Draft Circular by RBI on ‘Forms of Business and Prudential Regulation for Investments’ and Its Implications on the BFSI Sector

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

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