The Reserve Bank of India (RBI) has introduced a prompt corrective action (PCA) framework for non-banking financial companies (NBFCs) to bring them under better risk management.

Prompted by the collapse of some NBFCs, the RBI’s new PCA framework will come into effect from 1 October next year. It will be applicable to all deposit-taking NBFCs in middle, upper and top layers and be based on their financial position on or after March 31, 2022, the RBI said in a notification, adding that they will be reviewed after three years of being in operation.

Capital adequacy ratio and asset quality will be the key moniterables for deposit and non-deposit taking NBFCs while the central bank will also look at leverage along with capital and asset quality for core investment companies (CICs), RBI said.

Until now, the RBI had imposed PCA only on banks if their financial parameters, including non-performing assets (NPAs), fell below a threshold. These banks had to face restrictions on their business operations.

"NBFCs have been growing in size and have substantial inter-connectedness with other segments of the financial system. Accordingly, a PCA framework for NBFCs has also been put in place to further strengthen the supervisory tools applicable to NBFCs," the RBI said in a statement.

Shadow banking can get exposed to lending excesses in absence of strict regulation and adequate checks and balances. India has seen examples of NBFCs like IL&FS, Dewan Housing Finance Ltd (DHFL), the Srei Group and Anil Ambani-controlled Reliance Capital collapsing.

Three risk threshold parameters

The RBI has introduced three risk threshold categories for bringing the NBFCs under the PCA framework.

If capital adequacy falls up to 300 bps, Tier-1 capital ratio falls up to 200 bps below the regulatory minimum and net NPA rises above 6%, the NBFC will fall under risk threshold -1. This will mean restrictions on dividend distribution/remittance of profits. There will also be restrictions on the issue of guarantees or taking on other contingent liabilities on behalf of group companies.

NBFCs falling under threshold-2 will be restricted from branch expansions, in addition to the other impositions in threshold-1. NBFCs will be categorised under this if their capital adequacy falls more than 300 bps but up to 600 bps below the regulatory minimum, and the tier-1 capital ratio falls more than 200 bps but up to 400 bps below the regulatory minimum and net NPA rises above 9%.

Appropriate restrictions on capital expenditure and on variable operating costs will be imposed on those NBFCs who fall under  threshold-3. They will also face other restrictions imposed on NBFCs who fall under thresholds-1 and 2. In case of these NBFCs, the capital adequacy would have fallen 600 bps, the tier-1 capital ratio to more than 400 bps below the regulatory minimum and the net NPA would be above 12%.

PCA restrictions will be withdrawn from an NBFC if no breaches in risk thresholds in any of the parameters are observed as per four continuous quarterly financial statements, one of which should be annual audited financial statement, the RBI said.