Chapter 1

Non-Banking Financial Companies

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The system/schemes of regulation of the working and operations of the NBFCs comprises: (i) RBI Act (Chapter III-B), (ii) RBI Directions, (iii) ALM Framework, (iv) Guidelines for Fair Practices code and (v) Credit Information Companies Act.

RBI Act
The RBI regulates and supervises the NBFCs under Chapter III-B of the RBI Act. The regulatory and supervisory objective is to (a) ensure the healthy growth of the NBFCs, (b) ensure that they function as part of the financial system within the policy framework in such a manner that their existence and functioning do not lead to any systematic aberration and (c) ensure that the quality of surveillance and supervision is
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sustained by keeping pace with the developments that take place in this sector of the financial system. An NBFC is a company engaged in the business of loans and advances, acquisition of shares/bonds/debentures/ securities issued by the Government or local authority or other similar marketable securities, leasing, hire-purchase, insurance business, venture capital, merchant banking, broking and housing finance.

It is mandatory that every NBFC should be registered with the RBI to commence/carry on any business. It should have a minimum net owned fund of Rs. 25 lakh. The NBFCs registered with the RBI are (i) equipment leasing, (ii) hirepurchase, (iii) loan and (iv) investment companies. The other types of NBFCs are regulated by other regulators. They could be further classified into those accepting deposits and those not accepting deposits. The registered NBFCs are required to invest in unencumbered approved securities worth at least 5 per cent of their outstanding deposits. Every NBFC must
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create a reserve fund by transferring at least 20 per cent of its net profits before declaring any dividend. The RBI can regulate/prohibit solicitation of deposits from public. It can give directions to NBFCs relating to (a) prudential norms for income recognition, accounting standards, provisioning on capital adequacy and (b) deployment of funds. It can also issue directions for providing information relating to deposits/for conduct of business. For contraventions/defaults by an NBFC, the RBI can impose penalty. It can also cancel the registration of an NBFC.
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The RBI has issued four directions to the NBFCs: (1) Acceptance of Public Deposits Directions, (2) Prudential Norms Directions for NBFCs-D and NBFCs-ND-SI, (3) Auditors Reports Directions, and Core Investment Companies Directions.

Acceptance of Public Deposit Directions

As per the public deposits directions, there is a ceiling on the acceptance of public deposits. An NBFC maintaining the required net owned funds (NOF) and capital adequacy ratio (CRAR) and complying with the prudential norms, can accept public deposits as follows: Equipment leasing (EL)/hire-purchase companies (HP) maintaining CRAR of 15 per cent without credit ratingthe lower of 1.5 times of NOF or Rs. 10 crore; EL/HP
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with 12 per cent CRAR and minimum investment grade rating4 times of NOF; and loan companies/investment companies with 12 per cent CRAR and minimum investment grade rating1.5 times of NOF. The NBFCs can accept/renew deposits for 12-60 months. They cannot offer interest higher than the ceiling rate prescribed by RBI which may be paid/compounded at rests not shorter than monthly rests. Deposits may be accepted by NBFCs in joint names. Premature withdrawl of deposits within 3 months from the date of
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acceptance is not permitted. The NBFCs cannot offer gifts/incentives or any other additional benefit to the depositors. They can open branch(es)/appoint agents to collect deposits. They should furnish deposit receipts containing details to the depositors and maintain register(s) of deposits. The unencumbered approved securities required to be maintained by an NBFC should be kept with a bank/depository and cannot be withdrawn/encashed except for payment of deposits.

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Prudential Norms Directions

The prudential norms relate to income recognition, income from investment, accounting standards, accounting for investments, asset classification, provisioning, capital adequacy, prohibition on loans/investments, loans against own shares, investment in land/building and unquoted shares and concentration of credit and investments.
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Income on a non-performing asset (NPA) should be recognised only when actually realised. An asset (i.e., asset/term loan/call loan/bill/ receivables/sale of assets or services) becomes non-performing when an income/instalment remains overdue for 6 months. The lease rentals/hire-purchase instalments should be overdue for 12 months.

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Dividends on shares/units should be accounted for on cash basis. However, accrual basis can be used if the dividend has been declared and the right to receive established, the interest is predetermined and paid regularly or the interest is guaranteed by the Government.

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The quoted current assets should be valued at the lower of the cost or market value. Net depreciation should be provided but net appreciation should be ignored. Unquoted equity shares should be valued at cost or break up value/air value, whichever is lower. Unquoted preference shares are to be valued at the lower of the cost and face value. The basis of valuing an investment in Government securities and commercial papers should be the carrying cost. Units of mutual funds should be valued at NAV.
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The loans and advances, lease/hire-purchase assets and other forms of credit should be classified into standard, doubtful and loss. A standard asset is not an NPA. An asset classified as an NPA for less than 2 years is a sub-standard asset. Doubtful assets remain NPAs for more than 2 years. Loss assets are those identified and written off.

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The loss assets should be provided for upto the extent of 100 per cent. There should be 100 per cent provision for the unsecured portion of doubtful assets and 20-50 per cent of the secured portion. A general provision of 10 per cent and 0.25 per cent of total outstanding sub-standard assets and standard assets respectively, should be made.

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In respect of hire-purchase/lease assets, the total dues (overdues plus future instalments) minus the finance charges not credited to the profit and loss account and carried forward as unmatured finance charges, and the depreciable/net realisable value of the underlying asset, whichever is lower, should be provided for. An additional provisioning of 10-100 per cent of the net book value of the lease/hire-purchase assets is required in case of overdues between 12 months and 48 months.
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All NBFCs-D are required to maintain a minimum capital ratio of Tier-I and Tier II capital, equivalent to 12 per cent of the aggregate risk weighted assets and risk adjusted value of off-balance sheet items. The Tier-II capital should not exceed 100 per cent of the Tier-I capital. While Tier-I capital means owned funds, Tier-II capital consists of preference shares, revaluation reserves, general provision and loss reserves, hybrid debt and subordinated debt. Risk weighted assets mean the weighted aggregate of
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funded and non-funded items. The degree of credit risk, expressed as percentage weightage, is assigned to the balance sheet assets and conversion factors to off-balance sheet items. The aggregate should be taken into account for reckoning the capital ratio.

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The prudential norms applicable to NBFCs-ND-SI differ from those applicable to NBFCs-D. These relate to capital adequacy ratio, concentration of credit/investments, submission of information in regard to change of address, directors, auditors and so on. The elements of the prudential norms in applicable to NBFCs-ND-SI pertain to prohibition from making loans/investments; restrictions on investments in land, buildings and unquoted shares; submission of half-yearly return; and exposure to capital market.

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An NBFC-D cannot grant a loan/other credit facility/make investment/create any other asset as long as it defaults in the repayment of any deposit. It cannot lend against its own shares. It can also not lend to any single borrower/group of borrower in excess of 15-25 per cent respectively, of its owned funds. The ceiling on loans and investments together is 25-40 per cent for a single borrower and a group borrower respectively.

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Auditors Report Directions

In addition to the normal auditors report under the Companies Act, the auditors of the NBFCs should also make a separate report on their financial statements to the shareholders containing statements on matters of supervisory concern to the RBI in respect of all NBFCs/NBFCs accepting deposits/NBFCs not accepting deposits. In case of an unfavourable, qualified report relating to the above matters, the reasons for the same should also be stated. The auditors should also submit a report to the RBI in case of unfavourable/qualified report.
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Core Investment Companies

The main elements of the regulatory framework for core investment companies are their registration, capital requirements, leverage ratio and submission of annual statutory auditors certificate.

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Every systematically important core investment company (CIC-ND-SI) should be registered with the RBI. A CIC-ND-SI means a core investment company, having total assets of at least Rs 100 crore and holding public funds in the form of deposits/CP/bank finance excluding compulsorily convertible instruments within 10 years from the date of issue. A core investment company (CIC) means a NBFC carrying on the business of acquisition of shares/securities where at least (i) 90 per cent net assets are in the form of shares/debentures/debt/loan to group
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Companies, (ii) 60 per cent net assets are in equity shares including compulsorily convertible instruments in group companies and (iii) which trades in its investment only through block sale for dilution/disinvestment/carries on only the business of investment in deposits, money market instruments, unit of mutual funds, Government securities, bonds, debentures of and grant of loan/guarantee to, on behalf of, group companies. Group companies refer to an arrangement involving entities related to each other through any of the following relationship:
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Subsidiary parent, joint venture, associate, promoter-promotee; common brand name, and at least 20 per cent investment in equity. The adjusted net worth (ANW) of CIC-ND-SI should be at least 30 per cent of its aggregate risk weighted assets on balance sheet items and risk adjusted value of off-balance sheet items. The ANW means total owned funds plus 50 per cent of the unrealised appreciation in the book value of quoted investments and increase in share capital minus the diminution in the block value of quoted investments and reduction in share capital.
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Their outside liabilities should never exceed 2.5 times their ANW.

An annual compliance certificate from the auditors should be submitted to the RBI within one month of the finalisation of the balance sheet.

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ALM Framework
The RBI guidelines relating to ALM focus on interest rate and liquidity risk management systems in banks, which form a part of the ALM function. The main elements of the ALM system are: ALM information system, ALM organisation and ALM process.

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The ALM system should be built up on a sound methodology, with the necessary information system as a back up. Information is key to the ALM process. A uniform system is not feasible for all banks. The ALM system analyses information on the basis of residual maturity and behavioural pattern. Banks should initially follow the ABC approach, that is, analyse the behaviour of the asset and liability products in the sample branches that account for significant business and make rational assumptions about the behaviour of the assets and liabilities in other
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branches. The data and assumptions can be refined over time in the light of experience of conducting business within the ALM framework. The spread of computerisation would facilitate accessing of data.

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The Board of Directors should have the overall responsibility for the management of risk and of deciding the risk management policy of the bank, besides setting limits for liquidity, interest rate, forex and equity price risk. The ALCO should ensure adherence to the limits set by the Board and decide the business strategy of the bank on the assets and liability side, in line with the budget and risk management objectives. A subcommittee of the Board should oversee the implementation of the system and review its functioning periodically.
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The ALM process mainly addresses liquidity and interest rate risks.

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NBFCs management should not only measure the liquidity position of NBFCs on an ongoing basis, but also examine how liquidity requirements are likely to evolve under different assumptions. Liquidity should be tracked through maturity/cashflow estimates. The use of the maturity ladder and calculation of cumulative surplus/deficit of funds at selected maturity dates may be used to measure/manage the net funding requirements. The maturity profile of the various heads of accounts should be used for
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measuring the future cashflows in different time brackets: 1-14 days; 15-28 days; 29 days upto 3 months; 3-6 months; 6 months 1 year; 1 3 years; 3 5 years; and over 5 years. Within each time bracket, there could be mismatches between cash-inflows and outflows. The main focus should be on short-term mismatches, namely, 114 days and 15-28 days. The mismatches (negative gap) in the normal course should not exceed 20 per cent of the cashoutflows in each time bracket.

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A statement of structural liquidity may be prepared by placing all cash inflows (i.e., maturing assets) and cash outflows (i.e., maturing liabilities) in the maturity ladder, according to the timing of the cashflows. While determining the tolerance level in mismatches, NBFCs should take into account all the relevant factors, based on their asset liability base, nature of business, future strategy and so on and further refined with experience gained in liquidity management. To monitor their short-term liquidity on a dynamic basis, over a time horizon spanning from 190 days, NBFCs may estimate
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Their short-term liquidity profiles on the basis of business projections and other commitments for planning purposes.

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Interest rate risk has two dimensions. The immediate effect of a change in the interest rate is on its net interest income (NII) or net interest margin (NIM). The long-term impact is on the market value of equity (MVE)/networth.

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Initially, NBFCs should use the traditional gap analysis to measure the interest rate risk and move over to modern techniques of interest risk measurement, such as duration gap analysis, simulation and VaR overtime, when they acquire sufficient expertise and sophistication in acquiring and handling MIS.

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Gap analysis measures mismatches between rate sensitive liabilities and assets. Such assets and liabilities should be grouped into time brackets according to the residual maturity or next repricing period, whichever is earlier. The gaps may be classified into the following timebrackets: 128 days; 29 days to 3 months; 36 months; 6 months 1 year; 13 years; 35 years; over 5 years; and non-sensitive.

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The gap is the difference between rate sensitive assets (RSAs) and rate sensitive liabilities (RSLs) for each time bracket. RSAs > RSLs = positive gap; RSAs < RSLs = negative gap. The gap report indicates whether the bank can benefit from rising interest rates (positive gap) or from a declining interest rate (negative gap).

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Fair Practices Code

The main elements of the RBI guidelines on fair practices code for NBFCs are: application forms and their processing; loan appraisal and terms/conditions; loan disbursements including changes in terms and conditions; and general.

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Credit Information Companies

To facilitate the efficient distribution of credit and to provide for regulation of CICs, the CICs Act was enacted in 2005. Credit information includes (1) nature of loans, advances, amount under credit cards, other credit facilities; (2) nature of security; (3) guarantee/non-fund based facility; (4) credit worthiness of a borrower and so on. Credit institutions include banks, NBFCs, PFIs, SFCs, HFCs, companies in credit card business and so on. The main elements of the framework of regulation of CICs are: registration, management, auditors, functions, information privacy principles, and offences/penalties.
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To commence/carry on its business, a CIC requires registration with the RBI, for which it has to satisfy conditions like minimum capital, general character of its management and any other condition to ensure that it would not be detrimental/prejudicial to public interest/banking policy/credit system/specified users/borrowers/ clients and so on. While granting registration, RBI may impose conditions it may consider fit. It can cancel the registration of a CIC on failure (1) to comply with the conditions of registration, (2) to fulfil conditions relating to capital, general
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character of its management and so on, (3) to comply with provisions of any law/RBI directions and so on.

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The superintendence, control and direction of the CIC would be vested in its Board of Directors, who should act on business principles. At least 50 per cent directors should have special knowledge in public administration, law, banking, finance, accounting, management and IT. The RBI can supersede the Board for upto 12 months. It has also the powers to determine the policy and to issue directions and conduct inspection of a CIC.

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The auditors of the CIC are duty bound to inquire if it has complied with RBIs requirements of submission of statements/information/particulars of its business and report to the RBI if not satisfied. The RBI may order a special audit of the accounts of the CIC.

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The functions of a CIC are: (i) to collect, process and collate information on trade, credit and financial standing of borrowers, (ii) to provide credit information/credit scoring to specified users/CICs, (iii) to undertake research projects and (vi) to undertake any other form of business specified by the RBI. A CIC may register CIs/CICs as members and charge a fee for furnishing credit information to specified users.

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All CICs/CIs/specified users in possession/ control of credit information should ensure that the data maintained by them is accurate and complete, duly protected against loss and unauthorized access/use/disclosure. They should follow the following privacy principles in relation to collection, processing, collating, recording, preservation, secrecy, sharing and usage of credit information: (i) principles followed/adopted; (ii) purpose, (iii) extent of obligation, (iv) preservation, (v) networking and (vi) any other.
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Penalties for offences relate to (a) a wilful false statement in any material particular/omission of a material statement, (b) breach of any privacy principle, (c) wilful provision/omission of false information in any material particular/to make a material statement, and (d) contravention of any legal provision. The RBI can impose penalty (a) for unauthorised access, (b) for a breach of the privacy principle/wilful provision or omission of material particulars and (c) for a contravention of the provisions of the CICs Act/rules/orders/ directions.
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