Government of India Ministry of Finance Department of Financial Services

Transcription

1 Government Ministry of Finance Department of Financial Services Report of the Key Advisory Group on the Non-Banking Finance Companies (NBFCs) 31 st January, 2012

2 F.No.17/7/2011-BO.II Government Ministry of Finance Department of Financial Services REPORT OF THE KEY ADVISORY GROUP (KAG) ON THE NON-BANKING FINANCE COMPANIES (NBFCs) Government constituted a Key Advisory Group (KAG) on the Non-Banking Finance Companies (NBFCs) vide Order dated The constitution and terms of reference of the Group is in ANNEX. The Group had representation from all the stakeholders from the sector including the Indian Banks' Association, FICCI, CII and ASSOCHAM representing major NBFCs in the Country; Ernst & Young, prominent Law firms viz. Amarchand Mangaldas, Juris Corp; FIDC (a representative body of NBFCs) and also from some prominent NBFCs. The terms of reference of the Group was as under i. Review of existing legal / regulatory / institutional framework for NBFCs and its efficacy; ii. Action plan including policy initiatives for orderly growth of the Sector; iii. To recommend the legal / institutional / regulatory initiatives related measures required for orderly growth of the Sector. 2. Though RBI was included as a member of the KAG, they have expressed their inability to be a part of the Group stating that the KAG is to essentially discuss and deliberate on the Report of RBI Working Group, and therefore, their association with the Group may not be desirable. The Group held its meetings on and and had extensive deliberations and consultation on a wide range of issues having a bearing on orderly growth of the sector. The draft Report was also discussed with the stakeholders, and has been modified taking into consideration the views expressed by the stakeholders. Accordingly, the Report of the Group has been finalised on The Group expresses its sincere gratitude to the team of Shri D.D. Maheshwari, Under Secretary, Department of Financial Services for putting in unstinting efforts in organising the meetings of the Group, facilitating deliberations, organising relevant information and finalizing its Report. (Alok Nigam) Chairman 31 st January,

3 Contents 1. Overview of the NBFC sector Introduction 1.2 NBFCs - growth and evolution 1.3 Bank Exposure to NBFCs 1.4 Summing up 2. Role and Vision for the NBFC sector Issues 2.2 Is there an economic role that the NBFCs fulfill? Infrastructure financing Serving unbanked customer segments Strong understanding of customer segments and ability to deliver customized products 2.3 What kind of regulatory structure that can be envisaged for the sector? 2.4 What is the systemic risk posed by the sector and the progression curve for NBFCs? 2.5 Is there any additional category of NBFCs required? 2.6 Future growth and development of NBFCs 3. Recommendations of the Thorat Committee The RBI Working Group Report 3.2 Broader objective of RBI Working Group Report 3.3 Recommendations General Categorization of NBFCs 4. Recommendations - II Prior approval of RBI for mergers of NBFCs 4.2 Definition of Public Funds 4.3 Participative Financing 4.4 Fixed Deposits as Financial Assets 4.5 Banking credit for priority sector lending 4.6 ECB financing 4.7 Prudential norms for certain categories of NBFCs to be more relaxed 4.8 Lending to stock brokers and merchant banks 5. Recommendations - III Direct Tax Issues Tax Deduction at Source on Interest (Section 194A of the Income Tax Act) Tax benefits for Income deferral under Section 43D of the Income Tax Act Allowing of provisions made for Non-performing Assets (NPAs) under Section 36(1)(viia) of the Income Tax Act Declaration in Form 15G / 15H read with Section 206AA Introduction of the threshold limit for TDS on the interest income on unlisted debentures Depreciation in respect of Construction Equipments registered under the Motor Vehicles Act 5.2 Indirect Tax Issues Extension of Cenvat credit rule to other services Service Tax on Hire Purchase / Lease Transactions 6. Gist of recommendations Conclusion ANNEX - Order of Constitution of the Key Advisory Group on NBFCs

4 1. Overview of the NBFC sector 1.1 Introduction The Indian economy has been witnessing high rates of growth in the last few years. Financing requirements have also risen commensurately and will continue to increase in order to support and sustain the tremendous economic growth. NBFCs have been playing a complementary role to the other financial institutions including banks in meeting the funding needs of the economy. They help fill the gaps in the availability of financial services that otherwise occur in bank-dominated financial systems. The gaps are in regards the product as well customer and geographical segments. NBFCs over the years have played a very vital role in the economy. They have been at the forefront of catering to the financial needs and creating livelihood sources of the so-called unbankable masses in the rural and semi-urban areas. Through strong linkage at the grassroots level, they have created a medium of reach and communication and are very effectively serving this segment. Thus, NBFCs have all the key characteristics to enable the government and regulator to achieve the mission of financial inclusion in the given time. 1.2 NBFCs growth and evolution The number of NBFCs has decreased from 13,014 in FY06 to 12,409 in FY11 however the sector has grown by 2.6 times between FY06 and FY11 at a CAGR of 21%. It accounted for 10.8% in terms of outstanding advances and 13% in terms of assets of the banking system in FY06. This share has risen to 13.2% and 13.78% respectively in FY11. In terms of deposits the share of public deposits held by NBFCs as compared to deposit base of banks has decreased from 1.05% in FY06 to 0.22% in FY11. Public deposits held by NBFCs have shown a falling trend, decreasing by approximately 48% in the last 5 years, while owned funds (reserves & surplus and capital deployed) have gone up by 195%. The outstanding advances have grown approximately 3 times in the last 5 years to reach Rs.536,074 crores in FY11. Banks exposure to NBFCs has increased from Rs.62,308 crore in FY06 to Rs.183,839 crore in FY11, an increase of approximately 3 times growing at a CAGR of 24% during the period FY06-FY11 and a 37% increase over FY10. 4

5 SCBs include Regional Rural Banks and Co-operative Banks NBFCs include NBFCs-D, NBFCs-ND-SI and RNBCs All amounts in Rs.Crores Table 1 Consolidated Balance Sheet of NBFCs* FY06 (Rs.Cr) FY10 (Rs.Cr) FY11 (Rs.Cr) % FY11 Share Capital 22,154 43,275 47,222 6% Reserves & Surplus 47,741 1,39,312 1,58,683 19% Public Deposits 22,842 17,352 11,964 1% Borrowings 2,07,597 4,49,857 5,70,754 67% Of which Borrowings from Banks/FIs 62,308 1,31,720 1,83,839 22% Current liabilities and Provisions 30,267 51,139 58,629 7% Total Liabilities 3,30,601 7,00,935 8,47, % Loans and Advances 1,69,449 4,19,636 5,36,074 63% Bill Business % Hire Purchase Assets 44,715 41,685 50,019 6% Investments 81,630 1,52,183 1,64,130 19% Cash & Bank Balances NA 25,857 29,877 4% Other Current Assets NA 40,565 42,444 5% Other Assets 34,762 20,965 24,619 3% Total Assets 3,30,601 7,00,936 8,47, % *NBFCs include NBFC-D, NBFC-ND-SI and RNBCs (Residuary Non-Banking Companies) 5

6 Table 2 Comparison with Banking Sector FY06 (Rs.Cr) FY10 (Rs.Cr) FY11 (Rs.Cr) No. of NBFCs 13,014 12,630 12,409 Bank credit of all Scheduled Banks* 1,572,780 3,337,659 4,060,843 NBFC advances as a % of Bank credit 10.77% 12.57% 13.20% Assets of all Scheduled Banks* 2,531,462 5,258,495 6,146,590 NBFC assets as a % of Bank assets 13.06% 13.33% 13.78% Deposits of all Scheduled Banks* 2,185,809 4,635,224 5,355,160 NBFC Public Deposits as a % of Bank Deposits 1.05% 0.37% 0.22% *Scheduled Banks include Scheduled commercial banks and Co-operative Banks For FY and 71, Total 289, For FY and 69, Total Dependence on Public Funds Table 3 Sources of Funds of NBFCs FY06 (Rs.Cr) FY10 (Rs.Cr) FY11 (Rs.Cr) FY06 FY10 FY11 Share Capital 20,971 40,444 44,234 7% 6% 6% Reserves and Surplus 48, , ,671 16% 22% 21% Public Deposits 22,842 17,352 11,964 8% 3% 2% Borrowings 207, , ,754 69% 69% 72% Bank/FI borrowings 62, , ,839 21% 20% 23% Debentures 68, , ,320 23% 24% 26% Inter-corporate Borrowings 19,459 22,153 24,883 6% 3% 3% Commercial Paper 13,123 31,049 32,321 4% 5% 4% Others 44, , ,391 15% 17% 16% Total 300, , , % 100% 100% Table 4 Public Funds as a percentage of Total Sources of Funds FY06 FY10 FY11 NBFCs-D 59.3% 59.8% 59.0% NBFCs-ND-SI 59.4% 53.6% 57.8% RNBCs 94.5% 83.3% 72.6% Overall NBFC Sector 61.9% 55.1% 58.1% Public Funds (as defined by RBI) funds raised either directly or indirectly through public deposits, commercial papers, debentures, inter-corporate deposits, guarantees and bank finance or any other debt instrument, but exclude funds raised by issue of share capital and/ or instruments compulsorily convertible into equity shares 6

7 The dependence of NBFCs sector on public funds has gone down from approximately 62% in FY06 to 58% in FY11. The share of public deposits to total funds has gone down from 8% to 2% and Bank/FI borrowing has increased marginally from 22% to 23% during the same period. With the development of capital markets, NBFCs have increasingly been tapping the corporate debt markets with debentures issued growing from Rs.68,138 crores in (23% to total borrowings) FY06 to Rs.1,87,568 crores (26% to total borrowings) in FY11. Banks exposure to NBFC sector has been increasing and gone up approximately 3 times in the last 5 years. Apart from lending banks also have exposure as investment in debenture and commercial papers of NBFCs. 1.3 Bank Exposure to NBFCs On a disaggregated basis NBFCs-D have a higher reliance on bank funds, which as a percentage of total borrowings has gone up from 37% to 51% for the FY06 and FY11 respectively. For NBFCs-ND-SI it has increased marginally during the period. Table 5 Bank Borrowings by NBFCs Amount in Rs. Crore FY06 FY10 FY11 FY06 FY10 FY11 NBFCs-D Borrowings from Banks & FIs 8,796 31,853 35, % 49.7% 50.6% Total Borrowings 23,641 64,078 69, % 100% 100% NBFCs-ND-SI Borrowings from Banks & FIs 53,512 99, , % 25.9% 29.6% Total Borrowings 245, , , % 100% 100% Banks total exposure to NBFCs amounted to Rs.35,320 crores as advances to NBFC-D and Rs.1,48,519 crores amounting to a total of Rs.1,83,839 crores. In addition Rs.10,750 crores was invested by banks in debentures and CPs issued by NBFC-ND-SI. Table 6 Bank Borrowings of NBFC-ND-SI As on March 2011, Amount in Rs.Crore Bank Group Term Working Debentures/ Others Total loans Capital Loans CPs Nationalized Banks 74,806 14,233 4, ,870 State Bank Group 8,634 5,089 1, ,868 Old Private Banks 4,892 1, ,712 New Private Banks 23,076 6,541 3, ,450 Foreign Banks 6,947 1, ,625 TOTAL 1,18,356 28,902 10,750 1,517 1,59,525 7

8 1 Capital Adequacy As on March 2011 Capital Adequacy NBFCs-D NBFCs-ND-SI Total Less than 12% %-15% %-20% % More than 30% TOTAL Out of the 297 NBFCs registered as deposit taking, capital information of 204 was available and only 2.5% of these had capital adequacy less than 15%. For NBFC-ND-SI, 3.6% had capital adequacy less than 15% and on an overall basis only 15 out of 478 NBFCs representing 3.1% had capital adequacy less than 15%. 2 Non Performing Assets NBFC-D NBFC-ND-SI FY Gross Advances NPA % Gross NPA %Net NPA Gross Advances % Gross NPA %Net NPA , # 348, , # 458, # negative, provision exceeds NPA Both the gross and net NPA have shown a declining trend for the overall NBFC sector. The net NPA for deposit taking NBFCs has been negative since FY Summing up NBFCs have registered impressive growth in the past decade. They provide valuable service to many productive sectors of the economy for asset creation and also in conversion of physical assets to financial assets (eg: gold loans). A large part of the growth can be attributed to prudential norms brought in by the regulator. However, the large number of NBFCs carrying on diverse businesses poses regulatory challenge given their growing size. Regulations have to be suited to diverse aspects of various businesses and strengthened to increase the trust and transparency in the sector. The Group is of a firm opinion that the registered NBFCs - both deposit taking and non-deposit taking, play a vital role in the economy. There is, however, a strong perception that there may be in the country a large number of unregistered and therefore unregulated NBFCs in urban as well as rural geographies, which is difficult to be estimated. The RBI s Report on Trends and Progress in Banking in India of gives an indication pointing out that the RBI received 38,244 applications for grant of certification as an NBFC. Therefore, the unregistered entities could be manifold the number of registered NBFCs. Further, a total of 575 NBFCs (both deposit and non-deposit taking) accounted for 80% of the total assets of the NBFC sector in FY10. In addition, the Residuary Non-banking Companies 8

9 (RNBCs) account for 66% of public deposits held by the NBFC sector. Therefore, the Group underlines that the regulatory and supervision mechanism for the NBFC sector need to be widened and strengthened. *** 9

10 2. Role and Vision for the NBFC sector 2.1 Issues The Group underlines the fact that the NBFCs have grown substantially and are rendering valuable services to the unbanked and under-banked population of the country. Even the RBI appointed Thorat Committee has lauded the role of NBFCs in the economic growth of the country. NBFCs have been innovators in financial services, designing products and services customized to the needs of the target customers. In addition they have created a suitable operational structure to make the business models viable. They have helped expand the financial services markets to the interiors of the country and newer products and services. The role and vision for NBFC sector has, therefore, been looked at and analyzed from the following viewpoints: 1. Is there an economic role that the NBFCs fulfill? 2. What is the kind of regulatory structure that can be envisaged for the sector? 3. What is the systemic risk posed by the sector and the progression curve for NBFCs? 4. Apart from the existing categories, is there any need for providing of additional categories of NBFCs considering the economic role played by them? Answering the above questions will crystallize the shape and direction of policy action for the sector. 2.2 Is there an economic role that the NBFCs fulfill? NBFCs have been operating various businesses under sound economics. Many businesses started by the sector have later been taken up by banks and become regular banking services. For instance, car financing, which was started by NBFCs has now become one of the larger revenue streams for banks. The NBFCs themselves have now moved on to financing second hand cars. Other businesses, namely, infrastructure finance, asset finance, hire purchase and, in the recent past, microfinance have been the major areas of operations for NBFCs. Additionally, NBFCs play a supportive role in the economy and also in financial inclusion and therefore need to be encouraged. Some of the economic roles played by NBFCs are: Infrastructure financing While the RBI doesn t have any specific sector exposure limits, it has asked the banks to formulate internal policies for exposure to the infrastructure sector. The banking sector s exposure to infrastructure was Rs. 5,50,178 crore as on May 2011, which was 15% of total non-food bank credit of the banks. In comparison, the Infrastructure Finance 10

11 NBFCs had an outstanding infrastructure loan book size of Rs.1,96,158 crore. Banks further exposure to infrastructure is constrained by prudential internal limits (which typically are 12-15%) and asset liability mismatch due to long tenure of assets and short tenure of liabilities. Given the projected capital requirement for infrastructure sector in the 12 th five-year plan, NBFCs will play a part in supplying capital to the sector. However, proper credit rating, accounting and financial norms have to be ushered in for greater transparency and soundness of the sector as also operating in the NBFC sector Serving unbanked customer segments NBFCs have traditionally focused on customer segments which were not served by banks like micro, small and medium enterprises (MSMEs), funding of commercial vehicles including old vehicles, farm equipments viz. tracking, harvesters, etc. loan against shares, funding of plant and machinery; etc. NBFCs typically are specialized vehicles both in terms of products and the geographies in which they operate. This specialization provides them a unique framework to assess the risk in the undertaken business. A much closer market awareness provides them the ability to rate borrowers, monitor them, price the relative credit suitably and effect recoveries from them. NBFCs also provide credit for certain sectors which are not served by banks and Financial Institutions because Banks/FIs do not have adequate market relationships and infrastructure for the same. Some of these sectors are: (a) Used Trucks (b) Used passenger vehicles (c) Consumer durable loans (d) Personal Loans (e) Funding to the Small & Enterprises (SME Sector) which do not have access to institutionalized funding, etc. Traditionally, these sectors were financed entirely by the unorganized financiers at exorbitant high interest rates. In the last 10 years, with their retail strength, NBFCs have rendered significant service by extending credit to these sectors. Now banks and financial institutions are availing of the reach and expertise of NBFCs for employing funds in these sectors through NBFCs. This has brought in lot of funds into these sectors, thereby reducing interest rates Strong understanding of customer segments and ability to deliver customized products The ability of NBFCs to produce innovative products in consonance with needs of their clients is well recognized. This, in addition to the proximity to the clients, makes the 11

12 NBFCs distinct from its banking sector counterparts. In a short period of time, NBFCs have become market leaders in most of the retail finance segments like commercial vehicles, car financing and personal loans. In the last decade or so, the Indian retail finance markets have seen several new products being developed and introduced by NBFCs. The following are some cases in point - Used vehicle financing, Small ticket personal loans (ST-PL), Three-wheeler financing, Loan against shares, Promoter funding, Public issue financing (IPO financing) and Finance for tyres and fuel. NBFCs have a significant economic role, especially servicing the under-banked and unbanked populace and geographies. Bringing the diverse set of NBFCs under regulation rather than curtailing their operations, would help orderly growth of the sector. 2.3 What kind of regulatory structure that can be envisaged for the sector? With the substantial size of the NBFC sector it is prudent that the regulation and supervision structure is strengthened. However, given the large numbers, the regulation and supervision is a huge challenge. Prudential norms for stricter monitoring and reporting norms should be put in place and, at an initial stage; it could be through data mining and analytics which could evolve into on-site and other inspections in due course of time. Further, increased regulatory focus and prudential framework are required for systemically important NBFCs. For smaller entities, elaborates reporting norms is likely to a better option as it will same on time, energy, cost and resources both to the Regulator as well as to the regulated entities. To achieve this objective, the Regulator may also consider size-wise uniform accounting requirements and financials reporting requirements for different sets of NBFCs. 2.4 What is the systemic risk posed by the sector and the progression curve for NBFCs? The systemic risk posed by the sector is the inter-connect and dependence on public funds which amounts to approximately 58% of all funding to the sector. The size of the NBFC sector is approximately 13% of the banking sector. Once the regulatory structure and prudential norms are put in place and the regulator is in a position to assess and manage the risks posed by the sector, there could be an even increased interplay with the banking sector. Additionally, development of the corporate bond market will help the NBFC sector source funds from the capital market and be less dependent on deposits or bank borrowings and limit the risk posed to the banking sector. 2.5 Apart from the existing categories, is there any additional category of NBFCs required in view of the economic role played by them? Currently, the RBI classifies NBFCs into 7 categories as following: 1. Asset finance company (AFC) 2. Investment company (IC) 3. Loan company (LC) 12

13 4. Infrastructure finance companies (IFC) 5. Core investment companies (CIC) 6. Infrastructure debt fund Non-banking finance company (IDF-NBFC) 7. Non-banking finance company Micro finance institution (NBFC-MFI) - (introduced on December 2, 2011). The Group has observed that the NBFCs are engaged in financing physical assets and resultant creation of a large number of jobs - which supports and strengthens economic activities across sectors, and play a critical role as an effective instruments of credit delivery particularly in the small and retail sectors of the economy. Therefore, the Group is of the opinion that the policies may be geared towards the development and growth of the sector. The regulator has also been proactive in recognizing the diverse and critical role played NBFCs and has accorded added regulatory focus on the sector by introducing and strengthening prudential frameworks for NBFCs. Considering the role played by NBFCs in creation of assets, financial inclusion, generation of employment opportunities for marginalized sections of the society and their outreach, an additional category of NBFC loan company priority sector (NBFC-LC-PS) may be looked at for NBFCs engaged in servicing priority sector customers as defined by RBI. 2.6 Future growth and development of NBFCs Given the important role played by NBFCs as innovators, serving unbanked and under-banked geographies and customer segments and services not provided by banks, it is imperative that the growth and development of the sector be accorded some degree of priority. With adequate regulatory oversight of systemically important NBFCs, implementation of prudential norms, regular reporting and monitoring, etc., NBFCs may be looked at playing a larger part in the financial services sector. *** 13

14 3. Recommendations of the Thorat Committee 3.1 The RBI Working Group Report The Report of the Working Group on the "Issues and Concerns in the NBFC Sector", chaired by Smt. Usha Thorat, was released by The (RBI) on August 29, The report made recommendations on strengthening the governance and supervision of NBFCs, which are greatly appreciated especially in the following matters: Extension of the benefits of the SARFAESI Act, 2002 to NBFCs Extension of the benefit of tax deduction for provisions made by NBFCs Strengthening of the Corporate governance and supervisory framework for the NBFCs 3.2 Broader objectives of RBI Working Group Report The KAG appreciates the concerns indicated in the Thorat Committee Report arising out of regulatory arbitrage and constraints in regulating a large number of smaller NBFCs. The KAG is also conscious of the risks associated with a large number of un-registered / un-regulated smaller entities, particularly because of their activities among and inter-action with the lowincome target populations. The KAG also notes that RBI views a large part of the activities of the NBFCs as productive in nature and also views positively the role played by most of the NBFCs including the smaller ones in meeting the funding requirements of the financially excluded sections of the society. Therefore, KAG is of the view that addressing the regulatory and supervisory concerns should not be abrupt, may not result in policy uncertainties, and also not create a vacuum in the financial space for the financially excluded sections of the society. The KAG also underlines and appreciates the aspect that, in view of diverse circumstances and requirements of different sets of entities, RBI has been prescribing different regulatory norms for various category of entities, such as, banks, NBFCs, target sectors, etc. For example, exposurenorms, provisioning requirements, NPA classification norms, priority sector prescriptions, etc. are different for various categories of entities (banks / NBFCs) or sectors, etc. 3.3 Recommendations Keeping in view all these factors and to harmonise the broader objectives of financial inclusion viz-a-viz to gradually minimise the regulatory arbitrage, we make a few observations on some of the recommendations of the Working Group Report, as under: (i) RBI recognises a large part of the activities of NBFCs as productive in nature. However, because of increase in cost of funding, the ability of NBFCs to carry on business may be impacted adversely. RBI may create framework and prudential 14

15 norms to contain the risks posed with a view to support and develop those NBFCs which meet the needs and requirements of the productive sectors of the economy. RBI also need to support NBFC-IFC, NBFC-MFI and NBFC-LC-PS by facilitating bank lending to this sector by easing in securitization of assets of these sectors, lower capital requirements, lower provisioning requirements and by taking other appropriate regulatory measures. (ii) (iii) The use of public funds by NBFCs has gone down from 62% in FY06 to 58% in FY11. During the same period, owned funds as a percent of total source of funds increased from 23.3% to 26.1%. However, in the absence of authentic data, it may not be possible to assess the actual usage of public funds by NBFCs for productive and non-productive segments of the economy. The data available with RBI may suggest / identity the NBFCs which have borrowed from Banks for onward lending to the Priority Sector segments. Such entities should be encouraged in larger public interest and such NBFCs should be distinguished from other NBFCs which access bank funds for other end uses such as real estate / capital market transactions. RBI may also consider putting in place appropriate framework to ensure any potential mal-practices noticed in this regard, instead of blocking flow of funds altogether, which may be detrimental to the access of genuine priority sector borrowers to the funding through NBFCs. Further, this also underlines the requirement of creating a comprehensive databank of NBFCs to ascertain the funding pattern vis-à-vis the growth in assets for different class of NBFCs, which may provide valuable pointers and enable meaningful decision making for regulatory framework and prescriptions required for various types of NBFCs. At the time the Companies Act was last amended, it provided that an issuance to more than 49 persons would make such issuance a public issue. However, considering their business requirements and subject to their complying with other requirements of a private placement as set out in Section 67 of the Companies Act, the Government decided to exempt Banks, Financial Institutions and NBFCs from this limit. This exemption to the NBFCs may be allowed to continue. Liquidity: (iv) Asset Liability Management (ALM) guidelines have been made mandatory for NBFC-ND-SIs with assets of Rs. 100 crore and above and for deposit taking NBFCs with deposits more than Rs. 20 crore. Such NBFCs are required to maintain a gap not exceeding 15% of their net cash outflows in the 1-30/31 day bucket. The KAG is of the view that prescribing a separate liquidity requirement for near-term bucket (upto 1 month) will avoidably increase the cost for NBFCs, and consequent cost of funds for their customers. KAG therefore recommends that for NBFCs, the tolerance limit of 15% for the negative mis-matches over one year time buckets may be restored, which would be in line with the existing 15

16 prudential guidelines for both banks and NBFCs. Alternatively, the changes are phased-out to provide adequate time to the affected entities to align with the revised regulations. (v) NBFCs normally invest in money market instruments indirectly through liquid money market Mutual Funds. Therefore, for the purpose of computing total financial assets, investments in liquid funds of mutual fund should also be included in the eligible liquid instruments apart from G-Sec, T-Bills etc. (vi) The non-deposit taking systematically important NBFCs were permitted to augment their capital by issuing perpetual bonds, after their CRAR requirement was increased from 12% to 15%. RBI has now prescribed similar CRAR requirements for Deposit accepting NBFCs as well. Therefore, the same flexibility of raising perpetual bonds may be permitted to both deposit-taking systematically important and non-deposit taking systematically important NBFCs. Capital Adequacy: (vii) The RBI Working Group has suggested that the Tier-I CRAR be raised to 12% from the current 10%. It is evident from the report that the main consideration for raising the Tier-I CRAR is on the basis that banks have CRR/SLR requirements as well as priority sector obligations. But, while the banks have the burden of CRR/SLR as well as priority sector obligations, they also have the benefit of riskweighted CRAR requirements based on the credit rating of their borrowers. For example, for AAA rated borrower, the applicable risk weightage is 20%. After adjusting the potential Tier-II capital, the Tier-I capital to be provided against the AAA asset will be 1.2% of the value of the loan. The NBFCs do not have the benefit of such calibrated risk weightage. An increase in the Tier-I CRAR would severely impact the competitiveness of NBFCs. Therefore, KAG is of the view that the Tier-I CRAR requirement for the NBFCs may be retained at 10%. (viii) From , RBI had increased the CRAR requirements for NBFCs from 12% to 15%, out of which 10% should be Tier-I capital. The RBI Working Group has recommended that Tier-1 CRAR requirement for NBFCs be raised to 12%. This would mean another increase in Tier-I capital of NBFCs by 20%, which would severely affect the cost side of NBFCs. RBI has prescribed a calibrated risk-weighted regime for the banks depending upon the associated risk in lending - both for the sectors as well as the borrowal entities. KAG is of the view that the importance of 'risk-assessment' or 'risk-perception' as guiding principles for determining capital requirement of NBFCs need no additional emphasis, and would bring enhanced discipline and efficiency in their functioning. The KAG also recommends that 16

17 Minimum Net Owned Funds: i. the risk weightage for asset financing / financial inclusion / SME businesses be reduced to 50%; and ii. on Loan against property where shares are only taken as secondary collateral (property being the main security), it doesn t tantamount to capital market exposure, and as such risk-weight may be prescribed as 100%. (ix) RBI permits NBFCs an overall leverage by borrowing based on the prescribed CAR. NBFCs essentially borrow only as working capital loans as they are deployed for their business and the repayment is also funded out of the business collections. Currently, rated AFCs are permitted to accept deposits upto 4 times of their net-owned-funds (NOF). RBI Working Group has recommended that the limit for acceptance of deposits for rated Asset Finance Companies (AFCs) should be reduced from 4 times NOF to 2.5 times NOF. AFCs presently exceeding this limit may not renew or accept fresh deposits till such time as they reach the revised limit. The committee has recommended compulsory rating of AFCs for raising deposits. Most of AFCs raise fund by way of NCD issuance which are rated and if same are not secured by immovable property equivalent to one times the issue size are considered as deposit. The aforesaid restriction will further limit the avenue of raising money by NBFCs and thereby hamper their contribution to economic growth by way of financing of productive assets. Non Performing Assets (NPAs): (x) The period for classifying loans as NPAs in case of NBFCs is higher at 180/360 days compared to 90 days for banks. A 90 day reference for recognizing NPAs in NBFCs in line with banks would impose provisioning burden on the NBFCs and could result in NBFCs deciding to opt for early foreclosures, depriving their borrowers of an income generating asset. Given the higher capital requirements, accelerated provisioning would further burden the NBFCs. Any change in the provisioning requirements for NBFCs to match that of Banks may be to the detriment of NBFCs which serve specific unbanked sections of the society, particularly the small truck operators and the SME businessmen. Their repayment to the NBFC is linked to their collection. Invariably, their collection gets delayed due to various reasons beyond their control. Further, the small borrowers of NBFCs have, over the years, tuned their business model to match the collection requirements of the NBFCs. The NBFCs have also been able to exhibit good collection record and the default rate is extremely low. Therefore, KAG is of the view that the current NPA classification norms for NBFCs may continue. Instead, RBI may put in place an effective and elaborate reporting 17

18 mechanism to assess the delinquency pattern, behavior and incidents in various categories of NBFCs; to design an appropriate regulatory regime GENERAL In respect of the capital requirements; risk-weights for various classes of assets, sectors and entities, the classification and provisioning requirements for stressed assets, borrowing-limits; or the balance-sheet size of the NBFCs for registration / de-registration requirements, KAG is of the view that the regulatory prescriptions should be gradual and duly phased-out so as not to create policy uncertainties; and also afford adequate time to the affected NBFCs to be able to align themselves with the revised regulatory framework without substantial dislocation of their normal business activities. This will also inculcate a sense of stability among the stakeholders to visualise and undertake long term plans Categorization of NBFCs The RBI Working Group has recommended that since there is no difference in the regulatory framework for loan companies (LCs) and investment companies (ICs), and since most of the NBFCs-ND-SI are a mixture of loan and investment companies, a single category of LCs and ICs should be made. The KAG is of the view that may not appropriately factor-in the risk profile of LCs viz-a-viz ICs. While the assets of ICs typically carry the risk of equity / capital markets, the asset side of LCs largely consist of loan receivables. Consequently, LCs present a far lesser risk than ICs and therefore need to be differentially regulated from ICs. Also, the borrowings by LCs are typically supported by credit rating by independent credit rating agencies. *** 18

19 4. Recommendations - II 4.1 Prior approval of RBI for mergers of NBFCs The RBI Working Group has recommended that all registered NBFCs should take prior approval of the RBI whenever there is a change in control or transfer of shareholding of the said NBFC, directly or indirectly, exceeding 25% of its paid-up share capital. Prior approval of the RBI should also be taken for mergers of NBFCs under the Companies Act or any acquisition by / of an NBFC governed by the SEBI Takeover Regulations. Recommendation: The requirement of taking prior approval of the RBI whenever there is a change in control or transfer of shareholding of an NBFC, directly or indirectly, exceeding 25% of its paid-up share capital, should only apply in cases where the acquirer acquiring the NBFC or the NBFC being acquired has raised public deposits. In other cases, the requirement of only providing information to the RBI should be mandated. Similarly, considering that the public offers under the SEBI Takeover Regulations are presently being supervised by SEBI and mergers under the Companies Act, 1956 require prior approval of the High Court, the need for approval from another regulatory authority viz. RBI may be dispensed with. Further acquisitions / mergers may also require approval of the Competition Commission under the Competition Act. Approvals from multiple regulatory authorities will only delay the process. Therefore, in such cases also, the requirement of providing information to the RBI should be mandated. In case the proposal for prior approval from RBI for such restructuring of NBFCs is accepted, for increased transparency, accountability and objectivity in the decision making process of the regulatory functions of RBI, KAG also recommends that the concept of deemed approval should also be provided in cases where the RBI does not communicate its approval / rejection to the said restructuring within a certain prescribed reasonable period. 4.2 Definition of Public Funds The RBI Working Group has defined public funds as funds raised either directly or indirectly through public deposits, commercial papers, debentures, inter-corporate deposits, guarantees and bank finance or any other debt instrument, but exclude funds raised by issue of share capital and/ or instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue or registration with RBI. Recommendation: KAG recommends that the term public funds should not include loans / deposits from the Holding / Group Company, if funded through internal accruals of the Holding / Group Company. The RBI may insist on a certificate from the statutory auditors of the Holding Company to that effect. 19

20 4.3 Participative Financing: In the backdrop of the recent concerns pertaining to levy of usurious rate of interests by Micro Financial Institutions and earlier RBI guidelines on Fair Practice Code in 2009 (to ensure transparency in charging high rates of interests by NBFCs), charging of high interests on loans disbursed to retail borrowers, has always raised issues in India. This can be mitigated if NBFCs are expressly allowed to undertake participative financing which consist of financings in a manner that returns are linked to the actual cash flows of the venture for which financing was availed but such that the returns are capped. Mezzanine financing is one such form. While per se the Act, 1934 does not prohibit participative financing, the circular on 2nd January 2009 on Fair Practice Code required NBFCs to, inter-alia, adopt an interest rate model taking into account relevant factors such as, cost of funds, margin and risk premium, etc. and determine the rate of interest to be charged for loans and advances. In our view, while the said 2009 circular was intended to clarify RBI s earlier circular on Fair Practice Code and ensure transparency, given the language used therein, it has been interpreted to mean that NBFCs must follow an explicit interest based model. We therefore urge the RBI to issue a clarificatory circular stating therein that the 2nd January 2009 circular on Fair Practice Code applies to those NBFCs that are disbursing interest based loans and does not prohibit NBFCs from undertaking other forms of financing such as participative financing / non-interest based financing. As regards NBFCs that are undertaking participative financing and / or any other non-interest based financing, the following directions should be complied with: (i) The Fair Practice Code should set out the model on which facilities will be granted to borrowers. The NBFCs should also set out the commercial considerations for its facilities, (after factoring in aspects such as cost of funds, expected return and other parameters to determine credit viability). The Fair Practice Code should be displayed on the website of the NBFCs and updated periodically; (ii) The borrowers should be made aware of these commercial considerations in the agreement and the loan sanction letter. Expected returns, servicing charges should be communicated separately. If the expected rates of return and service charges are different for different category of borrowers, then the same should be communicated to the borrowers. 4.4 Fixed Deposits as Financial Assets: Presently RBI excludes fixed deposits from the definition of financial assets. Secondly, the Report recommends that bank deposits maturing within 30 days should be taken into 20

21 consideration for computing financial assets. We urge the RBI to consider including fixed deposits under financial assets for the purpose of computing principal business of an NBFC. For this purpose, the following amendment (in bold) is proposed to the definition of principal business stated in the circular dated 19 th October 2006 on Amendment to NBFC regulations - Certificate of Registration (CoR) issued under Section 45-IA of the RBI Act, 1934 Continuation of business of NBFI -Submission of Statutory Auditors Certificate- Clarification The company will be treated as a non-banking financial company (NBFC) if its financial assets (including fixed deposits) are more than 50 per cent of its total assets (netted off by intangible assets) and income from financial assets is more than 50 per cent of the gross income. Both these tests are required to be satisfied as the determinant factor for principal business of a company. 4.5 Bank credit for priority sector lending: Banks lending to NBFCs who further supported the priority sector was previously allowed to be classified by banks as priority sector. NBFCs therefore received such funding at a discounted cost of funds. However such on lending by banks has been disallowed for NBFCs in a circular issued by RBI on May 3, Given the importance of the role that NBFCs play in propagating financial inclusion, i.e serving low income families and small businesses, on lending by banks should be classified as priority sector. This will not only enhance the growth for NBFCs but also give banks a profitable channel to deploy funds earmarked for priority sector instead of investing the funds at a nominal return. The NBFCs could be asked to provide evidence to the effect that the end use of the borrowed funds was by the priority sector participants; Further banks could be assigned the responsibility of monitoring the end use of funds. 4.6 ECB financing: Sources of funding for NBFCs are currently limited - this hampers the growth of credit by NBFCs and ultimately the government's objective of financial inclusion. Much like infrastructure finance companies, NBFCs should be allowed to raise funds in the form of ECB financing In a rising interest rate environment, this will give NBFCs the much needed fillip in terms of funding cost. Further, the differential cost would be the difference between rupee finance and ECB financing (post hedging). In our view this could range between 1% to 2%, and would significantly ease the interest cost burden that NBFCs are facing. End use of the ECB should be allowed to on-lend to the end customers. 21

22 4.7 Prudential norms for certain categories of NBFCs to be more relaxed Currently, all NBFCs are treated equally with regard to prudential norms. However given their contribution to the development of the economy, infrastructure finance companies have been carved out as a separate category with relaxation in terms of sources of borrowings (ECB allowed) given the long term funding needs. Certain large NBFCs that are systematically important and have healthy asset quality, good corporate governance practices, sufficient capital, strong parentage need to be given a separate status to enhance their growth and reach. Secondly, these NBFCs must be differentiated from a few smaller NBFCs that have indulged in unsecured lending leading to higher levels of non-performing assets. Therefore our recommendation is to create a separate category of NBFCs either in terms of (i) size or in terms of (ii) lending against a security / income generating asset ("asset financing") or (iii) a combination of both these parameters. The capital adequacy, provisioning, risk weight norms for these NBFCs can be more relaxed i.e retained at the current levels. 4.8 Lending to stock brokers and merchant banks The working group has recommended that regulations for lending to stockbrokers and merchant bankers by NBFCs (Loan companies focused on capital market financing) should be similar to banks. We believe that the NBFCs / Loan companies focused on capital market financing are essentially capital market players while banks are lenders; consequently these NBFCs face capital market risk while banks deal with lending risk. Hence we suggest that the current NBFC regulations on the subject be retained and RBI must address the regulatory need through reporting by NBFCs of stockbroker and merchant bank exposures. *** 22

23 5. Recommendations III 5.1 DIRECT TAX ISSUES Tax Deduction at Source on Interest (Section 194A of the Income Tax Act) As per Sec 194A of the Act, the Tax Deduction at Source is required to be deducted on the interest portion of the installment paid to the NBFC under loan / finance agreements. However, the banking companies, LIC, UTI, public financial institution, etc. engaged in banking business are exempted from the purview of this Section. NBFCs carry-on the financing business mostly to retail customers, most of whom are in unorganized sectors including a large number of individuals and SME sector borrowers. A single point collection of tax by way of advance tax payments from NBFCs would mean greater convenience to the Income Tax Department than collecting of tax through large number of such customers from all over the country by way of TDS. Further, the distinction in the provision puts NBFCs in a disadvantageous position viz-a-viz other financing entities. Recommendation This Group, therefore, recommends that the NBFCs may also be exempted from the provisions of section 194A of the Income Tax Act, at par with other financial sector entities Tax benefits for Income deferral under Section 43D of the Income Tax Act Section 43D of the Income Tax Act recognises the principle of taxing income on sticky advances only in the year they are received. The provisions of Section 43D have been extended to the Banks, Financial Institutions and State Financial Corporations. Further, this benefit was also extended to the Housing Finance Companies by the Finance Act, In accordance with the directions issued by the RBI, NBFCs follow prudential norms in line with other financial sector entities to defer income in respect of their non-performing accounts. However, the Income Tax authorities do not recognise these directions and tax such deferred income on accrual basis, resulting in levying of tax on income which may not be realized at all. Recommendation This Group, therefore, recommends that the provisions / benefits of Section 43D of the Income Tax Act be extended to include NBFCs registered with RBI, as in the case of other institutions Allowing of provisions made for Non-performing Assets (NPAs) under Section 36(1)(viia) of the Income Tax Act 23

24 NBFCs are RBI regulated entities and are required to make provisions for NPAs in accordance with the applicable RBI guidelines concerning income recognition and provisioning norms. The provisions of Section 36(1)(viia) of the Income tax Act allow the banks a deduction to the extent of 7.5% from the gross total income and 10% of aggregate average rural advances towards provisions for bad and doubtful debts made by them. Alternatively, such banks have been given an option to claim a deduction in respect of any provision made for assets classified by the RBI as doubtful assets or loss assets to the extent of 10% of such assets. Recommendation Since the NBFCs are also RBI regulated entities and are required to make provisions for NPAs as per applicable RBI guidelines, the benefits of Section 36(1)(viia) of the Income tax Act may also be extended to the NBFCs, as available to the banks Declaration in Form 15G / 15H read with Section 206AA Effective 1st April, 2010, a new Section 206AA has been introduced in the Income Tax Act which require furnishing of the Permanent Account Number (PAN) issued by the Income Tax Department mandatorily for all categories of payments. The mandatory quoting of PAN has been extended to cover payment of interest without tax deduction even for those persons who provide the declaration in Form 15G / 15H. The declaration in Form 15G / 15H are given by those persons who have income below the taxable threshold limits, and therefore, may not have a PAN number. Further, the details of depositors giving such declarations in Form 15G / 15H are being furnished in the TDS Returns filed electronically every quarter and such declaration forms are also submitted to the relevant authority as prescribed under the Income Tax Act. This provision causes undue hardship to the small depositors, pensioners and senior citizens, etc. whose income is below the taxable threshold, as they are also required to apply and obtain PAN from the Income Tax Department. Recommendation This Group, therefore, suggests that sub-section 2 of Section 206AA may be removed to enable the small depositors to furnish declaration forms 15G / 15H without mandatorily furnishing PAN Introduction of the threshold limit for TDS on the interest income on unlisted debentures NBFC-AFCs issue secured non-convertible debentures to retail investors (individuals) in order to raise funds. In the case of unlisted debentures, TDS is to be deducted from the interest paid, without any minimum threshold limit. This provision proves harsh for the individuals investing their small savings in these secured debentures. Recommendation This Group, therefore, suggests that clause (v) of proviso to Section 193 may be suitably amended, and the words, being debentures listed on a recognised stock exchange in India in accordance with the Securities Contracts (Regulation) Act, 1956 (42 of 1956), and any rules made there-under, may be considered for deletion. 24