NBFC Advisor
NBFC Advisor

Revised Regulatory Framework for Banks and NBFCs: Impacts on the BFSI Sector

  • 07-Oct-2024
Framework for Banks and NBFCs
GET AN ENQUIRY

On October 4, 2024, the Reserve Bank of India (RBI) issued a Draft Circular titled "Forms of Business and Prudential Regulation for Investments" that seeks to amend the extant Master Direction—Reserve Bank of India (Financial Services provided by Banks) Directions, 2016. These amendments focus on ring-fencing the core business of banks and revising the prudential regulations that apply to their investments in financial and non-financial services companies, as well as Alternative Investment Funds (AIFs).

The revised draft framework touches upon various aspects, such as permissible forms of business, group entity restrictions, prudential limits for investments, and prior approval requirements for certain categories of investments. The implications of this draft framework are widespread, particularly for the Banking, Financial Services, and Insurance (BFSI) sector. This article aims to delve into the granular details of these changes and explore their potential impacts on the BFSI ecosystem.

Understanding the Amendments

Section 1: Permissible Forms of Business

Section 6(1) of the Banking Regulation Act, 1949, outlines the forms of business banks are permitted to undertake. Banks can conduct their primary functions—deposit collection and lending—either departmentally or through a separate group entity such as subsidiaries or joint ventures, subject to conditions stipulated by RBI. The Draft Circular now makes further clarifications and restrictions regarding how these businesses can be carried out.

  1. Core Business vs Non-Core Business: The core business of banks, defined as deposit acceptance and lending, must be carried out departmentally. However, other financial services such as factoring, credit card business, equipment leasing, hire purchase, primary dealership, and housing finance may be conducted either departmentally or through group entities.

  2. Risky and Non-Core Activities: Activities like mutual fund businesses, insurance business, pension fund management, investment advisory services, and broking services are considered risk-bearing and must be ring-fenced. These are only permitted through a separate group entity, ensuring that banks' core business is not adversely affected by high-risk ventures.

  3. Overlapping Business: To avoid redundancies and overlapping risks, only a single entity within a banking group can undertake a specific permissible form of business. This means multiple entities cannot hold the same licenses or engage in similar businesses, ensuring accountability and reducing the possibility of systemic risk from overexposure.

Section 2: Prudential Regulations on Investments

The revised prudential regulations focus on limiting banks’ exposure to equity investments, both within and outside their group entities. These include restrictions on the amount banks can invest, the type of businesses they can invest in, and the safeguards that must be in place when engaging in such investments.

  1. Investment Limits on Equity Capital: Banks are prohibited from holding more than 10% of their paid-up capital and reserves in any company, including group entities. Further, the aggregate equity investments across all companies, including group entities and overseas investments, cannot exceed 20% of their paid-up capital and reserves.

  2. Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs): A bank’s investment in these instruments is capped at 10% of the unit capital, subject to an overall ceiling of 20% of its net worth. This ensures that banks maintain adequate liquidity and avoid concentration risks in sectors prone to volatility.

  3. Alternative Investment Funds (AIFs): The Draft Circular introduces stringent regulations on banks' exposure to Category III AIFs, effectively barring direct investment in this category while allowing investment in Category I and II AIFs under limited conditions.

Section 3: Applicability to Non-Banking Financial Companies (NBFCs)

NBFCs, particularly those part of a bank’s group entity, are also brought under stricter scrutiny. They are now subject to Scale-Based Regulations applicable to Upper Layer NBFCs, along with regulatory restrictions akin to those that govern banks.

  1. Non-Banking Financial Companies (NBFCs): The revised guidelines impose tighter restrictions on NBFCs that are part of banking groups. These entities must comply with Scale-Based Regulations, ensuring that their lending activities align with the risk management practices required for Upper Layer NBFCs. Furthermore, lending activities across NBFCs and their parent banking entities must not overlap.

  2. Housing Finance Companies (HFCs): HFCs within a banking group are also required to adhere to stricter lending practices to ensure that they do not take undue risks that might jeopardize the group’s overall financial health.

Impact of the Revised Framework on the BFSI Sector

1. Increased Regulatory Oversight

The RBI’s Draft Circular reinforces its stance on tightening regulatory oversight over financial institutions. By curbing overlapping business models and ensuring that riskier non-core activities are conducted separately, the circular seeks to shield the core banking business from potential pitfalls. This increased regulatory scrutiny will likely result in:

  • Greater Accountability: By ensuring that only a single entity within a group undertakes a particular business, the RBI will be able to hold entities more accountable. This reduces the risks of contagion, especially in a group structure.

  • Enhanced Risk Management: The requirement that group entities follow the regulations applicable to NBFCs and banks, such as Scale-Based Regulations and restrictions on loans and advances, strengthens the risk management practices across the financial ecosystem.

  • Transparency and Compliance: With clearer definitions of the permissible forms of business, banks and NBFCs will now be more transparent in their activities, and the potential for regulatory arbitrage is minimized.

2. Operational Challenges for Banks

While the framework introduces much-needed structural reforms, it also imposes operational challenges:

  • Segregation of Activities: For banks that have historically carried out non-core activities departmentally, segregating these into separate entities may involve considerable restructuring costs and adjustments. This could potentially slow down operations, particularly for banks that have expansive group entities offering diverse services.

  • Investment Restrictions: The limits on investments, particularly the cap on equity investments in companies and AIFs, could hamper banks' ability to generate higher returns through such investments. Banks that rely heavily on investment income will have to re-evaluate their portfolios and strategies in light of these new restrictions.

3. Impact on NBFCs and Housing Finance Companies (HFCs)

NBFCs and HFCs within banking groups are particularly affected by the changes. Given the new restrictions:

  • Regulatory Convergence: NBFCs are now required to comply with regulations similar to those applied to banks, effectively blurring the lines between traditional banking and NBFC activities. This move could accelerate the consolidation of NBFCs and banks, encouraging more acquisitions and mergers in the BFSI sector.

  • Stricter Lending Norms: The restrictions on lending overlap between banks and NBFCs could constrain the growth of NBFCs, particularly those that have been aggressively expanding their loan portfolios. NBFCs will now need to focus more on niche segments or new product offerings to remain competitive.

4. Shifts in Investment Strategies

Banks and their group entities must now re-think their investment strategies, particularly concerning equity investments in non-financial companies and AIFs.

  • Diversification vs. Concentration: The restrictions on investments in equity capital, particularly in non-financial services companies, will force banks to diversify their portfolios more cautiously. Banks may now look for safer investment avenues, such as government bonds, which, while stable, may offer lower returns than riskier ventures like AIFs or real estate investments.

  • Strategic Partnerships: With the limitations on direct investments, banks may pivot toward forming strategic partnerships or joint ventures with fintech, insurance, and asset management companies, rather than holding significant equity stakes.

5. International Operations and GIFT City

The provisions in the Draft Circular also apply to banks operating in international markets and Indian banks operating within the International Financial Services Centre (IFSC) at GIFT City. This includes tighter scrutiny on activities that may be prohibited in the home country but allowed in the host country.

  • GIFT City as a Regulatory Sandbox: With stricter guidelines for overseas operations, the IFSC in GIFT City may emerge as a sandbox for innovation within permissible limits. Banks and fintech companies could leverage the regulatory framework of GIFT City to explore cross-border services, test new financial products, and expand globally without flouting Indian laws.

Conclusion: Balancing Growth and Risk

The RBI’s Draft Circular of October 4, 2024, marks a significant regulatory shift aimed at safeguarding the financial stability of India’s banking and non-banking sectors. While these regulations may initially seem restrictive, especially in terms of investment opportunities and operational freedom, they serve the larger purpose of ensuring the sustainability of the BFSI sector.

By segregating risk-bearing activities, limiting investment exposure, and preventing the overlap of businesses within banking groups, the RBI aims to create a safer and more resilient financial ecosystem. However, this will not be without challenges, as banks and NBFCs will need to adapt to the new regulatory landscape, which may involve restructuring, reduced flexibility in investment strategies, and greater compliance burdens.

For stakeholders in the BFSI sector, including banks, NBFCs, asset management companies, and fintech firms, the focus now shifts to balancing growth with risk management. While the revised framework provides the stability needed to avert crises, institutions must innovate within these constraints to remain competitive and profitable in the evolving financial landscape of India.

In summary, the RBI’s amendments, though complex, are necessary for fostering a more transparent and accountable BFSI sector. Institutions that can navigate these changes successfully will be well-positioned to lead the next

october 4 applied regulations similar regulatory convergence affected light strategies portfolios -evaluate investment income effectively blurring rely heavily hamper banks' ability cap limits investment restrictions expansive group entities offering diverse services operations potentially slow adjustments involve considerable restructuring costs generate higher returns separate entities lines nbfc activities - investment strategiesbanks shifts remain competitive product offerings niche segments focus loan portfolios aggressively expanding traditional banking growth lending overlap stricter lending norms bfsi sector mergers acquisitions encouraging consolidation accelerate move constrain segregating -core activities departmentally historically carried reduces accountable hold entities group undertakes greater accountability result increased regulatory scrutiny potential pitfalls core banking business risks shield conducted separately riskier curbing overlapping business models financial institutions tightening regulatory oversight stance draft circular reinforces increased regulatory oversightthe rbi’ bfsi sector1 circular seeks contagion group structure enhanced risk management segregation imposes operational challenges -needed structural reforms framework introduces bankswhile operational challenges minimized regulatory arbitrage potential transparent clearer definitions compliance transparency financial ecosystem risk management practices strengthens advances loans regulations applicable group entities follow requirement investment strategies -financial companies diversification concentration resilient financial ecosystem safer create rbi aims preventing limiting investment exposure segregating risk-bearing activities sustainability larger purpose challenges serve investment opportunities terms restrictive initially regulations -banking sectors india’ financial stability safeguarding operational freedom adapt regulatory landscape involve restructuring successfully navigate accountable bfsi sector fostering complex amendments rbi’ summary evolving financial landscape profitable constraints innovate institutions avert crises stability needed risk management fintech firms including banks stakeholders greater compliance burdens reduced flexibility significant regulatory shift aimed revised framework marks balancing growth banks operating gift citythe provisions international operations holding significant equity stakes asset management companies fintech forming strategic partnerships pivot direct investments international markets limitations real estate investments riskier ventures offer lower returns stable government bonds safer investment avenues cautiously diversify force banks strategic partnerships indian banks operating international financial services centre ifsc conclusion flouting indian laws expand globally financial products test explore cross-border services regulatory framework leverage fintech companies permissible limits innovation sandbox emerge overseas operations stricter guidelines regulatory sandbox host country allowed home country includes tighter scrutiny gift city riskthe rbi’ -positioned impact group’ carried businesses restrictions clarifications makes draft circular conditions stipulated subject joint ventures -core business subsidiaries departmentally lending— primary functions—deposit collection conduct undertake permitted business banks outlines banking regulation act separate group entity businesssection 6 defined lending banks' core business ensuring ring-fenced considered risk-bearing broking services investment advisory services pension fund management insurance business mutual fund businesses deposit acceptance activities risky group entities conducted housing finance primary dealership hire purchase equipment leasing credit card business factoring -core activities amendmentssection 1 understanding bfsi ecosystem prudential regulations revising core business ring-fencing amendments focus directions banks financial services provided extant master direction—reserve bank apply amend investments prudential regulation business forms draft circular titled issued rbi india reserve bank seeks financial -financial services companies alternative investment funds potential impacts explore granular details delve article aims sector bfsi insurance financial services banking widespread draft framework implications categories prior approval requirements prudential limits group entity restrictions permissible forms aspects revised draft framework touches aifs adversely affected high-risk ventures overlapping business avoid redundancies part nbfcs -banking financial companies applicability section 3 limited conditions ii aifs allowing investment category group entity effectively barring direct investment banks' exposure draft circular introduces stringent regulations volatility sectors prone avoid concentration risks banks maintain adequate liquidity ensures net worth 20% category iii aifs brought stricter scrutiny scale-based regulations applicable jeopardize undue risks ensure stricter lending practices adhere required hfcs housing finance companies overlap parent banking entities lending activities risk management practices required lending activities align scale-based regulations comply entities banking groups revised guidelines impose tighter restrictions govern banks regulatory restrictions akin upper layer nbfcs ceiling financial health unit capital instruments amount banks include restrictions equity investments limiting banks’ exposure investmentsthe revised prudential regulations focus section 2 overexposure systemic risk possibility invest reducing similar businesses engage licenses hold means multiple entities specific permissible form banking group single entity overlapping risks ensuring accountability type safeguards place investment bank’ invits infrastructure investment trusts reits real estate investment trusts exceed 20% overseas investments companies aggregate equity investments including group entities company reserves capital paid- 10% holding prohibited equity capital investment limits engaging capped lead