Large Exposures Framework for Non-Banking Financial Company – Upper Layer (NBFC-UL)
Introduction
Prudential guidelines aim to address credit risk concentration in non-banking financial companies (NBFCs). These guidelines focus on identifying and managing large exposures, which refer to the sum of all exposure values of an NBFC-UL (an NBFC placed in the upper layer) to a counterparty or group of connected counterparties. The guidelines define large exposure as an exposure equal to or exceeding 10% of the NBFC-UL’s eligible capital base, which refers to Tier I capital as defined in the Master Direction for NBFCs.
To determine large exposures, the guidelines refine the criteria for grouping of connected counterparties. A group of connected counterparties refers to two or more natural or legal persons who satisfy either a control relationship or economic interdependence criteria. Control relationship means that one person directly or indirectly controls the other(s) or that such persons are under the common control of a third party, irrespective of whether the NBFC has exposure to the third party or not. Economic interdependence criteria involve several factors, such as transactions between counterparties, guarantees, production, funding sources, and potential financial problems.
To manage large exposures, the guidelines require NBFC-UL to put in place reporting norms for large exposures and obtain an external auditor’s certificate on completion of the augmentation of capital. The guidelines also expect NBFC-UL to identify possible connected counterparties based on economic interdependence in all cases where the sum of all exposures to one individual counterparty exceeds 5% of the eligible capital base.
Overall, these guidelines provide a framework for NBFCs to manage credit risk concentration and ensure financial stability.
This provides guidelines applicable to Non-Banking Financial Companies – Urban Co-operative Banks (NBFC-UL) at both the solo and consolidated (group) level. These guidelines primarily focus on exposure limits and credit risk transfer instruments for the NBFC-UL.
According to the guidelines, exposure shall comprise both on and off-balance sheet exposures by the NBFC-UL, and the exposure limits will apply to all the NBFC-UL’s counterparties and groups of connected counterparties, except for specific exempted exposures listed in the guidelines.
The guidelines also allow exposures to be offset with credit risk transfer instruments such as cash margin, central government guaranteed claims, and hedged corporate bonds. In cases where exposure to the original counterparty is reduced due to an eligible credit risk transfer instrument, it needs to be recognized as an exposure to that extent on the credit risk transfer instrument provider.
Furthermore, the guidelines specify that entities economically dependent on an entity that falls within the scope of the sovereign exemption will not be deemed to constitute a group of connected counterparties. NBFC-UL’s exposure to an exempted entity which is hedged by a credit derivative shall be treated as an exposure to the counterparty providing the credit protection.
The guidelines also have specific provisions for NBFC-UL’s held by Non-Operative Financial Holding Companies (NOFHC), which cannot have any exposure to the Promoters/Promoter Group entities or individuals associated with the Promoter Group or the NOFHC, invest in the equity/debt capital instruments in any of the financial entities under the NOFHC, or invest in equity instruments of other NOFHCs.
The Large Exposure Limits:
The guidelines outlines the limits on exposure of Non-Banking Financial Companies – Upper Layer (NBFC-UL) to single counterparties and groups of connected counterparties.
For single counterparties, the sum of all exposure values of an NBFC-UL must not be higher than 20 percent of the NBFC-UL’s eligible capital base at all times. This means that an NBFC-UL cannot have more than 20 percent of its eligible capital base exposed to a single counterparty at any given time. However, the board of the NBFC-UL may allow additional 5 percent exposure beyond 20 percent but at no time higher than 25% of the NBFC-UL’s eligible capital base, subject to certain conditions. These conditions include having a policy approved by the board of directors that sets out the conditions under which exposure beyond 20% may be considered, and recording in writing the exceptional reasons for which exposure beyond 20% is being allowed in a specific case.
An Infrastructure Finance Company (IFC) may further exceed the exposure limit by 5 percent of Tier I capital for exposure to a single counterparty. Furthermore, an NBFC-UL may exceed the exposure limit by 5 percent of its Tier I capital for exposure to a single counterparty, if the additional exposure is on account of infrastructure ‘loan and/or investment’. However, the single counterparty limit shall not exceed 25% in any case for NBFC-UL (other than IFC) and 30% for NBFC-UL(IFC).
For groups of connected counterparties, the sum of all exposure values of an NBFC-UL to a group of connected counterparties shall not be higher than 25 percent of the NBFC-UL’s available eligible capital base at all times. If the additional exposure is on account of infrastructure ‘loan and/or investment’, an NBFC-UL may exceed the exposure limit by 10 percent of its Tier I capital for exposure to a group of connected counterparties.
Each NBFC-UL shall frame a policy approved by its board to determine the existence of a group of connected counterparties. The policy framed and assessments made under such a policy shall be subject to supervisory scrutiny.
In exceptional cases, if a NBFC-UL demonstrates to the Reserve Bank of India (RBI) that despite control being established, such control does not necessarily result in the entities concerned constituting a group of connected counterparties, then it is not required to classify the entities as a group of connected counterparties. Similarly, if a NBFC-UL can demonstrate to the RBI that a counterparty which is economically closely related to another counterparty may overcome financial difficulties or even the second counterparty’s default by finding alternative business partners or funding sources within an appropriate time period, then it is not required to classify the entities as a group of connected counterparties.
The guidelines also highlights the relationship between interconnectedness through control and interconnectedness through economic dependency. It notes that there may be situations where the control relationship and economic interdependence are interlinked, and that one group of connected counterparties could include both types of factors in such a way that all relevant counterparties constitute a single risk for the NBFC-UL. Therefore, NBFC-ULs should assess counterparties with a view to identifying the chain of contagion leading to possible default of all entities.
Values of Exposures:
Exposure to counterparties refers to the amount of credit risk a financial institution is exposed to when lending money or engaging in other financial transactions with a particular counterparty. The exposure can be calculated as both on and off-balance sheet items, and the calculation method is prescribed in the Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016.
The exposure may be offset with credit risk transfer instruments that are permitted under the prescribed directions. This means that if an NBFC enters into a credit risk transfer agreement with a counterparty, it can offset its exposure against the counterparty by the amount of the credit risk transferred.
For factoring transactions, which involve the sale of accounts receivable to a third party (the factor) at a discount, the exposure is calculated based on whether the transaction is on a “with-recourse” or “without-recourse” basis. In a with-recourse factoring transaction, the assignor (the party selling the receivables) retains the risk of non-payment by the debtor, so the exposure is calculated based on the assignor. In a without-recourse factoring transaction, the factor assumes the risk of non-payment by the debtor, so the exposure is calculated based on the debtor, irrespective of any credit risk cover or protection provided.
Exposure to Central Counterparties (CCPs), which are entities that facilitate the settlement of transactions between financial institutions, are assigned a zero exposure value for derivatives trading and securities financing transactions outstanding against them. However, the amount of collateral provided by the NBFC to the CCP is included in arriving at the exposure limit, which is the maximum amount of exposure that an NBFC can have to a single counterparty.
Any breach of the Large Exposure (LE) limit, which is set by the RBI, must be reported immediately to the RBI’s Department of Supervision, Central Office, and rapidly rectified. NBFCs are not allowed to undertake any further exposure until they bring their exposure down within the limit. Failure to comply with the exposure limit may lead to penalties being imposed on the NBFC by the supervisor.
Regulatory Reporting:
The guidelines is related to reporting requirements for Non-Banking Financial Companies (NBFCs) in India, specifically related to Large Exposures as defined by the Reserve Bank of India (RBI). Large Exposures refer to situations where an NBFC’s total exposure to a single counterparty or group of connected counterparties exceeds a certain percentage of the NBFC’s eligible capital.
This states that NBFCs are required to report their Large Exposures to the RBI’s Department of Supervision, Central Office, using a reporting template provided in Appendix 1. This reporting should cover all exposures that meet the definition of a Large Exposure, as well as other exposures that meet certain criteria related to their size relative to the NBFC’s eligible capital.
In addition to reporting on Large Exposures and other qualifying exposures, the reporting should also cover the exempted exposures that are still significant relative to the NBFC’s eligible capital, as well as the ten largest exposures regardless of their size relative to the NBFC’s eligible capital.
Finally, the text notes that these reporting requirements will be applicable from October 1, 2022, and that once an NBFC is subject to Large Exposure reporting, the credit concentration norms related to single/group borrowers contained in the Master Direction for NBFCs will no longer be applicable to the NBFC.
