Reserve Bank of India (RBI) will introduce a regulatory framework for non-banking financial companies (NBFCs) based on the size of the entities to improve their risk management systems and improve compliance.

Failure of big NBFCS like IL&FS and DHFL is forcing the regulator to put in place prudential guidelines akin to those that govern scheduled commercial banks.

The central bank has been working towards unification of supervisory functions to bring the standard of supervision of urban co-operative banks (UCBs) and NBFCs proportionately at par with that of commercial banks

"This regulatory regime based on the principle of proportionality warrants a review. It is felt that a scale-based regulatory approach linked to the systemic risk contribution of NBFCs could be the way forward," said RBI governor Shaktikanta Das. A discussion paper in this regard will be issued before 15 January 2021 for public comments.

Risk Based Internal Audit (RBIA) was mandated by RBI for commercial banks in 2002. "It has now been decided to issue guidelines to large UCBs and NBFCs on adoption of RBIA. This will enable the creation of independent risk focused internal audit system," RBI said in its internal document.

The apex bank said in its policy document that in the past weakness in three lines of defence mechanism often proved to be major fault lines affecting certain banks and NBFCs adversely. These, it said, were the business unit itself, risk management and compliance and internal audit.

RBI said that the regulatory regime governing the NBFC sector is built on the principle of proportionality such that adequate operational flexibility is available to the sector through calibrated regulatory measures. However, there are rapid developments in the last few years, which have led to significant increase in size and interconnectedness of the NBFC sector. There is, therefore, a need to review the regulatory framework in line with the changing risk profile of NBFCs.

RBI will also formulate a dividend distribution policy for NBFCs and UCBs. Unlike banks, currently there are no guidelines in place with regard to distribution of dividend by NBFCs. "With the increasing significance of NBFCs in the financial system and their inter-linkages with different segments, it has been decided to formulate guidelines on dividend distribution by NBFCs. Different categories of NBFCs would be allowed to declare dividend as per a matrix of parameters, subject to a set of generic conditions. A draft circular in this regard will be issued shortly for public comments," RBI said in its policy document.

Like the commercial banks, NBFCs and the UCBs have to appoint statutory auditors. RBI is of the view that the internal audit function, as a third line of defense, needs to be strengthened in UCBs and NBFCs. While external statutory auditors remain outside the internal mechanisms of a supervised entity, they are often termed as fourth line of defence, given the vital role they play. Recent amendment in Banking Regulation Act, 1949 bestowing certain additional responsibilities to RBI in appointment of statutory auditors in UCBs is also a pointer in that direction.