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Revamping Asset-Classification Standards for NBFCs: A Comprehensive Analysis


Last Updated on September 12, 2023 by Kanakkupillai

Revamping Asset-Classification Standards for NBFC

As the financial terrain grows, the spotlight has turned to the significance of the new asset quality classification norms for Non-banking Finance Companies (NBFCs). These norms carry profound implications for financial intermediation, pivotal in fostering economic growth. The transformation of NBFCs’ role aligns with the prospect of synergizing with banks, expanding the scope of services offered to the economy. Recognizing this dynamic shift, the Reserve Bank of India (RBI) has introduced a scale-based supervisory model, tailoring regulations to match the inherent risks.

Understanding the Importance of NBFCs

Non-banking Finance Companies (NBFCs) have increasingly become integral to the financial ecosystem. These entities play a critical role in bridging the void between conventional banking institutions and the unbanked or underserved segments of the population. NBFCs offer diverse financial services, including lending, investment, insurance, and more. As their role expands and their influence deepens, it becomes imperative to establish robust regulatory measures that ensure financial stability and consumer protection.

The Essence of Scale-Based Supervision

To enhance the regulatory framework for NBFCs, the RBI has introduced a scale-based supervisory model. This model recognizes that a one-size-fits-all approach to regulation may not be effective given the diverse nature and scale of operations of NBFCs. The principle of proportionality is central to this approach, wherein regulatory measures are calibrated based on the size and complexity of an NBFC’s operations. This calibrated approach acknowledges the diverse landscape of NBFCs and aims to provide operational flexibility to foster growth while maintaining adequate risk management protocols.

Categorizing NBFCs: A Layered Approach

To effectively implement the scale-based supervisory model, the RBI has categorized NBFCs into distinct layers based on asset size, activities undertaken, and perceived riskiness. This categorization ensures that regulatory measures are commensurate with the scale of operations while mitigating risks associated with various activities. The categorization encompasses four layers: Base Layer, Middle Layer, Upper Layer, and Top Layer.

Base Layer: This layer comprises non-deposit-taking NBFCs with assets below Rs 1000 crore, and NBFCs engaged in specific activities such as Peer-to-Peer Lending Platforms (P2P), Account Aggregator (AA), Non-Operative Financial Holding Companies (NOFHC), and those without public funds or customer interfaces.

Middle Layer: Encompassing deposit-taking NBFCs, regardless of asset size, and non-deposit-taking NBFCs with assets exceeding Rs 1000 crore. This layer also includes NBFCs engaged in activities like Standalone Primary Dealers (SPDs), Infrastructure Debt Fund – Non-Banking Financial Companies (IDF-NBFCs), Core Investment Companies (CICs), Housing Finance Companies (HFCs), and Infrastructure Finance Companies (NBFC-IFCs).

Upper Layer: This layer mandates enhanced regulatory requirements based on specific parameters and scoring methodologies. The top ten NBFCs, ranked by asset size, reside in this layer irrespective of other factors.

Top Layer: Currently unoccupied, this layer is designed to address substantial systemic risk emanating from specific NBFCs in the Upper Layer. If deemed necessary by the RBI, NBFCs could be transitioned from the Upper Layer to the Top Layer.

Permissibility of NBFCs to Become Banks: A Strategic Option

In a dynamic financial landscape, the boundaries between the roles of banks and NBFCs have been gradually blurring. Acknowledging this shift, RBI has accepted key recommendations from the ‘Report of the Internal Working Group (IWG) to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks.’ These recommendations outline standards and norms for NBFCs seeking to convert into universal or small finance banks (SFBs). This conversion option aligns with the fit, proper criteria, and specified capital base.

Emerging Norms for Asset Classification of NBFCs

To bolster the regulatory framework governing NBFCs, RBI issued clarifications on November 12, 2021, specifically related to income recognition, asset classification, and provisioning rules for banks, NBFCs, and all-India financial institutions. Key highlights of these clarifications include the classification of special mention accounts (SMA) and non-performing assets (NPAs) on a day-end basis. Moreover, transitioning from NPA to the standard category is only permissible after clearing all outstanding arrears. This effectively means NPAs can only be upgraded to the standard category when all overdue payments are settled.

While banks have been accustomed to adhering to such norms, NBFCs traditionally upgraded NPA accounts even with partial overdue payments, provided the total overdue on the reporting date was less than 90 days. However, transitioning to the standard asset category could be more challenging under the new framework. This is particularly relevant as borrowers from NBFCs, in general, are under stress, making complete overdue clearance a formidable task.

Impact of Stringent NPA Norms on NBFCs: A Closer Look

Introducing these stricter norms is expected to impact NBFCs’ slippages from the restructured book significantly. The categories of 31-90-day (SMA-2) and delays in upgrading to the standard category may lead to an increase in the stock of NPAs for NBFCs. This paradigm shift compels NBFCs to enhance their internal controls and methodologies for loan management. Timely recognition and collection updates, particularly for cash collections, become paramount.

Under the new framework, the restructured books of NBFCs and Housing Finance Companies (HFCs) have risen to approximately 4.1-4.4% and 1.8-2.2%, respectively, as of September 2021, compared to 2.2% and 1.0% in March 2021. While implementing stricter norms can lead to initial-term pains, these norms serve the long-term interests of the sector. Such challenges were encountered when early stress detection norms were introduced for banks. Nevertheless, these norms can serve as effective internal controls for NBFCs to detect early stress and take proactive measures to prevent them.

Fostering a Culture of Responsible Borrowing and Lending

As the economic landscape continues to evolve, adopting stricter asset classification norms is a testament to RBI’s commitment to enhancing the health and resilience of the financial system. These norms will bolster risk management practices and foster a responsible borrowing and lending culture. Identifying early stressed loan portfolios can ultimately lead to improved asset quality and a heightened commitment to honouring loan servicing commitments.

In the larger context, these measures serve the best interests of the financial sector. As NBFCs navigate the intricacies of the new asset classification norms, they must reorient their asset management strategies to align with the heightened rigour imposed by these regulations. The transformation of NBFCs into entities that seamlessly blend the roles of traditional financial intermediaries and innovative fintech players is a testament to their adaptability and resilience in an ever-evolving financial landscape.

Strengthening MSMEs through RBI’s New NPA Norms: Leveling the Playing Field for NBFCs

The landscape of credit and finance for Micro, Small, and Medium Enterprises (MSMEs) in India has undergone a transformative shift with the exponential growth of non-banking financial companies (NBFCs). These entities have become crucial players in the nation’s economy, fostering financial stability and inclusion. Their significance can be measured by their role in expanding the ambit of financial inclusivity, particularly by embracing the MSME sector—a critical engine of growth that has long grappled with limited access to financial services.

For years, small businesses have faced obstacles in securing loans due to intricate procedures and constraints. NBFCs have emerged as crucial allies, driving MSME lending and supporting a largely underserved sector. This support is particularly noteworthy, considering that only 8% of the sector can access formal credit channels, per a report. The unique value proposition of NBFCs lies in their ability to extend credit at the grassroots level across diverse locations, filling a significant gap in financial services. These entities offer swift disbursal of loans, flexible interest rates, and lenient eligibility criteria, making them an attractive choice for smaller businesses.

Moreover, NBFCs have harnessed innovative lending approaches tailored to the MSME segment. This innovation has translated into wider outreach, offering a notably accessible and reliable pathway for small businesses to access loans—something that was previously constrained by limited options.

While NBFCs have undoubtedly played a pivotal role in fortifying the MSME sector, they encounter specific challenges related to scalability and raising equity and debt capital. In this context, aligning asset classification norms with those of banks will introduce greater transparency, fostering comparable accounting practices and consequently enhancing the flow of equity and debt capital to NBFCs. Hence, the recent move by the Reserve Bank of India (RBI) in this direction is a positive stride towards harmonizing the regulatory environment.

Unpacking RBI’s NPA Classification Norms: Equating NBFCs and Banks

The RBI has unveiled a set of asset classification norms for NBFCs that align them with the practices of banks. These norms foster uniformity in treating non-performing assets (NPAs) across the financial sector. Under these new norms, two critical changes stand out. Firstly, all NBFCs are now required to recover the entire arrears of interest and principal to reclassify a non-performing asset as a standard asset, mirroring the requirements for banks. Secondly, the timeline for classifying an account as an NPA has been modified—accounts will be classified as NPAs 

Exactly 90 days from the overdue date, a change from the existing practice of starting 90 days from the end of the month when the account becomes overdue.

This alteration eliminates NBFCs’ cushion for upgrading NPA accounts to standard assets by collecting partial overdue amounts. Recognizing Special Mention Accounts (SMAs) and NPAs will also align with banks. While this shift may initially lead to higher NPAs for many NBFCs, resulting in increased provisioning and potentially lower profitability for those following aggressive accounting practices, it ultimately bolsters transparency, corporate governance, and accounting consistency, not just among banks but also across various NBFCs.

Significance of the Move and its Implications

Understanding the significance of this move requires a glimpse into the fundamental concepts of NPAs and standard assets. An account is classified as an NPA if the repayment of principal or interest remains overdue for a stipulated period. On the contrary, standard assets are those with normal risks attached to a business. Knowing the NPA figures of a financial institution is crucial as it serves as a barometer of portfolio health and underwriting quality. A high NPA ratio indicates flawed underwriting and recovery management and raises concerns about the business model’s viability.

The updated NPA classification norms respond to RBI’s observations of certain lending institutions upgrading accounts to the standard category upon the payment of only overdue interest, partial overdue, or similar factors. Furthermore, the new norms stipulate that an amount will be considered overdue if not paid on the fixed due date established by the bank. This brings greater clarity, especially as many loan agreements lack precise due dates, previously allowing room for different interpretations. The overarching goal is to foster consistent accounting practices across the NBFC sector.

The Broader Implications and the Road Ahead

The importance of this move extends beyond the immediate regulatory adjustments. Numerous NBFCs are reinventing themselves to become full-fledged banks, seeking to carve a niche in the dynamic financial markets. Leveraging their robust loan origination capabilities and cost-effective operations, NBFCs are well-positioned for such a transition. As the central bank continues to promote financial innovation for inclusive growth, bringing NBFCs at par with banks holds long-term benefits for financial stability and broader economic development.

Furthermore, the alignment of asset classification norms assumes particular significance in the context of partnership models between banks and NBFCs. The co-lending model, where most loans are booked in banks with a smaller share in NBFCs, underscores the need for uniform asset classification norms to avoid discrepancies in NPA recognition. This becomes even more relevant as both banks and NBFCs focus on retail loans, levelling the playing field and fostering collaboration over the medium and long term.

The RBI’s prudent decision to provide NBFCs until September 2022 to implement the revised norms underscores its commitment to a smooth transition. While the initial impact may lead to a marginal rise in NBFC NPAs, the move will ultimately enhance the health and transparency of the financial sector.

As the RBI continues to monitor sector developments and introduce scale-based regulations closely, harmonising norms can open the door for larger NBFCs to venture into banking, already complying with rigorous norms akin to banks. The consistent norms among banks and NBFCs are poised to foster deeper collaboration and, most importantly, act as a catalyst for the MSME sector. This sector stands to gain immensely from a level playing field and heightened financial transparency. This strategic alignment promises to fortify the MSME ecosystem and serve as a shot in the arm for its growth trajectory.



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