NON BANKING FINANCIAL COMPANIES (NBFC)

1. Context

The Reserve Bank of India (RBI) has updated its “guidance note” on operational risk management for the financial sector, and also extended it to the non-banking financial companies (NBFCs), including housing finance companies.

2. What are the non-banking financial companies (NBFCs)?

Non-Banking Financial Companies (NBFCs) are financial institutions that provide banking services but do not hold a banking license.
They are crucial to the financial system as they cater to the financial needs of sectors where traditional banks may not reach or provide services.
NBFCs offer various financial services such as loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority, leasing, hire-purchase, insurance business, chit business, etc.
They differ from traditional banks because they cannot accept demand deposits and do not form part of the payment and settlement system like banks do.
However, they play a significant role in providing credit to individuals, small businesses, and the unorganised sector, thereby contributing to financial inclusion and economic growth. Examples of NBFCs include companies engaged in equipment leasing, hire-purchase finance, vehicle finance, and microfinance

3. Classification of NBFCs

NBFCs can be classified into various categories based on their activities, ownership structure, and regulatory requirements.

Here are some common classifications:

Asset Financing NBFCs: These NBFCs primarily provide financing for the purchase of assets such as vehicles, machinery, equipment, etc.
Investment and Credit NBFCs: These NBFCs primarily make investments in securities or extend credit facilities.
Infrastructure Finance Companies (IFCs): These NBFCs focus on financing infrastructure projects such as roads, ports, power, telecommunications, etc.
Housing Finance Companies (HFCs): These NBFCs specialize in providing finance for housing and related activities.
Microfinance Institutions (MFIs): These NBFCs provide financial services, including small loans, savings, and insurance, to low-income individuals and microenterprises.
Non-Deposit Taking NBFCs: These NBFCs do not accept deposits from the public. They rely on other sources of funding such as borrowings from banks, financial institutions, and capital markets.
Deposit Taking NBFCs: These NBFCs accept deposits from the public and are regulated more closely, similar to banks, to ensure the safety of depositor funds.
Systemically Important NBFCs (SI-NBFCs): These are NBFCs whose failure could potentially disrupt the financial system. They are subject to additional regulatory requirements to mitigate systemic risks.
Core Investment Companies (CICs): These NBFCs are primarily engaged in the business of acquisition of shares and securities and hold not less than 90% of its Total Assets in the form of investment in equity shares, preference shares, bonds, debentures, debt, or loans in group companies.
Infrastructure Debt Funds (IDFs): These NBFCs are set up to facilitate the flow of long-term debt into infrastructure projects.

4. What is the 50-50 Criteria of Principal Business?

The 50-50 criteria of principal business refers to a regulatory guideline set by the Reserve Bank of India (RBI) for determining whether a company's principal business is that of a Non-Banking Financial Company (NBFC).
According to this criterion, if more than 50% of a company's total assets or gross income comes from financial assets or income derived from financial assets, it is considered to be primarily engaged in the business of an NBFC. In other words, if at least 50% of the company's assets or income is from financial activities, it falls under the purview of NBFC regulations.
This guideline helps to differentiate between companies engaged primarily in non-financial activities with some incidental financial activities and those whose main business revolves around financial services, thereby ensuring appropriate regulation and supervision of NBFCs by the RBI. It is an important criterion used by regulators to determine the regulatory classification of companies operating in the financial sector

5.RBI rules on Non Banking Financial Companies

The Reserve Bank of India (RBI) regulates Non-Banking Financial Companies (NBFCs) in India to ensure financial stability, consumer protection, and the smooth functioning of the financial system.

Some of the key rules and regulations imposed by the RBI on NBFCs include:

NBFCs need to obtain a Certificate of Registration (CoR) from the RBI to commence or carry on the business of non-banking financial institution.
RBI imposes prudential regulations on NBFCs to ensure the safety and soundness of their operations. These norms cover aspects such as capital adequacy, income recognition, asset classification, provisioning, liquidity management, and exposure limits.
NBFCs are required to adhere to a Fair Practices Code (FPC) prescribed by the RBI, which outlines the principles of transparency, fairness, and responsible lending practices.
NBFCs are mandated to follow KYC norms while onboarding customers, including verification of identity, address, and other relevant information, to prevent money laundering and terrorist financing activities
NBFCs are required to implement effective AML/CFT measures, including customer due diligence, transaction monitoring, and reporting of suspicious transactions, to mitigate the risks of money laundering and terrorist financing.
RBI mandates NBFCs to adhere to good corporate governance practices, including the composition of the board of directors, risk management framework, internal controls, and disclosure requirements
NBFCs are required to have robust risk management systems in place to identify, assess, monitor, and mitigate various risks such as credit risk, market risk, liquidity risk, and operational risk.
NBFCs need to submit various regulatory returns and reports to the RBI periodically, providing details of their financial performance, capital adequacy, asset quality, and compliance with regulatory requirements.
RBI conducts regular inspections and supervisory reviews of NBFCs to assess their financial health, compliance with regulations, and adherence to best practices.
RBI has the authority to issue directions, impose restrictions, and take corrective actions against NBFCs that fail to comply with regulatory requirements or pose risks to the financial system.

6. Way Forward

Non-Banking Financial Companies (NBFCs) play a vital role in India's financial landscape, serving as critical intermediaries between traditional banking institutions and underserved segments of the economy. With their diverse range of financial services and flexible approach to lending, NBFCs contribute significantly to promoting financial inclusion, fostering entrepreneurship, and driving economic growth. However, the regulatory framework governing NBFCs remains paramount in ensuring the stability and integrity of the financial system. As the sector continues to evolve and face new challenges, effective regulation, prudent risk management, and adherence to best practices will be essential for NBFCs to sustain their growth trajectory and fulfill their socio-economic mandate in a responsible and sustainable manner

For Prelims: Economy

For Mains: GS-III: Indian Economy and issues relating to planning, mobilisation, of resources, growth, development, and employment.

Previous Year Questions

1.The RBI acts as a bankers’ bank. This would imply which of the following? (UPSC CSE 2012)

1. Other banks retain their deposits with the RBI.

2. The RBI lends funds to the commercial banks in times of need.

3. The RBI advises the commercial banks on monetary matters.

Select the correct answer using the codes given below :

(a) 2 and 3 only

(b) 1 and 2 only

(d) 1, 2 and 3

Answer (d)

The central bank, also known as the apex bank, has overarching control over a nation's banking system. It holds the exclusive authority for issuing currency and regulates the money supply within the economy. As outlined in the Reserve Bank of India Act, 1934, the central bank fulfills several key functions:

Banking functions: Acting as the banker, agent, and advisor to both the central and state governments, the Reserve Bank handles all banking operations for these entities. It extends advisory services to the government on economic and monetary policy matters and manages the public debt. Furthermore, it functions similarly to a commercial bank for other banks, including providing loans to all commercial banks nationwide.
Supervisory functions: The central bank supervises and monitors other banks and governmental entities, guiding them through various economic conditions, especially during periods of inflation or deflation.
Promotional functions: In addition to its regulatory role, the central bank undertakes promotional activities such as fostering connections with global economies and managing foreign reserves. These efforts contribute to representing the country's economy on the international stage.
Advisory functions: Offering guidance on monetary issues to commercial banks is another essential role of the central bank, ensuring effective monetary policy implementation.

2.With reference to the Non-banking Financial Companies (NBFCs) in India, consider the following statements: (UPSC CSE 2010)

They cannot engage in the acquisition of securities issued by the government.
They cannot accept demand deposits like Savings Account.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Answer: (b)

Statement 1: They cannot engage in the acquisition of securities issued by the government. This statement is False. NBFCs can invest in government securities like bonds.
Statement 2: They cannot accept demand deposits like Savings Account. This statement is True. NBFCs are unlike banks and cannot accept demand deposits that are withdrawable on demand. They can only accept fixed deposits with a predetermined maturity period

Source: Indianexpress

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NON BANKING FINANCIAL COMPANIES (NBFC)

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