Scale-Based Regulation (SBR) framework: A catalyst for resilience in the NBFC sector

“Since the introduction of Scale-Based Regulation (SBR) framework in October 2022, the gross non-performing asset (GNPA) had decreased from 4.4% in December 2021 to 2.4% in December 2023 for government-owned NBFCs and from 10.6% in December 2021 to 6.3% in December 2023 for non-government NBFCs.”
– RBI report ‘Peeling the Layers: A Review of the NBFC Sector in Recent Times’

The need for the SBR framework

NBFCs have been playing an increasingly significant role in the financial system over the years by competing and complementing with banks at the same time. Due to this paradigm shift in the financial system, RBI felt the need to adopt a regulatory approach that would somehow address the contagion risk NBFCs pose to other entities due to their interconnectedness in the financial system and to protect the deposits that are placed with NBFCs.

The inception of the framework can be linked to the credit default crisis in 2018 that had a spillover effect on India’s financial system causing liquidity woes. It was introduced with the intent to strengthen asset quality, and capital requirements, and improve risk management at NBFCs.

The structure

The SBR framework is conceptualised as a pyramid with four layers — Base Layer (NBFC-BL), Middle Layer (NBFC-ML), Upper Layer (NBFC-UL), Top Layer (NBFC-TL) — based on the classification of NBFCs in terms of size, activity, and perceived riskiness. Regulatory intervention is kept the least at the bottom layer and rises as one moves to the upper layers.

• NBFC-BL: This comprises non-deposit-taking NBFCs having asset size of INR 500 crore & above but below INR 1,000 crore including categories of NBFCs like (i) Peer to Peer (P2P) lending platform, (ii) Account Aggregator (AA), (iii) Non-Operative Financial Holding Company (NOFHC), and (iv) NBFCs without public funds and customer interface.
• NBFC-ML: This comprises (i) all deposit-taking NBFCs (NBFCs-D) irrespective of asset size, (ii) non-deposit-taking NBFCs (NBFC-NDs) with asset size of INR 1000 crore & above, and (iii) NBFCs undertaking the following activities such as (a) Standalone Primary Dealers (SPDs) (b) Infrastructure Debt Fund (IDFs) (c) Core Investment Companies (CICs) (d) Housing Finance Companies (HFCs), and (e) Infrastructure Finance Companies (IFCs).
• NBFC-UL: This layer comprises a new category of NBFCs facing a bank-like regulation. These NBFCs would be identified by RBI based on a set of parameters and scoring methodology taking into account factors like size and leverage, interconnectedness, type of liabilities, segment penetration, etc. The top ten eligible NBFCs in terms of their asset size shall always reside in the upper layer, irrespective of any other factor. Entities that meet the specified criteria will move from ML to UL.
• NBFC-TL: This will ideally remain empty and can get populated if RBI believes there is a substantial increase in the potential systemic risk from specific NBFCs in the UL so that it can move to the TL.

The impact

As per a study published in the RBI bulletin, the performance of NBFCs improved since the introduction of the SBR framework as indicated by the profitability metrics of the sector such as return on assets and return on equity. However, the authors in the study noted that NBFCs need to be cautious about the fast-changing landscape of the financial sector and the emerging risks, such as cyber-security and climate risks.