RBI’s Scale-Based Regulatory Framework for NBFCs

Over the last decade, the NBFC sector expanded rapidly in size, complexity, and interconnectedness with the rest of the financial system. Some NBFCs grew to become as large and impactful as mid-sized banks. However, regulation had not kept fully in pace, allowing a degree of regulatory arbitrage (NBFCs had lighter norms than banks).

This culminated in stress events – notably the default of IL&FS (Infrastructure Leasing & Financial Services) in 2018, which triggered a liquidity crunch, and issues at other large NBFCs/HFCs like DHFL, prompting systemic concerns. These events highlighted that certain big NBFCs could pose systemic risks if they failed, similar to banks. In response, RBI decided to rejig the regulatory framework to be proportionate to the scale and risk profile of NBFCs.

In October 2021, RBI announced a new Scale-Based Regulation (SBR) for NBFCs, and it came into effect from October 1, 2022 (with some elements phased in by 2023). The SBR framework introduces a four-layered structure for NBFC regulation, wherein the stringency of regulatory requirements increases for higher layers. These four layers are (1) Base Layer (2) Middle Layer (3) Upper Layer and (4) Top Layer.  The idea is to focus regulatory resources and tougher norms on the larger NBFCs that could harm financial stability, while simplifying things for smaller NBFCs.

NBFC–Base Layer (NBFC-BL)

This is the bottom layer, consisting of the least significant NBFCs from a systemic risk perspective. It includes:

• All non-deposit-taking NBFCs with asset size below ₹1,000 crore (small and mid-sized NBFCs).
• Additionally, regardless of size, certain types of NBFCs that inherently carry lesser risk or operate under restricted scopes are always kept in the Base Layer. These are:
  • NBFC-P2P (peer-to-peer lending platforms)
  • NBFC-AA (account aggregators)
  • NOFHCs (non-operative finance holding companies for banks)
  • NBFCs not availing public funds and not having customer interface (e.g., an NBFC that doesn’t take any public funds and doesn’t interact with retail customers — perhaps an intra-group financing entity — would be base layer by virtue of low external impact).
• Also, certain Government-owned NBFCs which might be given some relaxation are placed in Base Layer or Middle Layer (but not higher).

Regulation for Base Layer

These NBFCs continue following existing norms akin to earlier non-systemically-important NBFCs. Notably, RBI raised the minimum NOF for new NBFCs (Base Layer) to ₹10 crore (from ₹2 crore earlier) to ensure stronger start-ups. All base layer NBFCs must now adhere to the 90-day NPA norm (earlier, smaller NBFCs had 180-day NPA recognition – that forbearance ended by March 2022). Base layer NBFCs have relatively simpler compliance requirements, but must still maintain minimum capital adequacy (if applicable) and submit basic returns. The philosophy is “light touch, but not no touch” for these small entities.

NBFC–Middle Layer (NBFC-ML)

This layer comprises:

• All Deposit-taking NBFCs (NBFC-D), regardless of their asset size. Accepting public deposits inherently elevates an NBFC to at least Middle Layer due to potential risk to public funds.
• Non-deposit NBFCs with asset size ₹1,000 crore or more. (This sets a higher bar than the old ₹500 cr threshold for systemic importance, effectively raising the cutoff for stricter norms. Smaller NBFCs < ₹1000 cr that were earlier NBFC-ND-SI will get some leeway now, unless they take deposits).
• Certain specialized NBFCs are by default put in Middle Layer (or higher if size warrants). These include:
  • Housing Finance Companies (HFCs)
  • Infrastructure Finance Companies (IFCs)
  • Core Investment Companies (CICs)
  • Infrastructure Debt Funds (IDF-NBFC)
  • Standalone Primary Dealers (SPDs)
  • (The rationale is that these businesses, due to their nature or statutory role, should not be in the base layer even if small. For instance, an HFC or IFC is directly tied to critical sectors; a primary dealer has a specific role in G-Sec markets.)

Regulation for Middle Layer

NBFC-ML are subject to stringent prudential regulations similar to banks in many respects. They must maintain minimum CRAR of 15%, adhere to exposure norms (limits on credit concentration to single borrowers or groups), follow stricter governance standards (like having independent directors, board committees for risk, audits, etc.), and enhanced disclosures.

Many of these norms were already applicable to NBFC-ND-SI and NBFC-D earlier, and now are formalized under ML. Additionally, RBI introduced a regulatory Prompt Corrective Action (PCA) framework for NBFCs in this layer (and Upper Layer) effective October 2022 – meaning if an NBFC’s capital falls or NPAs rise beyond certain levels, RBI can impose corrective restrictions (just as it does for weak banks). This is a significant step to monitor the health of large NBFCs.

NBFC–Upper Layer (NBFC-UL)

The Upper Layer is a new concept. It will consist of those NBFCs which are specifically identified by RBI as warranting enhanced supervision due to their size, interconnectedness, and risk factors. The selection criteria involve a scoring methodology – considering parameters like asset size, leverage, interconnectedness, substitutability, complexity of operations, etc.

• By design, the top 10 largest NBFCs by asset size will always be in the Upper Layer (unless they are already banks or something outside NBFC ambit, of course).
• Additionally, RBI can name more NBFCs (beyond the top 10) to UL if they are deemed risky.

In total, roughly 25-30 NBFCs might end up in Upper Layer at any time (though the exact count may vary year to year). For example, in the initial list (2022-23), RBI might have classified around 15-16 entities as NBFC-UL. These likely include the giants of the sector – major consumer finance companies, big housing finance companies, large infra financiers, etc.

Examples of Upper Layer NBFCs

These include the likes of Bajaj Finance, Shriram Finance, Tata Capital Financial Services, LIC Housing Finance, PNB Housing Finance, Mahindra & Mahindra Financial Services, Aditya Birla Finance, L&T Finance, Cholamandalam Finance, etc. – essentially top lenders outside the banking arena. These will now have close monitoring.

Regulation for Upper Layer

NBFC-UL will face bank-like regulation (“regulatory equivalence” to some extent). This means:

• Stricter governance norms: For instance, the CEO or MD of an NBFC-UL cannot serve more than 15 years (mirroring bank CEO tenure limits); a mandatory Risk Management Committee of the Board must be in place; compensation guidelines (including clawback provisions for senior management) similar to banks; enhanced fit-and-proper criteria for directors.
• Tighter prudential norms: NBFC-UL have to implement Internal Capital Adequacy Assessment Process (ICAAP) under Basel’s Pillar 2 guidelines – basically, they must assess their own capital needs for various risks and not just meet minimum CRAR. They are also subject to Large Exposure Framework (limits on exposure to a single counterparty or group, aligned with bank norms, e.g. not more than 25% of capital to one borrower, etc. unless specified otherwise). Standard asset provisioning for NBFC-UL is set to align with banks’ norms (differentiated by asset type; earlier NBFCs had a flat 0.4% standard asset provisioning, but UL may need to do higher for riskier loans).
• Listing requirement: If an NBFC is designated as Upper Layer and it’s not already publicly listed, it must list within 3 years (except if it’s a government NBFC). This is to increase transparency and market discipline for the largest NBFCs.
• Technology and risk management: NBFC-UL with significant customer interface must implement Core Banking Solutions (or equivalent integrated IT systems) by a set date, to improve data management and customer service akin to banks. They also have more robust cybersecurity and risk management guidelines to follow.
• Regulatory reporting and disclosures: NBFC-UL have to meet higher standards of disclosure, nearly on par with listed companies and banks – including in annual reports and regulatory returns (for example, disclosure of capital buffers, liquidity coverage ratios, NPAs, etc.). They might also have additional reporting requirements such as reporting sensitive exposures, group risk factors, etc., to RBI more frequently.
• Overall, NBFC-UL are essentially treated as “bank-equivalent NBFCs” due to their systemic importance. The supervision from RBI is more intensive (including frequent inspections).

NBFC–Top Layer (NBFC-TL)

The Top Layer is an empty layer under normal circumstances. It is intended as a reserve layer for extreme risk NBFCs. If RBI observes that certain NBFC(s) in the Upper Layer are exhibiting very high risk (maybe rapid growth, weak governance, signs of instability) and pose a substantially higher systemic threat, it can move them to the Top Layer.

These NBFCs would then potentially face even more stringent measures or ad-hoc restrictions to mitigate systemic risk. The Top Layer is more a supervisory tool and not a predefined list; ideally, RBI expects not to populate it unless required. In essence, think of NBFC-TL as a “watchlist” for critical NBFCs that are too important and too risky – analogous to Domestic Systemically Important Banks (D-SIBs) concept, though D-SIBs (like SBI) still operate under same bank regulations but with extra capital buffers. For NBFCs, Top Layer could invite custom regulatory prescriptions or accelerated corrective action.

To summarize the layering

• Base Layer = small NBFCs
• Middle Layer = all deposit-takers + bigger NBFCs and certain key players
• Upper Layer = top 10 + other big ones identified (the NBFCs that are effectively as important as big banks)
• Top Layer = contingency for very risky ones.

Key Regulatory Changes with SBR

Apart from classification, RBI introduced or reinforced several regulatory changes as part of SBR:

• Ceiling on IPO Funding: NBFCs had been known to lend against shares for clients to invest in IPOs (initial public offers). To curb speculative excesses, RBI capped loans from NBFCs for IPO subscription at ₹1 crore per borrower (effective April 2022). This applies to all NBFCs in middle and upper layers and prevents ultra-rich investors from using NBFC finance to corner IPO allocations.
• Introduction of Internal Ratings or Enhanced Disclosures: Large NBFCs now need to have board-approved internal credit risk models and publicly disclose capital adequacy, segment NPAs, etc. like banks do.
• Convergence in Asset Classification Norms: Disparities like NBFCs classifying NPAs only if 90+ days overdue (which was already aligned) or the income recognition on NPAs are largely aligned with bank norms now. One recent tweak was insisting NBFCs (ML and UL) also upgrade NPAs to standard asset status only after entire arrears are cleared (not just overdue EMI), similar to banks’ clarified norms.
• Liquidity Management: RBI has extended Liquidity Coverage Ratio (LCR) requirements to large NBFCs. NBFC-UL and big NBFC-ML must maintain a stock of high-quality liquid assets to survive a 30-day liquidity stress (phased in gradually). Earlier only banks had LCR mandates; now large NBFCs do too, ensuring better liquidity risk management. Even others must have an ALM (Asset-Liability Management) framework appropriate to their risk.
• Corporate Governance: For NBFC-ML and UL, there are guidelines on key personnel – e.g., the chief risk officer’s appointment, mandatory compliance function, rotation of audit partners, etc. Upper Layer NBFCs specifically must have at least 50% independent directors if they are board of significant size, separation of Chairman and MD roles (if applicable), and other governance improvements.

• Concentration Limits and Sensitive Sector Exposure: NBFC-UL have stricter concentration limits (like exposure to real estate and capital market as a % of capital) which were there for NBFCs but now more uniformly applied. Upper Layer NBFCs might also need to adhere to sectoral exposure caps if RBI finds concentration (e.g., not too much lending to one sector like commercial real estate beyond a point).
• Transition Arrangements: RBI provided timelines for NBFCs moving into these new categories to comply with fresh norms. For example, if an NBFC was identified in Upper Layer in Sep 2022, it has until Sep 2024 (max 2 years) to implement the stipulated enhancements like listing, etc., although some critical ones like NPA norms were sooner.

Impact of SBR

This framework is a significant overhaul. It effectively ended the old NBFC-ND-SI concept and replaced it with a more graduated approach. Smaller NBFCs got some reprieve (somewhat reduced regulatory burden for ₹500–1000 crore range, for instance), whereas the top NBFCs are now almost treated on par with banks in oversight.

The aim is to pre-emptively avoid another IL&FS-type scenario by having robust capital, governance, and risk checks on those large entities.

RBI’s Scale-Based Regulatory Framework is a tiered approach ensuring that “bigger the NBFC, tougher the regulation.” It preserves the agility of small NBFCs (important for last-mile credit delivery and niche services) by not over-burdening them, while simultaneously strengthening oversight on mid and large NBFCs to safeguard financial stability.