than ₹1,000 crore, primary dealers, government-owned NBFCs, and housing finance companies are exempt from this framework.

Rigour beyond parameters

The PCA framework has a unique built-in regulation of ‘mandatory and discretionary’ conditions. While mandatory conditions come with invocation of PCA, the discretionary conditions are aligned to the riskiness and threshold levels of the entity. Restrictions on dividend distribution, remittance of profits, needing stakeholders to infuse additional capital, and so on, at the discretion of the RBI.

If they enter higher risk thresholds, they may face more stringent restrictions like embargo on opening branches and altering the structure of the board composition to make regulations work their way to improve.

These conditions could be limiting the autonomy of the NBFCs but, at the same time, they could work as a systemic control to make them work upon specific strategies to come out of PCA as quickly as possible. Moreover, whenever PCA is invoked, it will be in public domain that could impinge upon the reputation of the entity. So, it can work as a control tool for NBFCs not to invite PCA by proactively guiding the entity to manage the risks better.

Out of the three key parameters — CRAR, Tier-I capital and NNPAs — some NBFCs, according to experts, could breach the 6 per cent mark of NNPAs, and the RBI may be prompted to invoke PCA. Since the NBFCs have time up to March 31, 2022, to set right their asset quality position, they may improve the performance and stay away from PCA.

It is an apt tool to bring about better sensitivity of NBFCs towards risk management.

The transparency of the PCA framework should be a potent tool for the boards of NBFCs to proactively keep tab on the key parameters and implement best business and risk-management practices to stay away from it.

The writer is Adjunct Professor, Institute of Insurance and Risk Management, Hyderabad. Views are personal

Published on December 20, 2021
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