The Reserve Bank of India (RBI) ’s guidelines on scale-based regulation (SBR) for non-banking finance companies (NBFCs) and housing finance companies (HFCs) restricts the excessive risk-taking by large-sized NBFCs and puts in appropriate checks & balances to monitor processes from a risk perspective. While improving the governance standards of NBFCs, the circular puts certain guardrails in terms of risk-taking ability and governance, says a research note.
In a report, India Ratings and Research Pvt Ltd (Ind-Ra) says the immediate impact could be felt on asset classes such as real estate lending, corporate lending and initial public offer (IPO) financing.
“It (the circular) stipulates higher capital and provisioning buffers, which could impact margins by capping riskier exposures. All this would result in a re-evaluation of business strategies factoring risk and return trade-off. This is because the level of supervision and restriction on upper and middle layer players would lead to some recalibration on growth and promote partnerships through co-lending and co-origination with banks,” Ind-Ra says.
Restrictions on real estate lending would require NBFCs to move towards the mid-stage of project financing with approvals in place, impacting their margins and subjecting them to higher competition from banks and housing finance companies.
“Also, capping the proportion of land acquisition funding under the commercial real estate exposure could increase the need of developer’s equity in incremental project funding. The regulation has diminished the arbitrage enjoyed by NBFCs and can have an implication on margins in the segment,” the ratings agency says.
According to Ind-Ra, the current strong capital markets have resulted in IPO financing gaining a lot of prominences, with high borrowers carrying highly levered bets. Factoring in the size of the IPO market, which can vary based on oversubscription and issuance, which could run up to Rs1 trillion, the regulator has capped the lender exposure to the borrower at Rs10 million.
“This could diminish the IPO financing appetite of large high net-worth individuals (HNIs) and institutions along with lowering subscriptions and investor participation. However, we opine IPO funding was limited to only a select few large NBFCs, and this regulation may distribute the business among several players. We also believe some companies would consider bringing forward their IPO plans, leading to an increased IPO pipeline, before the regulation comes into effect on 1 April 2022,” the ratings agency says.
According to the ratings agency, the revised regulation of having common equity tier 1 of 9%, leverage framework, differential standard asset provisioning and capital estimation in line with internal capital adequacy assessment process (ICAAP), and credit concentration norms in line with that of banks will narrow the arbitrage between the separate regulatory frameworks for non-banks and banks.
“While the current guidelines do not elucidate the industry demand for differential risk weightings on loan assets similar to that of banks, it could be considered as and when the RBI comes up with the guidelines on leverage for NBFCs under upper layer (NBFC-UL)” it says.
As per RBI’s SBR framework, NBFCs in the upper layer will be subject to further stringent regulations to maintain common equity Tier I of 9% and a leverage ratio prescribed by the regulator.
However, many large NBFCs would comply with this regulation as capital buffers across large NBFCs have been improved due to lack of growth, and capital raising has been taken to mitigate the pandemic impact. RBI stipulates a leverage cap for upper layer NBFCs. However, investors and the lending community would view leverage based on the riskiness and chunkiness of NBFCs’ asset class.
According to Ind-Ra, with a leverage cap, the capital commitment would go up for NBFCs. It says, “Tighter provisioning norms for standard assets for the upper layer NBFCs could result in shoring up of the buffers to absorb the asset-side stress. The Ind-As regime necessitated NBFCs to take prudent coverage on standard assets, and the sector increased the provision coverage during COVID-19 times. However, if the provision norms are further strengthened, it would compress profitability.”
“Mandatory listing within three years would bring additional disclosure norms and improve governance framework for NBFCs. The guideline also drives the adoption of core banking solutions for the middle and upper layers of NBFCs to strengthen the systems and processes,” the ratings agency says.
The internal capital adequacy assessment framework requires NBFCs to assess risks more transparent and structured and monitor it regularly. Ind-Ra says, “This is more in line with banks who have to compute risk-based capital factoring in credit, market, and operational risks. Enhanced disclosure norms in terms of a covenant breach, divergence in asset quality and provisioning would help all the stakeholders get a true picture of the state of affairs of NBFCs. It would increase the transparency of operations and lead to better evaluation of NBFCs.”
Additionally, governance and disclosure norms are strengthened, considering the large size that many non-banks have acquired and their deep interconnectedness with the broader financial system. The proposed regulation intends to bring in proportionality in the regulation in line with the systemic risk that could emanate from the scale of non-banks.
RBI defines those NBFCs as systematically important NBFCs which have assets under management (AUM) of Rs5 billion. However, the NBFC base level has been kept at AUM of Rs10 billion with moderate changes with the implementation spread over some period.
NBFCs in the base layer or with an asset size of less than Rs10 billion will have to operate with enhanced disclosure norms, constitute a risk management committee and adopt a 90 days past due (dpd) NPA recognition norm. The net owned fund requirement has been increased to only serious players with tangible material net worth operating in the industry. Related-party transactions will have to be approved by the board of directors for better checks & balances.
Acknowledging that the growing size of NBFCs can pose systemic risks, the regulations stipulate more significant governance norms for large-sized entities based on inter-connectedness, size and leverage, nature and granularities of liability structure, holding group structure and entities complexity.
The SBR classifies NBFCs into four layers, namely, base layer for non-banks with asset size below Rs10 billion, middle layer for non-banks with asset size above Rs10 billion and all deposit-taking NBFCs, upper layer for NBFCs that RBI identifies as those warranting an enhanced regulatory requirement based on a set of parameters and scoring methodology, and top layer for those non-banks that pose a systemic risk and would contain entities where RBI requires additional supervision.
The RBI guideline restricts the excessive risk-taking by large-sized NBFCs and puts in appropriate checks & balances to monitor processes from a risk perspective. It stipulates higher capital and provisioning buffers which could impact margins by capping riskier exposures.
According to Ind-Ra, all this would result in a re-evaluation of business strategies factoring risk and return trade-off. “This is because the level of supervision and restriction on upper and middle layer players would lead to some recalibration on growth and promote partnerships through co-lending and co-origination with banks. In a nutshell, the circular improves the governance standards of NBFCs, but would put certain guardrails in terms of risk-taking ability and governance,” it says.