NBFCs and scale-based regulation: types, layers and lessons

NBFCs now hold a large share of India's credit, and they lend to people and firms that banks often find hard to serve: truck owners, gold-loan borrowers, small shops, first-time home buyers. Their stress in 2018–19 showed they can also transmit shocks to banks and mutual funds. That combination of usefulness and risk is exactly what the RBI's scale-based regulation tries to balance, and it is a favourite Paper III topic. Learn the definition, the layers and the reasoning behind them.

What legally makes an NBFC

A non-banking financial company is a company registered under the Companies Act whose principal business is lending, investment in securities, hire purchase, leasing or similar financial activity. The RBI Act (Section 45-IA) requires it to register with the RBI and hold a minimum net owned fund (NOF).

It does not include companies whose principal business is agriculture, industry, trading or real estate. To decide "principal business", the RBI uses the 50-50 test. A company is treated as an NBFC if both:

1. financial assets are more than 50% of its total assets, and
2. income from financial assets is more than 50% of its gross income.

Worked example: the 50-50 test

Company A has total assets of ₹500 crore, of which ₹280 crore are loans and investments. Its gross income is ₹60 crore, of which ₹27 crore comes from those financial assets.

1. Financial assets share = 280 ÷ 500 = 56%, above 50%.
2. Financial income share = 27 ÷ 60 = 45%, below 50%.
3. Both conditions must hold, so Company A is not required to register as an NBFC.

Company B has the same assets but earns ₹33 crore of its ₹60 crore from financial assets (55%). It meets both conditions and must register.

Some entities are regulated by other bodies instead: insurance companies (IRDAI), stock brokers and merchant bankers (SEBI), chit funds (state governments) and nidhi companies (Ministry of Corporate Affairs). Housing finance companies moved from the NHB to the RBI in 2019, though the NHB still supervises them.

How NBFCs differ from banks

The last two rows are the key to NBFC risk. Without deposits or central bank liquidity, an NBFC that funds long loans with short-term borrowing depends on the market rolling over its debt.

Types of NBFCs

• NBFC-Investment and Credit Company (ICC): created in 2019 by merging asset finance, loan and investment companies. Most vehicle, gold, consumer and SME lenders are here.
• NBFC-MFI: microfinance lenders to low-income households.
• Housing finance companies (HFCs).
• Infrastructure finance companies (IFCs) and infrastructure debt funds (IDF-NBFCs).
• Core investment companies (CICs): hold investments mainly in group companies.
• NBFC-Factors: buy trade receivables.
• NBFC-Account Aggregators and NBFC-P2P lending platforms.
• Mortgage guarantee companies and standalone primary dealers.

Lessons from IL&FS and DHFL

In September 2018, IL&FS, a large infrastructure lender structured as a core investment company, defaulted on its debt. Mutual funds that held its paper took losses, and investors pulled back from all NBFC commercial paper. In 2019 DHFL, a large housing finance company, also defaulted; it became the first financial firm referred to the NCLT under Section 227 of the IBC.

The lessons shaped later rules:

• Asset–liability mismatch: long-term loans funded by short-term commercial paper collapse when rollover stops. The RBI introduced a liquidity coverage ratio and liquidity risk management framework for larger NBFCs.
• Interconnectedness: NBFCs borrow heavily from banks and mutual funds, so their failure spreads.
• Governance and disclosure: complex group structures and weak boards hid problems.
• Size matters: light-touch rules suited small NBFCs but not giants with bank-like balance sheets.

Scale-based regulation

The RBI announced the scale-based regulatory (SBR) framework in October 2021, effective October 2022. It places NBFCs in four layers, with regulation rising as size and risk rise. This is proportionality.

Government-owned NBFCs are placed in the base or middle layer, not the upper layer.

Worked example: which layer?

1. A non-deposit-taking gold-loan company with assets of ₹750 crore: base layer.
2. The same company grows to ₹1,400 crore of assets: middle layer.
3. A deposit-taking NBFC with assets of only ₹300 crore: middle layer, because all deposit-taking NBFCs start there.
4. An NBFC among the ten largest by asset size: upper layer, automatically.

Other developments

• Co-lending: banks and NBFCs jointly lend, combining the bank's low-cost funds with the NBFC's reach. The 2020 model for priority sector loans required the NBFC to keep at least 20% of each loan. The RBI widened the framework in 2025; check the current directions.
• Macroprudential tools: in November 2023 the RBI raised risk weights on bank lending to NBFCs by 25 percentage points to cool rapid credit growth, and it later rolled this back. It shows how the RBI can act on NBFC risk through banks.
• Digital lending rules apply when NBFCs lend through apps and partners.
• PCA for NBFCs: a Prompt Corrective Action framework for middle- and upper-layer NBFCs has applied since October 2022.

Model answer outline (15 marks)

Question: Why did the RBI adopt scale-based regulation for NBFCs? Evaluate the framework.

1. Introduction: role of NBFCs in credit delivery; last-mile reach.
2. Why change: growth in size and interconnectedness; IL&FS and DHFL; regulatory arbitrage with banks.
3. The framework: four layers; criteria; norms rising by layer.
4. Strengths: proportionality; closes the gap with banks for systemic NBFCs; keeps small NBFCs nimble; early NPA recognition.
5. Concerns: compliance costs for mid-sized NBFCs; possible slowdown in credit to niche segments; dependence on bank funding.
6. Conclusion: regulate by risk, not by label; the aim is stability without losing reach.

Short model answer (10 marks)

Question: Distinguish between a bank and an NBFC.

Both banks and NBFCs lend, but they differ in funding, regulation and safety nets. A bank accepts demand deposits, issues cheques, is a direct member of the payment system and can borrow from the RBI's liquidity windows. Its depositors are insured by the DICGC up to ₹5 lakh, and it must hold CRR and SLR.

An NBFC cannot accept demand deposits or issue cheques drawn on itself. Only some NBFCs may accept term deposits, which are not insured. NBFCs fund themselves mainly through bank loans, bonds and commercial paper, and they are not subject to CRR. They are registered under Section 45-IA of the RBI Act and are regulated under scale-based regulation, with the largest held to bank-like standards.

Because NBFCs lack stable deposits and direct access to central bank liquidity, they carry more rollover and liquidity risk. But their specialised knowledge and lighter structure let them reach borrowers that banks do not, which is why regulators aim to contain their risks rather than restrict their growth.

Practice questions

1. Under which section of the RBI Act do NBFCs register?
   • Section 45-IA.
2. What is the asset-size threshold between the base and middle layers for non-deposit-taking NBFCs?
   • ₹1,000 crore.
3. What is the minimum CET1 for an upper-layer NBFC?
   • 9%.
4. A company has 60% financial assets and 52% financial income. Is it an NBFC under the 50-50 test?
   • Yes. Both shares exceed 50%.
5. Which layer is kept empty?
   • The top layer.
6. Which financial firm was the first referred to the NCLT under Section 227 of the IBC?
   • DHFL, in 2019.

What to do next

• Draw the four layers from memory with one example of each.
• Redo the 50-50 test with financial assets of ₹240 crore.
• Read the NPA and IBC guide for Section 227 and resolution.
• Then read the financial regulators guide for who regulates which entity.