Understanding Non-Banking Financial Companies (NBFCs)
Non-Banking Financial Companies (NBFCs) in India are financial institutions registered under the Companies Act, 2013 (earlier under the Companies Act, 1956) that provide a range of financial services similar to banks but do not hold a banking license.
The Reserve Bank of India (RBI) defines NBFCs under Section 45-I of the Reserve Bank of India Act, 1934, as companies engaged in the business of loans and advances, acquisition of shares, stocks, bonds, debentures, and securities issued by the government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business, or other financial activities. However, NBFCs differ fundamentally from banks in that they cannot accept demand deposits and do not form part of the payment and settlement system.
NBFCs perform a critical role in the Indian financial ecosystem by providing credit and financial services to sectors and individuals often underserved by traditional banks. Their functions encompass retail lending, microfinance, infrastructure financing, factoring, and asset financing, thereby promoting financial inclusion and supporting economic growth. They are particularly significant in financing micro, small, and medium enterprises (MSMEs), affordable housing, and rural development, sectors that are vital for employment and overall economic development but often face credit constraints from conventional banks.
Definition and Functions of NBFCs
The RBI’s regulatory framework categorizes NBFCs based on their activities and systemic importance. NBFCs include Asset Finance Companies (AFCs), Loan Companies (LCs), Investment Companies (ICs), Infrastructure Finance Companies (IFCs), Microfinance Institutions (NBFC-MFIs), and Core Investment Companies (CICs).
Their primary functions involve providing credit facilities, acquisition of securities, and financial leasing. Unlike banks, NBFCs do not create money by credit creation but mobilize resources through borrowings, debentures, and deposits (subject to RBI regulations). They also engage in non-fund-based activities such as issuing guarantees and letters of credit.
NBFCs are instrumental in bridging the credit gap in the Indian economy, especially in rural and semi-urban areas where banking penetration is limited. They provide customized financial products tailored to local needs and often have better risk assessment capabilities for borrowers with limited credit history. This flexibility and specialization enable NBFCs to complement banks and enhance the overall efficiency of the financial system.
Importance of NBFCs in the Indian Financial System
NBFCs have emerged as a vital pillar of the Indian financial system, contributing significantly to credit disbursal and financial inclusion. They account for a substantial share of credit to sectors like MSMEs, affordable housing, and infrastructure, which are crucial for sustained economic growth. The agility and innovation of NBFCs allow them to serve niche segments that banks may find less attractive due to regulatory constraints or risk profiles.
Moreover, NBFCs diversify the financial system by providing alternative sources of credit and investment opportunities. They facilitate capital formation and support government initiatives such as priority sector lending and affordable housing finance. Their role became particularly prominent during periods when banks faced credit constraints, as NBFCs stepped in to fill the financing void.
Are NBFCs Regulated by RBI?
NBFCs are regulated by the Reserve Bank of India under the provisions of the Reserve Bank of India Act, 1934. Registration with the RBI is mandatory for companies that meet the criteria of an NBFC, including maintaining a minimum Net Owned Fund (NOF) of ₹2 crore. The RBI supervises NBFCs to ensure financial soundness, protect depositors’ interests, and maintain systemic stability.
However, some NBFCs, such as Housing Finance Companies (regulated by the National Housing Bank) and Insurance Companies (regulated by the Insurance Regulatory and Development Authority of India), are outside the RBI’s direct regulatory ambit to avoid overlapping regulations. The RBI’s regulatory framework for NBFCs has evolved to address the sector’s growing complexity and systemic importance.
NBFCs are subject to prudential norms relating to capital adequacy, asset classification, provisioning, liquidity, and corporate governance. The RBI also issues periodic guidelines on risk management, exposure limits, and disclosure requirements to ensure transparency and mitigate risks.
Features of NBFCs
NBFCs differ from banks primarily in their inability to accept demand deposits and participate directly in the payment and settlement system. They mobilize funds through term deposits (subject to RBI guidelines), debentures, commercial papers, and borrowings from banks and financial institutions. NBFCs are characterized by their specialized lending focus, operational flexibility, and ability to innovate in financial products and services.
The sector includes a wide range of entities from small microfinance institutions serving rural customers to large systemically important NBFCs (NBFC-ND-SI) with diversified portfolios. NBFCs often adopt technology-driven models to reach underserved markets, including digital lending platforms and fintech collaborations.
The Need for Scale-Based Regulations for NBFCs
The rapid growth and increasing complexity of NBFCs necessitated a differentiated regulatory approach. The RBI introduced the Scale-Based Regulation (SBR) framework to tailor regulatory requirements according to the size, complexity, and systemic importance of NBFCs. This approach recognizes that a one-size-fits-all regulatory regime is inadequate for a sector with diverse entities ranging from small non-deposit taking companies to large systemically important NBFCs.
The SBR framework, implemented from October 1, 2022, categorizes NBFCs into four layers—Base Layer, Middle Layer, Upper Layer, and Top Layer—each subject to progressively stringent regulatory norms. This stratification allows the RBI to focus supervisory resources on entities that pose higher risks to financial stability while reducing compliance burdens on smaller NBFCs, thereby fostering growth and innovation.
Lessons from Past Crises (e.g., IL&FS, DHFL)
The financial distress and near-collapse of entities like Infrastructure Leasing & Financial Services (IL&FS) and Dewan Housing Finance Corporation Limited (DHFL) exposed critical vulnerabilities in the NBFC sector and the regulatory framework. IL&FS’s failure in 2018 triggered a liquidity crisis that reverberated across the financial system, affecting banks, mutual funds, and NBFCs. The crisis revealed gaps in regulatory oversight, inadequate risk management, and excessive leverage.
Key issues included weak corporate governance, lack of transparency, over-reliance on short-term funding, and failure of credit rating agencies to accurately assess risk. The RBI’s inability to directly supervise IL&FS, which was not classified as systemically important at the time, highlighted the need for a more robust regulatory regime.
Similarly, the DHFL crisis underscored the risks of aggressive lending, poor asset quality, and governance lapses. These events prompted the RBI and government to strengthen regulatory norms, improve monitoring mechanisms, and enhance the resolution framework for stressed NBFCs.
The crises emphasized the necessity of scale-based regulation, stricter capital adequacy norms, improved risk management, and enhanced corporate governance to prevent systemic shocks and protect investor interests.
Objectives of Scale-Based Regulations
The primary objective of the RBI’s Scale-Based Regulation framework is to ensure financial stability by imposing regulatory requirements commensurate with the size, complexity, and risk profile of NBFCs. By categorizing NBFCs into layers, the RBI aims to focus supervisory attention on entities whose failure could have systemic repercussions, while allowing smaller NBFCs to operate with lighter compliance burdens.
The framework seeks to enhance transparency, accountability, and risk management practices across the sector. It mandates higher capital adequacy ratios, stricter asset classification norms, and robust corporate governance standards for NBFCs in the upper layers. The regulations also address liquidity management and exposure limits to mitigate contagion risks.
In addition, the scale-based approach supports the RBI’s broader objective of promoting inclusive growth by enabling smaller NBFCs to expand credit access without onerous regulatory constraints. This balanced regulatory architecture aligns with international best practices and prepares the NBFC sector to withstand financial shocks while continuing to support the Indian economy.
Understanding Scale-Based Regulations for NBFCs
The RBI implemented the Scale-Based Regulation (SBR) framework for Non-Banking Financial Companies (NBFCs) in October 2021, with operationalization commencing from October 1, 2022. This regulatory architecture is grounded in the RBI’s powers under Sections 45JA, 45K, 45L, and 45M of the Reserve Bank of India Act, 1934, and the Factoring Regulation Act, 2011.
The SBR framework supersedes earlier segmented directions for deposit-taking and non-deposit-taking NBFCs, consolidating them into a unified, risk-sensitive regime. It classifies NBFCs into four distinct layers—Base Layer (NBFC-BL), Middle Layer (NBFC-ML), Upper Layer (NBFC-UL), and Top Layer (NBFC-TL)—based on asset size, activities, and systemic importance. This stratification allows the RBI to impose regulatory requirements commensurate with the scale and risk profile of each NBFC, thereby enhancing supervisory effectiveness and financial stability.
The rationale behind SBR is to address the heterogeneity in the NBFC sector, which ranges from small, non-systemic entities to large, systemically important institutions whose distress could have significant repercussions on the financial system. The framework mandates graduated compliance obligations, including capital adequacy, governance standards, liquidity management, and disclosure norms, thereby aligning NBFC regulation closer to the prudential standards applicable to banks, while preserving proportionality.
Categorization of NBFCs into Layers
The Base Layer (NBFC-BL) comprises primarily non-deposit-taking NBFCs with asset sizes below ₹1,000 crore, including entities such as Peer-to-Peer (P2P) lending platforms, Account Aggregators, and Non-Operative Financial Holding Companies (NOFHCs). These NBFCs have limited public interface and pose minimal systemic risk.
Regulatory requirements for this layer are relatively relaxed, focusing on basic governance and disclosure, with a minimum Net Owned Fund (NOF) requirement of ₹10 crore for investment and credit companies. The classification of Non-Performing Assets (NPA) for this layer currently allows loans overdue for 180 days, progressively moving towards 90 days to harmonize with banking norms.
The Middle Layer (NBFC-ML) includes all deposit-taking NBFCs regardless of asset size, and non-deposit-taking NBFCs with assets exceeding ₹1,000 crore. It also encompasses NBFCs engaged in specialized activities such as Standalone Primary Dealers, Infrastructure Debt Funds (IDF-NBFCs), Core Investment Companies (CICs), Housing Finance Companies (HFCs), and Infrastructure Finance Companies (NBFC-IFCs).
Entities in this layer are subject to enhanced regulatory measures, including a minimum Capital Adequacy Ratio (CRAR) of 15%, mandatory Asset-Liability Management (ALM) policies, and stricter corporate governance norms such as the appointment of independent directors and risk committees. The NPA classification norm is aligned with banks at 90 days overdue.
The Upper Layer (NBFC-UL) designates NBFCs identified by the RBI as systemically important based on a scoring methodology that considers asset size, interconnectedness, complexity, and risk profile. The top 10 NBFCs by asset size automatically qualify for this layer. These NBFCs face the most stringent regulatory requirements, including a higher minimum CRAR with a Common Equity Tier 1 (CET1) capital of at least 9%, stricter liquidity coverage ratio (LCR) norms, enhanced governance standards, and mandatory public listing.
The RBI’s 2024-25 list of Upper Layer NBFCs includes prominent entities such as LIC Housing Finance Limited, Bajaj Finance Limited, Shriram Finance Limited, and Tata Sons Private Limited. Once classified in the Upper Layer, NBFCs remain subject to these enhanced norms for a minimum period of five years, even if they fall below the parametric thresholds subsequently.
The Top Layer (NBFC-TL) is a precautionary category reserved for NBFCs that may be shifted from the Upper Layer if the RBI perceives a significant increase in systemic risk. As of 2025, no NBFC has been designated in this layer, but it serves as a regulatory tool to impose the highest level of supervision, including potentially more stringent capital and liquidity norms, and intensive monitoring.
Regulatory Requirements for Each Layer
The SBR framework imposes a graduated regulatory regime reflecting the risk posed by NBFCs in each layer. Base Layer NBFCs face minimal regulatory intervention, with relaxed capital and governance norms, and a longer NPA recognition period. Middle Layer NBFCs must maintain a minimum CRAR of 15%, implement ALM policies, and comply with enhanced governance standards, including independent directors and risk committees.
Upper Layer NBFCs are subject to even more rigorous requirements, such as maintaining a CET1 capital of at least 9%, adhering to LCR norms akin to banks, and complying with public disclosure and corporate governance standards that include board composition and risk management frameworks. The Top Layer, when activated, will likely impose the most stringent prudential norms, reflecting the systemic importance of the entities involved.
The regulatory framework also mandates NBFCs to implement Core Financial Services Solutions (CFSS) if they have ten or more fixed-point service delivery units, enhancing transparency and customer grievance redressal. Additionally, the Large Exposure Framework (LEF) applies to NBFCs in the Middle and Upper Layers, limiting their exposure to single and group borrowers to contain concentration risks.
Comparison Between NBFCs and Banks
While both NBFCs and banks serve as financial intermediaries, their regulatory frameworks, operational scope, and systemic roles differ fundamentally. Banks are governed primarily by the Banking Regulation Act, 1949, and are authorized to accept demand deposits, which are repayable on demand and form a significant part of their liabilities. NBFCs, regulated under the Companies Act, 2013, and the RBI Act, 1934, cannot accept demand deposits; they may only accept fixed-term deposits ranging from 12 to 60 months, subject to RBI approval.
Banks are integral to the payment and settlement system, issuing cheques and participating in clearinghouses, while NBFCs are excluded from these systems and cannot issue cheques or facilitate direct payment services. Deposit insurance is available for bank deposits through the Deposit Insurance and Credit Guarantee Corporation (DICGC), providing a safety net to depositors. NBFC deposits lack such insurance, increasing the risk profile for depositors.
Banks are mandated to maintain statutory liquidity ratio (SLR) and cash reserve ratio (CRR) to ensure liquidity and financial stability, requirements which do not apply to NBFCs. This difference impacts the liquidity management and lending capacity of NBFCs. Banks engage in credit creation through fractional reserve banking, a facility unavailable to NBFCs.
In terms of capital requirements, banks must adhere to Basel III norms, including minimum capital adequacy ratios and leverage ratios. NBFCs, under the SBR framework, follow a tiered capital adequacy regime based on their classification, with Upper Layer NBFCs required to maintain capital standards comparable to banks.
Customer service offerings also differ; banks provide a broad spectrum of financial services including current and savings accounts, credit cards, remittances, and overdraft facilities. NBFCs primarily focus on credit delivery, leasing, hire purchase, and specialized financing such as microfinance, vehicle loans, and gold loans.
Interconnectedness with the Banking System
The NBFC sector in India is deeply interconnected with the banking system, accounting for nearly 30% of total bank credit. This interdependence arises because NBFCs rely heavily on bank funding for their operations, including working capital and long-term financing. The interconnectedness facilitates credit diversification and financial inclusion by enabling NBFCs to serve niche segments and underserved markets that banks may find less accessible.
However, this interconnectedness also introduces systemic vulnerabilities. Distress in large NBFCs can propagate through the banking sector, mutual funds, and corporate bond markets, potentially triggering liquidity crises and broader financial instability. The Reserve Bank of India has acknowledged these systemic risks and emphasizes a balanced regulatory approach that supports NBFC growth while safeguarding financial stability.
The RBI has encouraged NBFCs to diversify their funding sources beyond bank borrowings to mitigate concentration risk. It has also called for enhanced compliance, customer protection, liquidity management, and cybersecurity measures within the NBFC sector. The introduction of Self-Regulatory Organizations (SROs) for NBFCs is another developmental step aimed at strengthening sectoral governance and regulatory adherence.
Challenges and Setbacks Faced by NBFCs
NBFCs face multifaceted challenges that impact their growth and stability. Regulatory compliance under the SBR framework demands significant investment in technology, risk management, and governance infrastructure, particularly for smaller NBFCs in the Base Layer. The revised Net Owned Fund (NOF) thresholds—raised to ₹5 crore for Investment and Credit Companies and ₹7 crore for Microfinance Institutions—pose capital-raising challenges for smaller NBFCs, with non-compliance risking automatic cancellation of their Certificate of Registration (CoR).
Funding constraints remain a critical issue. Following the tightening of bank lending norms in late 2023, many NBFCs resorted to short-term commercial paper issuances, increasing reliance on market instruments that are susceptible to volatility. However, recent RBI relaxations on risk weights for bank loans to NBFCs, particularly microfinance loans, have improved access to bank funding, though a full normalization of lending patterns may take several months.
Asset quality concerns persist, especially in microfinance segments affected by regulatory changes and regional challenges, such as those observed in Karnataka. The limited ability of NBFCs to invoke the SARFAESI Act, 2002 for loans below ₹20 lakh constrains their capacity to manage stressed assets effectively in MSME and retail segments, leading to higher non-performing assets (NPAs) and increased litigation costs. There is a growing call to reduce this threshold to ₹1 lakh to align NBFCs with banks and Housing Finance Companies (HFCs), facilitating better recovery mechanisms.
The International Monetary Fund (IMF) has raised concerns about the concentrated exposure of NBFCs to the power and infrastructure sectors, which are historically vulnerable to structural inefficiencies. This concentration heightens systemic risk, as distress in these sectors could cascade through NBFCs to banks and financial markets. The IMF recommends enhanced liquidity regulations, regulatory parity between state-owned and private NBFCs, improved data sharing, and diversification of funding sources to mitigate these risks.
Taxation disparities also challenge NBFC competitiveness. Unlike banks, NBFCs are subject to Tax Deducted at Source (TDS) on interest payments, increasing their administrative burden and impacting margins.
Future Outlook and Potential Reforms
The future of Non-Banking Financial Companies (NBFCs) in India is poised for significant changes, driven by evolving regulatory frameworks and technological advancements. The Reserve Bank of India (RBI), under the Reserve Bank of India Act, 1934, continues to play a pivotal role in shaping the sector’s trajectory through its regulatory actions.
For instance, the RBI has recently relaxed certain lending norms for microcredit and non-bank lenders, reducing the risk weight for consumer microfinance loans to 100%, aligning with pre-2023 levels. This move aims to enhance financial stability and support the growth of the microfinance sector.
In the context of regulatory reforms, the RBI’s Scale-Based Regulation (SBR) framework categorizes NBFCs into different layers based on their size, complexity, and risk exposure. This framework ensures that larger NBFCs, classified under the Upper Layer, adhere to stricter norms regarding capital adequacy, risk management, and corporate governance. Such measures are crucial for maintaining financial stability and protecting customer interests.
Furthermore, the RBI’s decision to implement the Expected Credit Loss (ECL) guidelines from April 1, 2025, will require banks and NBFCs to make additional provisions, potentially impacting their profitability in the short term. This move aligns with international best practices under the Basel Accords and aims to ensure that financial institutions are better equipped to manage credit risks.
Emerging Trends in NBFC Business Models
NBFCs in India are increasingly adopting digital technologies to transform their business models. Digital lending has become a key area of focus, leveraging AI, machine learning, and big data analytics to streamline loan processes and enhance credit scoring. This shift towards digital platforms allows for faster loan disbursements, reduced paperwork, and improved customer experience. Additionally, the use of blockchain technology and smart contracts is gaining traction, offering secure and transparent transaction management and reducing the need for intermediaries.
Another significant trend is the integration of Robotic Process Automation (RPA) to automate repetitive tasks, improve operational efficiency, and reduce errors5. Furthermore, peer-to-peer (P2P) lending platforms are emerging as alternative financing models, connecting borrowers directly with investors and offering more flexible lending options.
The future of NBFCs also involves consolidation and specialization, with smaller players likely to merge or focus on niche areas to remain competitive6. Strategic partnerships with banks and fintech companies are expected to play a crucial role in unlocking new growth opportunities and driving innovation in financial services.
Conclusion
NBFC sector in India is undergoing significant transformations driven by regulatory changes and technological advancements. The RBI’s regulatory actions, such as the SBR framework and ECL guidelines, are aimed at enhancing financial stability and ensuring compliance with international standards. The adoption of digital technologies is revolutionizing NBFC business models, enabling them to offer more efficient and customer-centric services.
As NBFCs continue to evolve, they will play a critical role in promoting financial inclusion, supporting small and medium enterprises, and driving innovation in the financial sector. However, they must also address challenges such as increased competition, evolving regulatory requirements, and cybersecurity risks. By embracing technology responsibly and focusing on customer experience, NBFCs can thrive in the future and contribute significantly to India’s economic growth.
The Indian Contract Act, 1872, and the Consumer Protection Act, 2019, will remain crucial in governing the contractual relationships and consumer rights within the NBFC sector. Additionally, the Information Technology Act, 2000, will continue to guide the digital transformation of NBFCs, ensuring data privacy and security. As the sector continues to grow, adherence to these laws and regulations will be essential for maintaining trust and stability in the financial system.
Discover the essential regulatory framework for Non-Banking Financial Companies (NBFCs). Learn more about compliance requirements and best practices in the sector.
