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Confusion Re Systematically Important NBFCs

Published on Mon, Jul 20,2015 | 22:56, Updated at Mon, Jul 20 at 22:56Source : 

By: Vinod Kothari & Surbhi Jaiswal, Vinod Kothari & Company

If, as they are, by self-admission, important for the financial system, the RBI’s approach to revamping the regulatory system for systematically important non-banking financial companies (“NBFCs”) stops too short of being optimal. The approach has been flip-flop, unclear as well as unsystematic, leaving whole lot of companies wondering as to where they are – on which side of the supposedly-bright line distinguishing between those companies that are systematically important, and those that are not.

By way of an introduction, the RBI recently (that is, on 27th March 2015)[1], revamped its regulatory framework for systematically important NBFCs by re-promulgating the two statutory instruments viz., Systemically Important Non-Banking financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2015[2] (“SI Directions”) (applicable to systematically important NBFCs called NBFC-SI) and  Non-Systemically Important Non-Banking financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2015[3]  (“Non-SI Directions”)(applicable to non- systematically important NBFCs called NBFC-NSI  ). On 10th April 2015, it came with another regulatory instrument called Non-Banking Financial Companies – Corporate Governance (Reserve Bank) Directions, 2015[4] laying down certain corporate governance requirements for NBFC-SIs. These instruments (we collectively refer to these as the “Revised Regulatory Framework for NBFCs”) replace the regulations made in 2007 namely the Non-Banking Financial (Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007[5]. The earlier criteria for systematic significance was Rs 100 crores in assets – revised upwards, admittedly on the recommendations made by the  Working Group on the Issues and Concerns in the NBFC Sector chaired by Smt. Usha Thorat.

Why the distinction between NBFC-SI and NBFC-NSI?
The distinction between NBFC-SI and NBFC-NSI goes back to 2007 when the-then existing regulations, Non-Banking Financial Companies Prudential Norms (Reserve Bank) Directions, 1998[6], were replaced by two new regulatory instruments. This, for the first time, introduced the distinction between NBFC-SI and NBFC-NSI. The idea was mooted several years back by IMF in a document called Financial Sector Assessment – A Handbook wherein it was stated: “..if the structure (of financial regulation) gives rise to significant supervisory gaps—that is, differences in regulation of activities that have a similar function but that are performed by different institutional types—market participants are likely to seek opportunities for regulatory arbitrage and to engage in financial operations that are not appropriate from a regulatory perspective. This regulatory arbitrage, in turn, will lead to a developmental outcome for the financial sector that is suboptimal”[7].

The mid-term Monetary Policy for 2006 discussed the revised regulatory framework laying down criteria of asset value. The regulatory framework was implemented in 2007.

The underlying principle of systematic importance is (a) regulatory focus on such entities which are significant to the operation of the financial system, and (b) at the same time, ensuring that there is minimal intervention in the operation of smaller NBFCs, which do not involve public funds, and do not have customer interface.

Global idea of systematic importance
The idea of systematically important non-banking financial institutions is not new at all. The phrase “too big to fail” became popular during the crisis of 2007-2009 when collapse of some financial institutions sent jitters all over the world. Resultantly, financial supervisors globally have focused their attention to non-bank financial institutions which were large in size.

For instance, the Federal Reserve in the US treats non-bank financial entities having assets of USD 50 billion or more as systematically important financial institutions (SIFI), which are put under the supervision of Financial Stability Oversight Council. The number, USD 50 billion, is more than 600 times the number used by RBI in India, indicating a whopping gap even after considerable the scale of financial markets in the country. In the USA, based on this definition, only a handful of financial companies are classed as SIFI - including GE Capital, and some insurance companies[8].

The Basel Committee's framework[9] on the assessment methodology for global systemic importance banks (“G-SIBs”) is based on an indicator-based approach and comprises five broad categories: size, interconnectedness, lack of readily available substitutes or financial institution infrastructure, global (cross-jurisdictional) activity and complexity. In this regard the Financial Stability Board (“FSB”) issues a list identifying G-SIBs based on the same assessment methodology and as per the latest list published as on November, 2014 there are merely 30 G-SIBs.

In Singapore, the Monetary Authority of Singapore (“MAS”) states that Domestic Systematically Important Banks[10] (“D-SIBs”) are banks that are assessed to have a significant impact on the stability of the financial system and proper functioning of the broader economy.” All banks in Singapore will be assessed for their systemic importance annually based on their size, interconnectedness, substitutability and complexity." The same is in line with the principles set out by the Basel Committee. At present MAS identifies 7 D-SIBs.  Similar approach is adopted by Australian Prudential Regulation Authority (“APRA”) to identify D-SIBs in Australia[11]

The flip-flop
The Notification of November 2014[12] referred to notifications to come, and the notifications that came on 27th March nowhere contained a reference to aggregation of assets. The definition of “systematically important as provided in the 27th March, 2015 directions is given below:

“Systemically important non-deposit taking non-banking financial company', means a non-banking financial company not accepting / holding public deposits and having total assets of Rs. 500 crore and above as shown in the last audited balance sheet;

If the intent of the regulator is that the assets of so-called “NBFCs in the Group” were to be aggregated, there was nothing that stopped the regulator from saying so in the SI Directions itself. If there is a notification issued by a regulator, it is a correct presumption to make that all previous discussions, circulars or proposals have all been subsumed into what is notified. It will be ridiculous to read a notification with a circular which referred to the imminent notification.

However, the Master Circular issued on Miscellaneous Instructions to all Non-Banking Financial Companies on 1st July, 2015 (Miscellaneous Instruction)[13] makes reference to Multiple NBFCs. Para 29 of the said Master Circular made reference to the concept of multiple NBFCs and the aggregation of the assets of the ‘Companies in the group’ for the purpose of determining whether the same is systematically important or otherwise.

In the Directions of SI and Non-SI there is no reference to the concept of multiple NBFCs or aggregation of assets for ascertaining whether the company is SI or not.

If the concept of multiple NBFCs was to be given validity then the coy introduction to the same was unwarranted.

There certainly was a background to the aggregation of assets, as it featured in the draft guidelines by Usha Thorat Committee’s Review of the NBFC Regulatory Framework[14]. The Report by Nachiket Mor also prescribed the need for having separate definitions for aggregation – one for CICs and the other for NBFCs[15].

The draft guidelines were clear to state that the asset size of ‘companies in the group’ will be aggregated and herein ‘group’ was defined to mean the same as per CIC directions. Para 29 of the Miscellaneous Instructions Directions has re-instated the provisions of multiple NBFCs.

In essence, while the concept of multiple NBFCs originated from the Usha thoraat committee recommendations they have been dropped and picked in the regulations on whim and fancy it seems. In the last seven months, there has been a constant flip flop and it seemingly conveys that RBI itself is unsure of whether it wants the regulations to stay or to go.

The Group with a small g and the one with a capital G
As would be obvious looking at the aggregation approach used in November, 2014 Notification, the characterisation of an NBFC-SI is based on the concept of a “group”. But then, what, exactly, is a “group”? This crucial word has two definitions in the Circular, and surprisingly, both the definitions occur in the same paragraph– one with a small G and other with a capital G! Logically speaking there is no difference between the two. However, looking at the way the ‘group’ and ‘Group’ have been used there seems to be an obvious intent to differentiate between the two.

The first one is ‘group‘(here the word group not is capitalised). The accounting standard definition of “group” comes from AS-21 which defines “group” to mean as follows:

“A group is a parent and all its subsidiaries.”

The second definition is ‘Companies in the Group’ (here the word Group is capitalised). This definition is apparently a replica of the definition used in the CIC Directions, 2011[16]. The definition used in the November 2014 Notification is as follows:

“Companies in the Group”, shall mean an arrangement involving two or more entities related to each other through any of the following relationships:
• Subsidiary – parent (defined in terms of AS 21),
• Joint venture (defined in terms of AS 27),
• Associate (defined in terms of AS 23),
• Promoter - promotee [as provided in the SEBI (Acquisition of Shares and Takeover) Regulations, 1997]
• For listed companies, a related party (defined in terms of AS 18), common brand name, and investment in equity shares of 20% and above.  

The intent of the Master Circular is that the assets of NBFCs belonging to a group will be aggregated, but the issue is, what is a ‘group’? If the narrow definition of “group” as per accounting standards is taken, then the characterisation is quite easy, because the assets of the “group” may be reflected in the consolidated financial statements (CFS). However, if the wider meaning of the word “Group” is adopted, which seems to be the intent, then we come to grave difficulties of consolidation.

Consolidation principles
How will the assets of NBFCs in the “group” or the “same group” be computed? It will be outrightly illogical to simply sum together the assets, as, by definition, these NBFCs have interlocking investments. If Company A has an asset base of Rs 400 crores, out of which it has invested Rs 300 crores in Company B, and let us say, that is all the money that Company B has, and therefore, its asset base is also Rs 300 crore, the combined asset base is not Rs 700 crores, but only Rs 400 crores. It will lead to double-counting of the same assets if we simply aggregate the assets. Therefore, appropriately, consolidation principles that are applied for preparation of CFS will have to be used here as well, and investments/exposure in the same group will have to be netted out to properly compute the value of assets.

The Master Circular requires statutory auditors to give a certificate of consolidated value of assets. Auditors will be really at a loss as to how to do the said consolidation – it is not, strictly speaking, consolidation as per Accounting Standards, as the consolidation principles in case of subsidiary companies, and in case of joint venture/associate companies, are not the same. There is no consolidation in case of promoter/promotee companies. Ideally, the consolidation should only be to nullify double-counting, and therefore, it may just be netting off of assets. However, in view of total unclarity on this critical issue, it is quite likely that auditors will have variety of views, thereby putting both companies and auditors to an unwarranted confusion.

What applies in case of listed company- promoter-promotee or related parties?
Even though the definition of ‘Companies in the Group’ has been taken from the CIC Directions, 2011 there is a clear disparity between the two. In the CIC Directions, 2011 the definition has been given in a paragraph form where the phrase “for listed companies” lies between promoter-promotee and related party whereas under the Miscellaneous Instruction Notification the same has been given in bullet form where the phrase “For listed companies” is given with the term related party. Under the CIC Directions, 2011 placement of comma indicates that the phrase “for listed Companies” has been used for promoter-promotee relationship.

Even though the wordings in the Miscellaneous Instructions Directions and CIC Directions, 2011 are the same, the mere placement of comma changes the meaning of the definition. Underlying the age old need to use punctuation at the correct place, the CIC Directions, 2011 correctly used comma to state that identification of promoter-promotee was required in case of listed companies only. AS-18 being applicable to classes of companies, the need to apply the same in case of listed companies only was illogical. However the Miscellaneous Instructions Directions seem to have completely misplaced the comma. By stating that identification of related parties as per AS-18 will only apply for listed companies, it is difficult to apprehend the reason behind the same. This is because more than half the constituents of the As-18 definition i.e holding-subsidiary, associates, joint venture already form part of the “Companies in the Group” definition.

Further, usage of the phrase ‘for listed companies’ makes more sense as promoter-promotee in case of listed companies is always known whereas in case of unlisted companies, one will have to search, therefore will have to travel to the definition given in SEBI (Acquisition of Shares and Takeover) Regulations, 1997, which in turn would lead to the definition of promoter and promoter group given in SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009. The two definitions put together might mean that a whole lot of companies will be covered under the definition since the definitions used in the latter regulation is fairly wide. Further, both the regulations are applicable only in case where the company is a listed company. However para 29 of the Miscellaneous Instructions Directions has been drafted such that identification of promoter-promotee is required in case of every class of company.

It is almost as if the confusion about the use of the word group with a capital G and a small G being not enough, that the way ‘Companies in the Group’ is defined has added further woes for aggregation of asset size.

NBFCs-SI galore
As per the old regulatory framework, there were 465 NBFC-SIs in the country as on 24th November, 2014[17] which is quite huge when compared to 30 odd G-SIBs as per the updated list issued by the FSB as on 6th November 2014[18].

It is likely that though the asset base for NBFCs has gone up, the number of NBFC-SIs may actually increase, once the consolidation approach is used. This will mean, once again, de-focussing of regulatory attention. A whole lot of regulatory norms such as capital adequacy requirements, concentration norms, formations of various committees and policies etc. which was otherwise not applicable to an NBFC-NSI will become applicable.

We must not forget that the Indian definition of NBFCs suffers from an age-old problem – intra group holding companies are also regarded as NBFCs in the country. One wonders what could be the systemic risk arising out of a holding company holding shares of non-financial group companies? Since the holding company structure is obviously the most common structure used by most Indian business houses, an asset base of Rs 500 crores is quite likely to include a whole lot of group holding companies that have no relevance to the operation of the financial system.

RBI has to realise that it is corporate regulator – it is the supervisor of the financial system of the country. The less it concerns itself about investment companies and unimportant financial companies, the better it will be able to do what it is intended to do – safeguard the stability of the financial system in the country.

8 GE Capital, obviously unhappy with the tag of SIFI and the impact the same has on its leveraging ability, decided to drastically reduce its asset base.

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