UNIT 3

NON BANKING FINANCIAL COMPANIES

3.1 Introduction & Definition

Non-Banking Financial Companies (NBFC) play a crucial role in broadening access to financial services, enhancing competition and diversification of the financial sector. They are increasingly being recognized as complementary to the banking system, capable of absorbing shocks and spreading risks at times of financial distress. Simplified sanction procedures, orientation towards customers, attractive rates of return on deposits and flexibility and timeliness in meeting the credit needs of specified sectors (like equipment leasing and hire purchase), are some of the factors that enhanced the attractiveness of NBFCs.

Definition:

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act 1956/ 2013, engaged in the business of loans and advances, acquisition of shares, debentures and other securities, leasing, hire-purchase, insurance business and chit business. The term NBFC does not include any institution whose principal business is that of agriculture activity, industrial activity or sale of any good (other than securities) or providing any services and sale/purchase/construction of any immovable property.

Section 45 I(f) of Reserve Bank of India (Amendment) Act, 1997 defines a non- banking financial company as:

(i)                  A financial institution which is a company;

(ii)                A non-banking institution which is a company with principal business of receiving of deposits, under any scheme or arrangement or in any other manner, or lending in any manner;

(iii)               Such other non-banking institution or class of such institutions, as the Reserve Bank with the previous approval of the Central Government may specify by notification in the Official Gazette.

For purposes of RBI (Reserve Bank of India) Directions relating to Acceptance of Public Deposits, non-banking financial company means only the non- banking institution which is a – “Loan company”, “Investment company”, “Hire purchase finance company”, “Equipment leasing company” and “Mutual benefit financial company”.

As per RBI FAQ (Frequently Asked Questions) dated 10 January 2017, Non-Banking Financial Company (NBFC)

• Is a company registered under the Companies Act, 1956 or 2013;
• Engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/securities issued by Government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business;
• But does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property.

Residuary non-banking company- A non-banking institution which is a company and has its principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments by way of contributions or any other manner, or lending in any manner is also a non-banking financial company.

3.2 Registration & Regulation of NBFC

Under Section 45–IA of the Reserve Bank of India (Amendment) Act, 1997, a non- banking financial company is not allowed to commence or carry on the business of a non-banking financial institution without obtaining a certificate of registration issued by the Reserve Bank of India.

A company incorporated under the Companies Act, 1956 and desirous of commencing business of non-banking financial institution as defined under Section 45 I(a) of the RBI Act, 1934 should comply with the following:

1. It should be a company registered under Section 3 of the companies Act, 1956
2. It should have a minimum net owned fund of Rs 200 lakh.

They can apply to Reserve Bank of India in prescribed form along with necessary documents for registration. The RBI issues Certificate of Registration after satisfying itself that the conditions as enumerated in Section 45-IA of the RBI Act, 1934 are satisfied.

However, to obviate dual regulation, certain categories of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI

The Reserve Bank of India has issued directions to non-banking financial companies on acceptance of public deposits, prudential norms like capital adequacy, income recognition, asset classification, provision for bad and doubtful debts, risk exposure norms and other measures to monitor the financial solvency and reporting by NBFCs. Directions were also issued to auditors to report non-compliance with the RBI Act and regulations to the Reserve Bank, Board of Directors and shareholders. RBI has also issued Fair Practices Code to be adopted by all NBFCs while doing lending business. The guidelines inter alia, covered general principles on adequate disclosures on the terms and conditions of a loan and also adopting a non-coercive recovery method.

3.3 Types of NBFC

The different types of NBFCs:

The NBFCs can be categorized under two broad heads:

1. On the nature of their activity
2. On the basis of deposits

The different types of Non-Banking Financial Corporations or NBFCs are as follows:

1. On the nature of their activity:
   1. Asset Finance Company
   2. Loan Company
   3. Mortgage Guarantee Company
   4. Investment Company
   5. Core Investment Company
   6. Infrastructure Finance Company
   7. Micro Finance Company
   8. Housing Finance Company

2.      On the basis of deposits:

1. Deposit accepting Non-Banking Financial Corporations
2. Non-deposit accepting Non-Banking Financial Corporations

3.4 Net Owned Fund

The Net Owned Fund of a company can be defined as the funds owned by a company after deducting the intangible assets and reserves from its Total Owned Fund.

Net Owned Fund can be calculated using the following formula as per the definition of the Reserve Bank of India (RBI):

3.5 Guidelines prescribed by RBI to be followed by NBFC

The functions of the NBFCs in India are supervised by the Reserve Bank of India (RBI). Hence, the NBFCs have to abide by the guidelines put forward by the RBI in Chapter III B of the RBI Act of 1934. The regulations prescribed by the RBI are as follows:

• NBFCs cannot accept demand deposits from public depositors or investors as it is not authorised by law.
• The minimum time period for which the public deposits can be taken by the company is 12 months, while the maximum tenure can be 60 months.
• The Reserve Bank of India will not guarantee the repayment of any amount which is taken by the NBFCs.
• The Company cannot charge an interest rate which is more than the rate prescribed by the Reserve Bank of India.
• NBFCs can issue cheques to their customers in order to make payments or settlements.
• The company has to furnish a record of the statutory return on the deposits taken by the company in the form NBS- 1 every year.
• The company has to furnish a quarterly return on the liquid assets of the company.
• The audited balance sheet of the company has to be submitted every year.
• The company has to ascertain its credit ratings every 6 months and submit the same to the RBI.
• The companies which have a Public Deposit of Rs.20 Crore or more or have assets worth Rs.100 Crore or more will have to submit a half-yearly ALM return.
• The depositors of the NBFCs cannot avail the securing facility of the Deposit Insurance and Credit Guarantee Corporation (DICGC).
• Only the NBFCs that have been duly rated and matches the recommended Minimum Investment Grade Credit (MIGC) rating, are eligible to accept conditional deposits from public depositors.
• The RBI has restricted the NBFCs from providing additional benefits, extra incentives, or gifts to the customers or depositors, than those which are offered by the banks.
• The company has to maintain a minimum of 15% of the Public Deposits in its Liquid Assets.

3.6           Income Recognition

1. The income recognition shall be based on recognised accounting principles;
2. All the Accounting Standards and Guidance Notes issued by the Institute of Chartered Accountants of India shall be followed in so far as they are not inconsistent with these directions;
3. Income including interest or any other charges in respect of all the NPAs shall be recognised only when it is actually realised, i.e. ‘Cash' method of accounting shall be applicable for recognising the income on all the NPA. Any such income recognised before the asset became non-performing and remaining unrealised shall be reversed.

3.7 Income from Investments

Income from State/Central Government Securities shall be recognised on accrual basis, provided that the interest rate on these instruments is pre-determined and interest is serviced regularly and is not in arrears for a period of 180 days.

Valuation of Investments

All investments held by the Securitisation and Reconstruction Company shall be marked to market and accounted for as per the accounting standards and guidance notes issued by the ICAI of the ICAI.

3.8 Asset Classification

1. Every Securitisation / Reconstruction Company shall, after taking into account the degree of well-defined credit weaknesses and extent of dependence on collateral security for realisation, classify the assets it has acquired for reconstruction and held by it, into the following categories namely, -
   1. Standard assets; and
   2. Non-Performing Assets
2. The Non-Performing Assets held by the Securitisation Company/Reconstruction Company for the purpose of reconstruction shall be classified

1. As ‘sub-standard asset' for a period of 12 months from the date it was classified as non-performing.
2. As ‘doubtful asset' if the asset remains a substandard asset for a period exceeding 12 months.
3. As ‘loss asset' if the asset is non-performing for a period exceeding 36 months or if the asset is adversely affected by a potential threat of non-recoverability due to either erosion in the value of security or non-availability of security or if, it has been identified as loss asset by the Securitisation Company/Reconstruction Company or its internal or external auditor.

3.      Assets acquired by the Securitisation Company/Reconstruction Company for the purpose of reconstruction will be treated as standard assets during the planning period.

4.      Every registered Securitisation / Reconstruction Company may, wherever appropriate and on the basis of circumstances for the purpose of enforcement of security interest, classify an asset as non-performing within the planning period.

3.9 Non Performing Asset (NPA)

‘Non-performing asset’ means:

(a)          an asset, in respect of which, interest has remained overdue for a period of  six months or more;

(b)         a term loan inclusive of unpaid interest, when the instalment is overdue for a period of six months or more or on which interest amount remained overdue for a period of six months or more;

(c)          a demand or call loan, which remained overdue for a period of six months or more from the date of demand or call or on which interest amount remained overdue for a period of six months or more;

(d)         a bill which remains overdue for a period of six months or more;

(e)          the interest in respect of a debt or the income on receivables under the head ‘other current assets’ in the nature of short term loans/advances, which facility remained overdue for a period of six months or more;

(f)            any dues on account of sale of assets or services rendered or reimbursement of expenses incurred, which remained overdue for a period of six months or more;

Note: As per Non-Banking Financial Company - Systemically Important Non- Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016, the above six months criteria for the assets covered under

(a) to (f) is 4 months for the financial year ending March 31, 2017; and from next year ending March 31, 2018 and thereafter it will be 3 months.

(g)        the lease rental and hire purchase instalment, which has become overdue for a period of twelve months or more;

Note: The above twelve months criteria for the assets covered under (g) is 6 months for the financial year ending March 31, 2017 and from next year ending March 31, 2018 and thereafter it will be 3 months.

(h)         in respect of loans, advances and other credit facilities (including bills purchased and discounted), the balance outstanding under the credit facilities (including accrued interest) made available to the same borrower/beneficiary when any of the above credit facilities becomes non- performing asset:

Provided that in the case of lease and hire purchase transactions, a non-banking financial company may classify each such account on the basis of its record of recovery;

3.10 Applicability of Prudential Norms

One of the main objectives of prudential regulation is to address systemic risks.  The systemic risks posed by NBFCs functioning exclusively out of their own funds and NBFCs accessing public funds cannot be equated and hence cannot be subjected to the same level of regulation. Hence, as a principle, enhanced prudential regulations has been made applicable to NBFCs wherever public funds are accepted and conduct of business regulations are made applicable wherever customer interface is involved.

Accordingly, the regulatory approach in respect of NBFCs-ND with an asset size of less than Rs 500 crore is as under:

(i)             They shall not be subjected to any regulation either prudential or conduct of business regulations viz., Fair Practices Code (FPC), KYC, etc., if they have not accessed any public funds and do not have a customer interface.

(ii)            Those having customer interface will be subjected only to conduct of business regulations including FPC, KYC etc., if they are not accessing public funds.

(iii)          Those accepting public funds will be subjected to limited prudential regulations but not conduct of business regulations if they have no customer interface.

(iv)          Where both public funds are accepted and customer interface exist, such companies will be subjected both to limited prudential regulations and conduct of business regulations.

All NBFCs-ND with assets of Rs 500 crore and above, irrespective of whether they have accessed public funds or not, has to comply with prudential regulations as applicable to NBFCs-ND-SI. They have to also comply with conduct of business regulations if customer interface exists.

3.11 Capital Adequacy

(1) Every applicable NBFC shall maintain a minimum capital ratio consisting of Tier I and Tier II capital which shall not be less than 15 percent of its aggregate risk weighted assets on-balance sheet and of risk adjusted value of off-balance sheet items.

(2) The Tier I capital in respect of applicable NBFCs (other than NBFC-MFI and IDF- NBFC), at any point of time, shall not be less than 8.5% by March 31, 2016 and10% by March 31, 2017.

(3) Applicable NBFCs primarily engaged in lending against gold jewellery (such loans comprising 50 percent or more of their financial assets) shall maintain a minimum Tier l capital of 12 percent.

Explanations:

I. On balance sheet assets–

In these Directions, degrees of credit risk expressed as percentage weightage have been assigned to balance sheet assets. Hence, the value of each asset / item requires to be multiplied by the relevant risk weights to arrive at risk adjusted value of assets. The aggregate shall be taken into account for reckoning the minimum capital ratio. The risk weighted asset shall be calculated as the weighted aggregate of funded items as detailed hereunder:

Weighted risk assets - On-Balance Sheet items 

Notes:

1. Netting shall be done only in respect of assets where provisions for depreciation or for bad and doubtful debts have been made.

2. Assets which have been deducted from owned fund to arrive at net owned fund shall have a weightage of ‘zero’.

3. While calculating the aggregate of funded exposure of a borrower for the purpose of assignment of risk weight, such non-banking financial companies shall net off the amount of cash margin/caution money/security deposits (against which right to set- off is available) held as collateral against the advances out of the total outstanding exposure of the borrower.

4. Norms for investment in securities pertaining to Infrastructure facility

1. Risk weight for investment in AAA rated securitized paper

The investment in “AAA” rated securitized paper pertaining to the infrastructure facility shall attract risk weight of 50 per cent for capital adequacy purposes subject to the fulfilment of the following conditions:

1. The infrastructure facility generates income / cash flows, which ensures servicing / repayment of the securitized paper.
2. The rating by one of the approved credit rating agencies is current and valid.

Explanation:

The rating relied upon shall be deemed to be current and valid, if the rating is not more than one month old on the date of opening of the issue, and the rating rationale from the rating agency is not more than one year old on the date of opening of the issue, and the rating letter and the rating rationale form part of the offer document.

Iii.            In the case of secondary market acquisition, the ‘AAA’ rating of the issue is in force and confirmed from the monthly bulletin published by the respective rating agency.

Iv.            The securitized paper is a performing asset.

II. Off-balance sheet items

(1) General

Applicable NBFC shall calculate the total risk weighted off-balance sheet credit exposure as the sum of the risk-weighted amount of the market related and non- market related off-balance sheet items. The risk-weighted amount of an off-balance sheet item that gives rise to credit exposure shall be calculated by means of a two- step process:

(i) the notional amount of the transaction shall be converted into a credit equivalent amount, by multiplying the amount by the specified credit conversion factor or by applying the current exposure method; and

(ii) the resulting credit equivalent amount shall be multiplied by the risk weight applicable viz. Zero percent for exposure to Central Government/State Governments, 20 percent for exposure to banks and 100 percent for others.

(2) Non-market-related off- balance sheet items

(i) The credit equivalent amount in relation to a non-market related off-balance sheet item shall be determined by multiplying the contracted amount of that particular transaction by the relevant credit conversion factor (CCF).

Note:

1. Cash margins/deposits shall be deducted before applying the conversion factor

2. Where the non-market related off-balance sheet item is an undrawn or partially undrawn fund-based facility, the amount of undrawn commitment to be included in calculating the off-balance sheet non-market related credit exposures is the maximum unused portion of the commitment that could be drawn during the remaining period to maturity. Any drawn portion of a commitment forms a part of applicable NBFCs on-balance sheet credit exposure.

For example: A term loan of Rs. 700 cr is sanctioned for a large project which can be drawn down in stages over a three year period. The terms of sanction allow draw down in three stages – Rs. 150 cr in Stage I, Rs. 200 cr in Stage II and Rs. 350 cr in Stage III, where the borrower needs the applicable NBFCs explicit approval for draw down under Stages II and III after completion of certain formalities. If the borrower has drawn already Rs. 50 cr under Stage I, then the undrawn portion would be computed with reference to Stage I alone i.e., it will be Rs. 100 cr. If Stage I is scheduled to be completed within one year, the CCF will be 20 percent and if it is more than one year then the applicable CCF will be 50 per cent.

(3) Market Related Off-Balance Sheet Items

(i) Applicable NBFCs shall take into account all market related off-balance sheet items (OTC derivatives and Securities Financing Transactions such as repo / reverse repo/ CBLO etc.) while calculating the risk weighted off- balance sheet credit exposures.

(ii) The credit risk on market related off-balance sheet items is the cost to an applicable NBFC of replacing the cash flow specified by the contract in the event of counterparty default. This shall depend, among other things, upon the maturity of the contract and on the volatility of rates underlying the type of instrument.

(iii) Market related off-balance sheet items shall include:

(a) interest rate contracts - including single currency interest rate swaps, basis swaps, forward rate agreements, and interest rate futures;

(b) foreign exchange contracts, including contracts involving gold, - includes cross currency swaps (including cross currency interest rate swaps), forward foreign exchange contracts, currency futures, currency options;

(c) Credit Default Swaps; and

(d) any other market related contracts specifically allowed by the Bank which give rise to credit risk.

(iv) Exemption from capital requirements is permitted for -

(a) foreign exchange (except gold) contracts which have an original maturity of 14 calendar days or less; and

(b) instruments traded on futures and options exchanges which are subject to daily mark-to-market and margin payments.

(v) The exposures to Central Counter Parties (CCPs), on account of derivatives trading and securities financing transactions (e.g. Collateralized Borrowing and Lending Obligations - CBLOs, Repos) outstanding against them shall be assigned zero exposure value for counterparty credit risk, as it is presumed that the CCPs' exposures to their counterparties are fully collateralized on a daily basis, thereby providing protection for the CCP's credit risk exposures.

(vi) A CCF of 100 per cent shall be applied to the corporate securities posted as collaterals with CCPs and the resultant off-balance sheet exposure shall be assigned risk weights appropriate to the nature of the CCPs. In the case of Clearing Corporation of India Limited (CCIL), the risk weight shall be 20 per cent and for other CCPs, risk weight shall be 50 percent.

(vii) The total credit exposure to a counter party in respect of derivative transactions shall be calculated according to the current exposure method as explained below.

(4) Current Exposure Method

The credit equivalent amount of a market related off-balance sheet transaction calculated using the current exposure method is the sum of (i) current credit exposure and (ii) potential future credit exposure of the contract.

(i) Current credit exposure is defined as the sum of the gross positive mark-to- market value of all contracts with respect to a single counterparty (positive and negative marked-to-market values of various contracts with the same counterparty shall not be netted). The Current Exposure Method requires periodical calculation of the current credit exposure by marking these contracts to market.

(ii) Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts, irrespective of whether the contract has a zero, positive or negative mark-to-market value by the relevant add-on factor indicated below according to the nature and residual maturity of the instrument.

a. For contracts with multiple exchanges of principal, the add-on factors are to be multiplied by the number of remaining payments in the contract.

b. For contracts that are structured to settle outstanding exposure following specified payment dates and where the terms are reset such that the market value of the contract is zero on these specified dates, the residual maturity shall be set equal to the time until the next reset date. However, in the case of interest rate contracts which have residual maturities of more than one year and meet the above criteria, the CCF or add-on factor is subject to a floor of 1.0 per cent.

c. No potential future credit exposure shall be calculated for single currency floating / floating interest rate swaps; the credit exposure on these contracts would be evaluated solely on the basis of their mark-to-market value.

d. Potential future exposures shall be based on 'effective' rather than 'apparent notional amounts'. In the event that the 'stated notional amount' is leveraged or enhanced by the structure of the transaction, the 'effective notional amount' must be used for determining potential future exposure. For example, a stated notional amount of USD 1 million with payments based on an internal rate of two times the lending rate of the applicable NBFC would have an effective notional amount of USD 2 million.

(5) Credit conversion factors for Credit Default Swaps (CDS):

Applicable NBFCs are only permitted to buy credit protection to hedge their credit risk on corporate bonds they hold. The bonds shall be held in current category or permanent category. The capital charge for these exposures shall be as under:

(i) For corporate bonds held in current category and hedged by CDS where there is no mismatch between the CDS and the hedged bond, the credit protection shall be permitted to be recognised to a maximum of 80% of the exposure hedged. Therefore, the applicable NBFC shall continue to maintain capital charge for the corporate bond to the extent of 20% of the applicable capital charge. This can be achieved by taking the exposure value at 20% of the market value of the bond and then multiplying that with the risk weight of the issuing entity. In addition to this, the bought CDS position shall attract a capital charge for counterparty risk which shall be calculated by applying a credit conversion factor of 100 percent and a risk weight as applicable to the protection seller i.e. 20 per cent for banks and 100 per cent for others.

(ii) For corporate bonds held in permanent category and hedged by CDS where there is no mismatch between the CDS and the hedged bond, Applicable NBFCs can recognise full credit protection for the underlying asset and no capital shall be required to be maintained thereon. The exposure shall stand fully substituted by the exposure to the protection seller and attract risk weight as applicable to the protection seller i.e. 20 per cent for banks and 100 per cent for others.

3.12 Preparation of Financial Statements of NBFC’s

All NBFCs should comply with the Accounting Standards and Guidance Notes issued by the Institute of Chartered Accountants of India, so far as these are not inconsistent with the prudential norms directions of the Reserve Bank of India.

On 30th March, 2016 the Ministry of Corporate Affairs of India (MCA) has issued the roadmap for implementation of Ind AS by Non-Banking Financial Companies;

As per the notification

1. The following NBFCs shall comply with the Indian Accounting Standards (Ind AS) for accounting periods beginning on or after the 1st April, 2018, with comparatives for the periods ending on 31st March, 2018, or thereafter—
   1. NBFCs having net worth of rupees five hundred crore or more;
   2. Holding, subsidiary, joint venture or associate companies of companies covered under item (a),
2. The following NBFCs shall comply with the Indian Accounting Standards (Ind AS) for accounting periods beginning on or after the 1st April, 2019, with comparatives for the periods ending on 31st March, 2019, or thereafter—

1. NBFCs whose equity or debt securities are listed or in the process of listing on any stock exchange in India or outside India and having net worth less than rupees five hundred crore;
2. NBFCs, that are unlisted companies, having net worth of rupees two- hundred and fifty crore or more but less than rupees five hundred crore; and
3. Holding, subsidiary, joint venture or associate companies of companies covered under item (a) or item (b) of sub-clause (B),

Other NBFCs shall prepare their financial statements based on the Companies (Accounting Standards) Rules, 2006.