Introduction
The Reserve Bank of India (‘RBI’) has issued a draft circular[i] to revise the regulatory framework governing the types of business and prudential norms related to banks' investments. The changes proposed in the Master Direction - Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 ('Master Direction') are designed to strengthen risk management and grant banks increased operational flexibility as part of the RBI's ongoing review of the financial services sector.
The key updates in the paragraphs 4 and 5 of the Master Direction are as follows:
1. Revised Framework for Forms of Business:
The RBI has amended the guidelines on the activities banks are allowed to engage in, emphasizing the separation of core and non-core businesses to protect banks from higher risk. The regulations are intended to ensure that a bank's core activities, such as accepting deposits and lending money, remain insulated from non-core activities that are highly risk-prone.
The activities of entities under the non-operative Financial Holding Company (‘NOFHC’) must be reviewed and approved by the NOFHC's risk management committee and board of directors.
Core Business: Banks must carry out core banking activities permitted under s. 6(1) of the Banking Regulation Act, 1949 (‘Act’), such as lending and deposit acceptance, departmentally, unless otherwise notified by the RBI. Other financial activities such as factoring, housing finance, and credit card business may be carried out either departmentally or via a group entity (subsidiary or joint venture).
Non-Core Businesses: Activities with higher risk, such as mutual fund business, insurance, pension fund management, investment advisory services, and broking services, are not carried out departmentally but only through group entities to ensure that the bank’s core business is ring-fenced. Additionally, within a banking group, only one entity may undertake a specific form of business, ensuring no overlap in lending activities between the bank and its group entities.
No Circumvention of Rules: Banks are prohibited from using their group entities to bypass regulations/guidelines that apply to the parent bank. Additionally, banks would need prior approval from RBI to undertake any new business activity through a group entity for activities for which permission has not already been granted via the banking regulations.
Further, existing Non-Banking Financial Companies (‘NBFC’), including housing finance companies, must adhere to scale-based regulations specific to NBFCs issued by RBI, along with other rules and restrictions on loans and advances.
NOFHC additional Compliances: NOFHC does not require prior approval for risk-sharing activities; however, only a single entity can undertake such business within the NOFHC. Additionally, NOFHC shall not establish any new entity for three years from the date of commencement of its business. Further, besides risk-sharing activities, NOFHC has to make prior intimation to the Department of Regulation, RBI, for such licensing guidelines.
Additional compliances for any departmental activity undertaken by a bank: the banks are required to follow the appropriate risk mitigation framework and guidelines issued by RBI relating to AML/KYC/CFT as applicable. Additionally, the banks must duly adhere to the general principles of the Charter of Customer Rights, including fair practices and consumer redressal, etc., and no engagement in any other activity(s) ought to be made without the RBI’s prior approval.
2. Prudential Regulations for Investments:
a. Limits on investment
Bank investments in group entities, other financial and/or non-financial companies, and overseas equities must adhere to the specified prudential limits. These guidelines would be applicable alongside the bank's exposure norms and large exposure framework. Small finance banks and payment banks must also adhere to their specific licensing guidelines and operational conditions.
Investment Limits: The revised guidelines impose a cap on the percentage of equity a bank can hold in any single entity, set at 10% of the bank’s paid-up capital and reserves. Such a threshold has been set at 10% of the bank's paid-up capital and reserves. The overall equity investments in all companies (including group entities and overseas investments) cannot exceed 20% of the bank’s paid-up capital and reserves.
Specific Restrictions: Banks are restricted from holding no more than 10% in the equity of deposit-taking NBFCs, excluding housing finance companies. Investments in real estate investment trusts (‘REITs’) or infrastructure investment trusts have been capped at 10% in any single entity, with an overall limit of 20% for all such investments. Further, banks cannot sponsor more than one asset reconstruction company (‘ARC’) at a time, and even in such cases, group shareholding in any ARC is capped at 20%.
Approval for large investments: Banks must obtain prior approval for investments of 20% or more in the equity capital of financial or non-financial companies. This includes investments made through mutual funds or the Asset Management Companies controlled by the bank.
Investment in Alternative Investment Funds (‘AIFs’): Banks and their subsidiaries are restricted from investing in Category III AIFs due to the high risks associated with them.
Banks operating under the NOFHC structure are restricted from holding more than 10% of the paid-up equity in any financial or non-financial entity unless the Reserve Bank of India grants permission. However, if such a limit is exceeded, the bank must report it to the RBI's department of regulation within seven working days.
b. Prior approval from the department of regulation, RBI is mandatory for specific investment thresholds.
The banks shall require prior approval before making the following investments:
The RBI would need to approve investments of 20% or more in the equity capital of financial services companies or Category I/II AIFs and/or investments of 20% or more in the equity capital of non-financial services companies by the bank, including mutual fund investments managed by bank-controlled Asset Management Companies.
No prior approval is needed if the bank group's aggregate shareholding is below 20%, provided the conditions mentioned herein below are satisfied:
i. The bank's capital to risk-weighted assets ratio (CRAR) must meet the minimum requirements post-investment.
ii. The bank must have reported net profit in the last two financial years.
iii. The bank's equity investments in the current year should not exceed the net profit of the previous financial year.
Further, investments categorised as 'Held for Trading' do not require prior approval of the RBI, subject to the bank adhering to limits set under s. 19(2) of the Act.
Conclusion
The Reserve Bank of India’s proposed amendments to the Master Direction are designed to enhance risk management and operational flexibility within the banking sector. By providing such a clear distinction between core and non-core business activities, the RBI aims to safeguard the fundamental operations of banks from the risks associated with non-core ventures. The revised prudential regulations impose stringent limits on banks. The process and requirement of getting approval for bank investments have also been tightened to ensure that banks maintain a sound financial position while diversifying their business activities. The RBI’s effort to foster a stable and resilient banking environment amidst the evolving financial landscape and turbulence-driven financial markets is commendable. Implementing such direction/guidelines in the correct direction shall ensure that the Indian banking sector stands tall amongst all storms.
End Note
[i] RBI/2024-25/DOR.RAUG.AUT.REC.No. /24.01.041/2024-25 dated 04.10.2024.
Authored by Arjun Singh Tamang, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinions.