RBI Tightens the Reins on Banks: Amends Master Circular

RBI recently introduced significant amendments on October 4th to the Master Direction - Reserve Bank of India (Financial Services provided by Banks) Directions, 2016. These amendments, aimed at streamlining permissible forms of business for banks and strengthening prudential regulations for their investments, reflect the central bank’s ongoing commitment to fortify the banking sector while ensuring it remains adaptable to evolving market conditions.

?Context and Rationale for Amendments

The primary objectives of the revisions are as follows:

1. Ring-fence Core Banking Operations: By creating a clear separation between the core banking activities and non-core, risk-bearing businesses.

2. Operational Flexibility for Investments: Providing banks with greater autonomy for investments while maintaining stringent prudential regulations.

3. Strengthen Risk Management: Ensuring robust risk management practices across the various forms of business that banks can undertake.

The amendments primarily focus on two key areas:

1. Permissible Forms of Business: Guidelines on the scope of business activities banks can undertake.

2. Prudential Regulation for Investments: Norms governing investments by banks in financial and non-financial companies.

?1. Forms of Business

The revised framework underscores that banks can only undertake activities permitted under Section 6(1) of the Banking Regulation Act, 1949, either directly or through subsidiaries, as discussed below. Any such business, whether managed by the bank or a subsidiary under a Non-Operative Financial Holding Company (NOFHC: a financial institution that holds a large stake in a group of financial services companies but does not engage in any financial operations itself), must adhere to strict oversight by both the Risk Management Committee and the Board of Directors.

The key provisions regarding business forms include:

- Core Business Mandate: Banks’ core operations, i.e., deposit-taking and lending, must be conducted departmentally. Other businesses such as factoring, credit card services, or housing finance may either be run departmentally or through a separate group entity, subject to conditions.

- Ring-fencing Riskier Activities: Activities like mutual fund management, insurance, or portfolio management, which inherently involve higher risk, must be conducted through a separate entity and cannot be run departmentally by banks.

- Single Entity Restriction: Only one entity within the bank group can undertake a particular business activity, preventing multiple entities from acquiring the same license or operating in the same domain, thus reducing overlaps in business operations.

These provisions ensure that banks' core business operations remain insulated from riskier non-core businesses, promoting financial stability.

?2. Prudential Regulation for Investments

Investments made by banks, particularly in financial and non-financial companies, now fall under stricter prudential regulations aimed at ensuring their stability while providing operational freedom. The regulations outlined in the amendments focus on managing risks associated with equity investments.

Key highlights include:

- Investment Limits Based on Capital and Reserves: Banks can invest up to 10% of their paid-up capital and reserves in individual companies, and aggregate investments in subsidiaries or other companies cannot exceed 20% of the bank's total paid-up capital and reserves. However, exceptions are made for circumstances like debt restructuring.

- Restrictions on Equity Holdings: The amendments impose strict limits on banks’ holdings in NBFCs, Real Estate Investment Trusts (REITs), and Infrastructure Investment Trusts (InvITs). Moreover, investments in non-financial companies are capped at 20%, with certain exceptions allowing up to 30% under specific conditions, such as safeguarding the bank's interests in cases of debt restructuring.

- Alternative Investment Funds (AIFs): Banks are prohibited from investing in Category III AIFs. Subsidiaries of banks are also restricted in their investments in these funds, following the regulations set forth by SEBI.

- Limitations on Asset Reconstruction Companies (ARCs): The amendments prohibit a bank group from sponsoring more than one ARC, and their total shareholding in an ARC cannot exceed 20%.

The prudential regulations aim to provide banks with the flexibility to make strategic investments while mitigating the risks associated with large exposures in financial markets.

3: Application to Non-Banking Financial Companies (NBFCs)

Non-Banking Financial Companies (NBFCs), especially those affiliated with banking groups, are now under heightened regulatory oversight. These entities are required to comply with the Scale-Based Regulations (SBR) framework, particularly the standards applicable to Upper Layer NBFCs. This brings their operations in closer alignment with the stringent risk management protocols governing banks.

NBFCs: The updated regulatory framework mandates stricter compliance for NBFCs associated with banking entities. These companies must follow Scale-Based Regulations to ensure their lending and operational activities reflect the advanced risk control measures demanded of upper-layer NBFCs. Additionally, overlapping lending functions between NBFCs and their parent banking entities are now restricted to prevent operational redundancies and excessive risk exposure.

Housing Finance Companies (HFCs): HFCs operating within banking groups are also subject to more rigorous lending standards, aimed at mitigating risks that could affect the financial stability of the entire banking group. These rules are designed to prevent undue risk-taking and ensure prudent lending practices across the board.

?Implications for the Banking Sector

The revised framework emphasizes stricter regulatory control, ensuring that riskier, non-core activities are conducted separately from core banking operations. This separation increases accountability by requiring that only one entity within a group undertakes specific activities, reducing risks of contagion. Additionally, enhanced risk management practices will be implemented across bank and NBFC operations, ensuring better compliance with sector-specific regulations.

While the framework introduces important structural reforms, it also presents operational hurdles. Banks that previously managed non-core activities departmentally may now face significant restructuring costs as they shift these activities to separate entities. This reorganization could slow down operations, especially for banks with extensive group entities. Moreover, the new restrictions on investments—particularly the cap on equity investments in companies and Alternative Investment Funds (AIFs)—could limit banks' ability to generate higher returns, forcing them to reevaluate their investment strategies.

NBFCs and HFCs within banking groups are particularly affected by the changes. The regulatory convergence between NBFCs and banks blurs traditional distinctions, likely driving more mergers and acquisitions within the sector. Additionally, stricter lending norms designed to avoid overlap between banks and NBFCs may constrain the latter’s growth, particularly for those aggressively expanding their loan portfolios. NBFCs will need to focus on niche markets and innovate their product offerings to remain competitive under the new regulations.

The revised regulations compel banks and their group entities to rethink their investment strategies, especially regarding equity investments in non-financial companies and AIFs. The new restrictions encourage banks to diversify their portfolios cautiously, likely shifting focus towards safer, lower-return investments like government bonds. To compensate, banks may look to form strategic partnerships or joint ventures with fintech, insurance, and asset management companies instead of holding significant equity stakes.

The updated framework also impacts banks with international operations, including those based in the International Financial Services Centre (IFSC) at GIFT City. Activities that are prohibited in India but permitted abroad will now face tighter scrutiny. However, GIFT City may emerge as a regulatory sandbox, providing banks and fintech companies with an opportunity to explore cross-border services and innovative financial products within permissible limits, helping them expand internationally without violating Indian regulations.