The Corporate & Commercial Law Society Blog, HNLU

Category: Banking Law

  • India’s Basel III Paradox: Failure of Mechanics Not Morals

    India’s Basel III Paradox: Failure of Mechanics Not Morals

    BY SMARAK SAMAL, LL.M STUDENT AT NLSIU, BANGALORE

    INTRODUCTION

    It is significant to write down a paradox that openly and dauntingly exists in the Indian banking system, and it should not be reduced to a conflict between strict regulations and lax implementation. There have been multiple occurrences in the Indian system, where white-collar actors have been able to get around the procedural flaws in banking regulations without having to go for deceptive techniques because these safety nets work well as a tool. Yes Bank, Infrastructure Leasing & Financial Services (‘IL&FS’), and Punjab National Bank’s (‘PNB’) crises are indications that they were not just typical governance failures but rather savage attacks on particular systemic underpinnings. The article’s main focus is the willful breach of Basel III regulations, which clarifies topics outside the typical crisis history and improves comprehension of system convergence. To give certain clarity, Basel III relies on 3 core Pillars. Pillar 1 ensures that banks have sufficient capital to absorb market, credit and management risks and hence sets up minimum capital requirements. Whereas supervisory guidance compelling regulators to measure bank’s internal risk control mechanisms and inducing concrete steps when defaults are recognized are acknowledged in Pillar 2. Lastly, Pillar 3 integrates market discipline by warranting public disclosures, permitting market participants and investors to judge a bank’s risk portfolio.

    PNB: THE CIRCUMVENTION OF PILLAR 1 OPERATIONAL RISK CAPITAL

    To start with the PNB scam, which was made possible by Letters of Undertaking (‘LoUs’), was both dramatic and a prime example of the inherent flaws in the Basel III methodology. The Basic Indicator Approach (‘BIA’) is being used by Indian banks to model operational risk in capitalisation. According to the BIA, banks must have capital that is equivalent to 15% of their average gross earnings over the previous three years.The true deception of the scheme lay in avoiding this exact calculation.

    Basically, the fabricated LoUs were exchanged through the Society for Worldwide Interbank Financial Telecommunication (‘SWIFT’) mechanism but never really entered into PNB’s Core Banking Solutions (‘CBS’). Since the official books of the bank were never made aware of these transactions, they never fed into the gross-income figure upon which the BIA is calculated.Thus, PNB’s reported operational-risk capital appeared adequate on paper but was derived from data that unobtrusively sidestepped multi-billion-dollar exposure. Theoretically, there was nothing technically wrong with the BIA formula except that its inputs were corrupted, rendering the compliance meaningless.

    This indicates that Pillar 1’s strict capital ratios come into play only when the bank’s data generation processes are maintained rigorously. The collapse of Pillar 2 calls for Supervisory and Evaluation Process (‘SREP’), which is marked at this juncture. Since 2016, the Reserve Bank of India has issued warnings regarding the dangers of handling SWIFT outside of the CBS.These cautions went unheeded and hence, PNB’s non-compliant “compliance reports” were approved during inspections.  This further suggests that, Pillar 2 supervision can’t be a mere ministerial exercise. It requires digging into the technical details of the Bank’s system since even one missing integration can render the entire Pillar 1 capital framework useless.

    IL&FS: SUBVERTING PILLAR 1 CREDIT RISK VIA A CORRUPTED PILLAR 3

    On the other side, the crisis of IL&FS highlights how  failure in market discipline can directly poison the foundation of Pillar-1’s credit risk calculation. The failure in market discipline can be attributed to violation Pillar 3. Referring to the Basel III Standardised Approach, rating a corporate borrower according to its external credit rating enables Indian banks to establish the corresponding risk weight. For instance, a borrower with a credit rating of “AAA” only attracts a risk weight of 20 percent, and thus, a bank is only required to set aside a tiny amount of capital to cover such an exposure. With an unmanageable debt load exceeding ₹91,000 crore in origin, IL&FS maintained the highly sought-after “AAA” rating from the establishment of Indian rating agencies till a few weeks prior to its default. In fact, the agencies damaged all banks holding IL&FS assets since they failed to raise an alarm in their purported Pillar 3 role of market discipline. The Standardised Approach forced lenders to classify what was effectively a ticking time bomb as a low-risk asset, making their reported capital adequacy levels misleading and needless.

    The distinctive lesson is that the credibility of credit rating organisations closely correlates with the effectiveness of a standardised methodology. In addition to the active supervision of rating agencies and knowledge of conflicts of interest inherent in the issuer-pays model, the self-correcting nature of market forces is a myth. In the absence of trustworthy ratings, Pillar 1’s capital calculations will be a wasteful exercise that will give the financial system a false sense of security.

    YES BANK: GAMING CREDIT RISK NORMS THROUGH ASSET MISCLASSIFICATION

    The bedrock of credit risk management’s honest asset classification was hit hard by the Yes Bank debacle. Evergreening, or lending to problematic borrowers to pay off the interest on past-due obligations, was the fundamental strategy used by the bank. According to the RBI’s Prudential Norms on Income Recognition, Asset Classification, and Provisioning (‘IRAC’), any loan that is past due by more than ninety days must be recorded as a non-performing asset (‘NPA’).

    The connection to Basel III is rather straightforward. The classification of a loan determines the risk weight that is allocated to it under Pillar 1. The risk weight of a corporate loan is typically 100%. However, the risk weight rises to 150 percent and the provision requirements dramatically increase resulting in poor NPA levels. Yes Bank overstated its capital adequacy ratio and negated the need for the Pillar 1 framework by concealing problematic loans under a “standard” classification, understating both its provisioning and its Risk-Weighted Assets (‘RWAs’).

    This only adds to the troubles past this case because under the regulator’s Pillar 2 supervision, the bank showed massive NPA divergences, meaning banks’ reported bad loans and practically a margin higher by regulators. In FY19, as per RBI’s report the gross NPA stood at Rs.11,159 Crore against the declared Rs.7,882 Crore, revealing glaring disparity of 41%. However, strong action from the central bank was delayed, allowing CEO Rana Kapoor’s evergreening to become systemic. Hence, after the RBI finally stepped in, it forced his resignation and arranged the rescue.

    The takeaway is straightforward, though details concerning the classification of assets create credit risk and capital rules. The supervisors who willfully ignore the innocent misreporting don’t simply look the other way; they knowingly participate in the manipulation of Basel requirements, pushing systemic risk under the cover of compliance.

    THE INEFFECTIVE LEGAL BACKSTOP

    When regulation and supervision collapse, the legal system is supposed to provide the last remedy, but in Indian banking the legal backstop has not been able to fulfil this role effectively. The Insolvency and Bankruptcy Code, 2016 was designed to give time-bound resolution and has indeed changed promoter behaviour, but in practice most cases have crossed statutory deadlines, and by the time resolution occurs, the asset value is already diminished. The haircut problem therefore reflects not the defect of IBC alone but the failure of governance and supervision before insolvency. Nevertheless, law as a mechanism of providing remedy, loses its efficacy when procedural timelines are disregarded and asset value is diminished.

    The legal backstop that would have been the ultimate means of holding to account has turned out to be the weakest link. Instead of introducing speed of action, it introduces filters of postponement and ambiguity. Systematic risks continue to be exist even with Basel III plus in action due to lack of effective deterrence which results in further intensifying the paradox and calling for effective solutions.

    These financial crises highlight the necessity to strengthen the Basel Pillars through structural, technological and supervisory reforms. To prevent breakdown of Pillar 1 operational risk safeguards, regulators shall make any manipulation technologically undoable by compulsory, forensic system-integration audits under the RBI’s Pillar 2 ‘SREP’. It will further enable Straight Through Processing (‘STP’) between SWIFT and CBS, supported by verifiable automated reconciliation and alerts for accurate entries. Failure of Pillar 3 market discipline and disputes in Credit Rating System (‘CRA’) was exposed in IL&FS crisis and situations like this could be avoided if RBI adopts a supervisory veto by imposing higher risk weights when external ratings hide stress. Further, by enforcing penalties on auditors and CRA’s for negligence to secure integrity and accountability implementation.

    CONCLUSION: FORGING A CULTURE OF CONSEQUENCE

    The study is also looking at the main bank frauds from the Basel III perspective, within the framework of an analytical grouping with a goal at its limits. In the end, they show that the primary flaw in the Indian banking system is not laws or regulations that take on complicated shapes, but rather how they are applied. This seems to be a recurring theme: the supervisory review in Pillar 2, as covered in more detail in this section, has not adequately evaluated the procedural integrity of Pillar 1 and Pillar 3 processes. Capital ratios are regarded as final measures since they focus entirely on quality of inputs such as credit ratings, asset classification and transactional data acting as key quantitative benchmarks and headline indicators.

    India’s Basel paradox therefore is not about rules but about accountability. It is only when consequence is enforced swiftly and firmly that Basel norms can function as real protection rather than a symbolic framework. Cultivating this culture of consequence is essential if the integrity of the financial system is to be preserved.

    In the long run, this involves more than just anticipating when the banks will file their compliance reports. Supervisory oversight must shift to real time analytics from retrospective assessment, alerting instant identification of evergreening and misclassification through integrated monitoring mechanism .

    The integrity of the systems themselves as well as the integrity of the gatekeepers engaged need to be examined more thoroughly. Bank audits with a technological bent, credit rating agencies’ accountability, and the heightened examination of the misclassified asset class. Systemic integrity will be a regulatory fantasy but not an institutional reality unless India adopts the mechanical foundations of the Basel framework.

  • Navigating RBI’s Revised Framework for Downstream Investments by FOCCs

    Navigating RBI’s Revised Framework for Downstream Investments by FOCCs

    BY PURNIMA RATHI, FOURTH-YEAR STUDENT AT SYBIOSIS LAW SCHOOL, PUNE

    On January 20, 2025, the Reserve Bank of India (‘RBI’) released a comprehensive revision of the Master Direction on Foreign Investment in India (‘Master Direction’). The update represents a landmark regulatory revision, particularly for Foreign Owned and/or Controlled Companies (‘FOCCs’) pursuing downstream investments. The updated Master Direction has attempted to resolve a number of ambiguities, align regulatory treatment with the Consolidated Foreign Direct Investment (‘FDI’) Policy, 2020 and the Foreign Exchange (Non- Debt_ Instruments) Rules, 2019 (‘NDI Rules’) and thus, stream lining the compliance requirements for both investors and companies.

    The blog shall analyse key regulatory changes made through the Master Direction and its effects on downstream investments made by FOCCs. This analysis is made by comparing the recent update to the earlier versions of the Master Direction.

    WHAT ARE FOCCs AND DOWNSTREAM INVESTMENTS ?

    To understand the significance of the Master Direction, it is first necessary to understand the meaning and the context in which FOCCs and downstream investments operate. A FOCC is defined in the Foreign Exchange Management Act, 1999 (‘FEMA’) and the NDI Rules as an Indian entity that is:

    •  Owned by non-resident entities (more than 50% shareholding); or

    •  Controlled by non-residents (in the sense of a non-resident entity or person is empowered to appoint a majority of directors or is empowered to influence decisions which are deemed to be strategic business decisions).

    Downstream investment is defined collectively, in this context, as an investment in capital instruments (equity shares, compulsorily convertible preference shares, etc.) made by said FOCC in another Indian entity. It is essentially an investment made by a company already partly or wholly owned by foreign investors, into another Indian entity.

    Analysis of Key Changes

    The updated Master Direction has important amendments which are aimed at reducing compliance complexities, providing legal clarity, and allowing flexibility with transaction structures. Analysed below are the key revisions from the Master Direction:

    1. Consistency with General FDI Norms

    The most important change is the explicit consistency of downstream investments by FOCCs with general FDI norms. Downstream investments are treated as a different investment category and require separate compliance obligations.  However, now it requires that FOCCs must comply with the same entry routes (automatic or government), sectoral restrictions, price restrictions, and reporting requirements as any direct foreign investment investor. The guiding principle of “what cannot be done directly, shall not be done indirectly” has the intention to place downstream investments on an equal level with FDI.

    This is particularly advantageous in sectors where the automatic route is available and removes unnecessary bureaucratic hurdles. For example, if a FOCC is investing in an Indian startup that provides services to the technology sector, they may now invest and treat it the same as a direct foreign investment provided that the sector cap and conditions are adhered to.

    2. Share Swaps Approved

    Another important change is the recognition of share swap transactions by FOCCs. Before the recent change, it was unclear whether share swaps were permitted for FOCCs at all, and companies tended to either seek informal clarifications or err on the side of caution.

    The updated direction explicitly provides that FOCCs can issue or acquire shares in lieu of shares of another company (either Indian or foreign) subject to pricing guidelines and sectoral limitations. This is an important facilitative measure for cross-border mergers, joint ventures, and acquisition deals where share swaps are the predominant form of consideration.

    This reform enhances transactional flexibility, encourages capital growth and will reduce friction in structuring deals between Indian FOCCs and foreign entities, thereby promoting greater integration with global capital market. 

    3. Permissibility of Deferred Consideration

    The RBI now formally recognizes deferred consideration structures such as milestone-triggered payments, escrows, or holdbacks. However, they are still governed by the ’18-25 Rule’, which allows 25% of total consideration to be deferred, which must be paid within 18 months of execution of the agreement. This represents a pragmatic acceptance of the commercial acknowledgment that not all transactions are settled upon completion.

    RBI shall have to give additional clarifications as the Master Direction still does not specify the extent to which provisions are applicable to downstream investments in comparison to the FDIs.

    4. Limitations on the Utilisation of Domestic Borrowings

    In an effort to safeguard the integrity of foreign investment channels and to deter round-tripping, or indirect foreign investment through Indian funds, the RBI continues to restrict FOCCs from utilising domestic borrowings for downstream investment. This implies that FOCCs can only downstream invest with foreign funds introduced through equity investments or through internal accruals. The restriction aims that downstream investments are made through genuine foreign capital introduced in the country through abroad, rather than through domestic borrowings.

    Practically this means that if the FOCC receives a USD 5 million injection from the parent organization abroad, then they can utilize such funds for downstream investment, but not if they were to borrow the same amount in INR through a loan from an Indian financial institution. This maintains investor confidence and enhances transparency in capital flows.

    5. Modified Pricing Guidelines for Transactions

    The revised framework reiterated pricing guidelines in accordance with the different types of company:

    •  For listed companies: The pricing must comply with the Securities and Exchange Board of India (‘SEBI’) guidelines,

    •  By unlisted companies: The price cannot be lower than the fair market value determined by internationally accepted pricing methodologies.

    Additionally, in all rights issues involving non-residents, if the allotment is greater than the investor’s allotted entitlement, price has to comply with these guidelines. In this case, the rights issue would protect minority shareholders and mitigate the dilution that would occur by no listings from unlisted companies.

    6. Reporting and Compliance via Form DI

    An excellent innovation is the new compliance requirement of filing on Form DI within 30 days of the date an Indian company becomes a FOCC or makes a downstream investment. This will assist the RBI in maintaining regulatory visibility and better tracking of foreign investment in India. Companies will have to implement stricter internal compliance mechanisms and timely reporting as failure to do so could result in penalties under FEMA. The RBI’s emphasis on transparency reflects a continuing trend toward digitization and live reporting of capital flows by Indian regulators.

    7. Clearer Application of the Reporting Forms (FC-GPR, FC-TRS, DI)

    In addition, the RBI has further clarified the documents to use the following forms:

    • Form FC-GPR: is for reporting the issuance of shares by an Indian entity to a FOCC. • Form FC-TRS: is for any transfer of shares involving FOCC as the non-resident and between residents and non-residents.

    • Form DI: is for downstream investments made by FOCC into any other Indian entity.

    This clarity will help eliminate confusion around these procedures and synchronize the reporting regime of the RBI with the reporting systems of the Ministry of Corporate Affairs (‘MCA’) and SEBI. FOCC should implement strong internal controls to monitor and track when these filings will become due.

    8. Classification of FOCCs based on Share Movement

    The new regulations will also provide clarity on how the status of a FOCC will influence a regulatory classification. Specifically:

    •  if a FOCC receives shares from an Indian entity, it will be treated as a ‘Person Resident Outside India’; and

    •  if it transfers shares to an Indian entity, it will be deemed to be domestic in nature but needs to comply with the repatriation norms.

    These classifications have an important bearing on the route and pricing of transactions especially in exits or complex internal restructuring transactions. Through these classifications, RBI intends to clarify the confusion from mischaracterizing transactions and reducing risk for the investors in the event of any enforcement action.

    Conclusion

    The amendments to the Master Direction represent a measured and thoughtful change in the foreign investment regulatory framework in India. The RBI has set the tone in favour of enabling policy predictability and investor confidence by clarifying FOCC structures’ downstream investment norms to be consistent with FDI, allowing for more sophisticated structures like share-swap transactions and deferred consideration, and imposing effective operational compliance requirements. Going forward, these refinements have set the foundation for deeper capital integration and increased investor trust in India’s FDI regime.

  • RBI’s Electronic Trading Platforms: a Bittersweet Take on Trading

    RBI’s Electronic Trading Platforms: a Bittersweet Take on Trading

    BY ABHISHEK KAJAL, FOURTH YEAR STUDENT AT IIM, ROHTAK
    Introduction

    The Reserve Bank of India (RBI) introduced the 2024 framework on Electronic Trading Platforms (“ETPs”) in April 2024 (“2024 Draft Framework”), superseding the earlier 2018 Direction (“2018 Framework”) with some key changes.

    As defined by the RBI, an ETP means any electronic system, other than a recognised stock exchange, on which transactions in eligible instruments are contracted.It is a platform that allows trading in eligible instruments as notified by the Reserve Bank of India. The main instruments include Government Securities (“G-Sec”), Money instruments, and Foreign Exchange instruments.

    No individual or organisation, whether local or foreign, is permitted to run an ETP without first securing authorisation or registration from the RBI. A resident person under the Foreign Exchange Management Act, 1999 (“FEMA”) is allowed to do online forex transactions only on authorised ETPs by the RBI. The purpose of this blog is to analyze the Indian ETP framework by tracing its evolution, examining key regulatory changes in the 2024 draft, highlighting challenges faced by domestic platforms, and suggesting practical solutions to strengthen the framework.

    Evolution of ETPs in India

    After the global financial crisis, trading on electronic platforms was being encouraged in several jurisdictions, driven primarily by regulatory initiatives to reform Over-the-Counter (“OTC”) derivative markets through a technology-driven approach. 

    Therefore, to have more market access, increased competition, and reduced dependency on traditional trading methods, the RBI, in 2017, issued a Statement on Developmental and Regulatory Policies as a part of its fourth bi-monthly Monetary Policy Statement 2017-18, where it highlighted its intention, for the first time, to regulate the money markets instruments under their purview through ETPs.  They recommended a framework to be put in place for ETPs that will deter market abuse and unfair trading practices, leading to better price discovery and improved market liquidity. Following this, the ETP Direction was first introduced in 2018.

    More Flexibility in Trading

    Under the 2018 framework, only banks were excluded from the framework’s applicability given that they allowed trading of eligible market instruments only with their customers on a bilateral basis and did not trade with market makers, including authorised dealers under FEMA.

    However, under the 2024 framework, the RBI has expanded the relaxation of this framework. Now, scheduled commercial banks (“SCB(s)”) and standalone primary dealers are also excluded from the framework for trading in eligible instruments. They can operate ETP platforms and trade in eligible instruments even without the authorization of the RBI, given that the SCB or primary dealer is the sole provider of price/quote and is a party to all the transactions of the platform.

    Certain reporting requirements have been provided for the SCBs or primary dealers, where they have to report any data or information whenever asked by RBI, and further, to avoid any misuse, the RBI can require such ETPs to comply with the ETP Direction. This change by the RBI reflects a balance between promoting ease of doing business and ensuring market protection in the ETP market.

    Setting up and Authorisation of ETPs

    To establish itself, an ETP must meet specific eligibility criteria for authorization from the RBI. The criteria are dynamic, beginning with the basic requirement that the ETP must be a company incorporated in India. Then, the ETP must comply with all applicable laws and regulations, including those of FEMA.

    The ETP or its Key Managerial Personnel (“KMP”) must have at least three years of experience in managing trading infrastructure within financial markets. This requirement serves as a preventive measure against potential market collapses. The ETP must have a minimum net worth of ₹5 crores at the outset and must maintain this net worth at all times. The ETP must have a robust technology infrastructure that is secure and reliable for systems, data, and network operations. All the trade-related information must be disseminated on a real-time or near real-time basis. Once an ETP meets the eligibility criteria, it must submit an application to the RBI in the prescribed format to obtain authorization.

    Offshore ETPs: Opening Doors for Cross-Border Trading

    The background of offshore ETPs is closely linked to the rising incidents of unauthorized forex transactions in India. In response, the RBI has periodically issued warnings against unauthorized platforms engaged in misleading forex trading practices and has maintained an Alert List of 75 such entities.

    The reason for such unauthorized practices lies in the previous 2018 framework, where a significant barrier for offshore ETPs was the requirement to incorporate in India within one year of receiving RBI authorization. This regulation proved challenging for foreign operators, leading to their non-compliance. Under the 2024 draft framework, foreign operators are now allowed to operate from their respective jurisdictions, however, they need authorisation from the RBI.

    The authorization process involves adhering to a comprehensive set of criteria aimed at ensuring regulatory compliance and market integrity. To qualify, the offshore ETP operator must follow some conditions, which include incorporating it in a country that is a member of the Financial Action Task Force (“FATF”). This will enhance the transparency and integrity of Indian Markets. It ensures adherence to global standards in combating money laundering and terrorist financing. This can enhance the overall credibility of India’s financial markets, making them more attractive to global investors.

    Then, the operator must be regulated by the financial market regulator of its home country. This regulator must be a member of either the Committee on Payments and Market Infrastructures (CPMI) or the International Organization of Securities Commissions (IOSCO), both of which are key international bodies that promote robust financial market practices and infrastructure. Once an offshore ETP operator meets these criteria, they must then follow the standard ETP application process for registration with the RBI.

    While analyzing this decision of the RBI, it is a promising initiative. The reason is that it does serve the purpose for which it was intended to be implemented, i.e., preventing unauthorized forex trading. The fundamental issue of unauthorized forex trading was about mandatory incorporation or registration in India, which has been done away with.

    Further, the framework specifies that transactions on these offshore ETPs can only involve eligible instruments that include the Indian rupee or rupee interest rates, and these transactions must strictly be between Indian residents and non-residents.

    Transactions between residents are not permitted under this framework, which indicates that the offshore ETP serves a cross-border trading function rather than facilitating domestic transactions. This is the right step in increasing Foreign Portfolio Investment in India and ensuring risk mitigation that may arise by allowing offshore ETPs to allow transactions among Indian residents.

    The Domestic Game

    However, when it comes to domestic ETPs, the 2024 draft framework is not very effective, the reason being that they do not incentivize domestic operators to apply for authorization. To date, over a span of six years, the RBI has authorized a total of only five ETP operators, one of which is the Clearing Corporation of India and four other private players.

    The reason for such slow adoption is that the operators are ineligible to apply for authorization due to stringent eligibility criteria (Regulatory Restriction). For example, the general authorization criteria for an ETP require that the applying entity or its Key Managerial Personnel must have at least three years of experience in operating trading infrastructure in financial markets. The issue here is that the requirement focuses solely on prior experience in operating trading infrastructure. This effectively limits eligibility to entities already active in this space, leaving little to no opportunity for new entrants to participate and innovate in the ETP market.

    This missed opportunity to foster domestic competition and innovation could limit the full potential of ETPs in India. Therefore, the RBI should take a liberalized approach towards domestic ETPs and ensure that the domestic ETP climate is conducive. To address this, the RBI should broaden the eligibility criteria to allow entities from other financial sectors, not just those with experience in trading infrastructure, to apply for ETP authorization. To ensure market safety, this relaxation can be balanced by imposing stricter disclosure requirements on such entities.

    A phased approach could also be taken by RBI where it could require new players with insufficient experience to first test their platform in the regulatory sandbox operated by RBI and then after rigorous testing, the same could be granted authorization. This will allow more domestic players to participate and will lead to enhanced forex trading in India which will potentially increase FDI investment in India.

    Way Forward

    Another potential change to increase the adoption rate of domestic ETPs might include examining and changing the eligibility requirements. Tax exemptions or lower net worth (less than 5 cr.) entry with certain restrictions could be considered to attract more participants, improving the entire market environment and addressing the low adoption rate found under the existing framework.

    The inclusion of offshore ETPs to register and operate in India has been the most favorable move towards facilitating foreign investment in India. The sturdy registration process ensures that only serious firms join the Indian market, which sets the pace for a market overhaul. The exclusion of scheduled commercial banks and standalone primary dealers is also a significant step forward in simplifying banking operations and increasing FPI.

    Finally, the 2024 Draft ETP Framework may be favorable to foreign ETPs, but the game is not worth the candle for domestic ones. With continued advancements and strategic enhancements, as suggested, India’s ETP framework has the potential to drive significant economic growth and elevate its position in the global financial landscape.

  • Evaluating the Impact of the RBI’s Draft Prudential Framework on Project Financing

    Evaluating the Impact of the RBI’s Draft Prudential Framework on Project Financing

    BY ARYAN SHARMA, THIRD-YEAR STUDENT AT MAHARASHTRA NATIONAL LAW UNIVERSITY, MUMBAI

    INTRODUCTION

    Project financing serves as a cornerstone for infrastructure development, by facilitating the construction of essential assets such as roads, power plants, and urban facilities. In May 2024, the Reserve Bank of India released the draft ‘Prudential Framework for Income Recognition, Asset Classification, and Provisioning pertaining to Advances—Projects Under Implementation, Directions 2024’. The draft was aimed at strengthening the regulatory environment that governs project finance. This circular created quite a stir in the financial sector.

    This article aims to examine the implications of these regulatory changes for lenders, borrowers, and the broader infrastructure sector. It explores whether the RBI’s cautious approach strikes the right balance between financial prudence and India’s ambitious infrastructure goals, and it analyzes potential market reactions and policy adjustments that may emerge in response to these new norms.

    UNDERSTANDING PROJECT FINANCE

    A discourse on the implications of the draft prudential norms requires an insight into project financing. Project finance refers to the method of financing infrastructure and other long-gestating capital-intensive projects like power plants, ports, and roads involving huge financial outlays. The typical project involves a high-risk profile, long gestation periods, and uncertain cash flows, all of which characterize the infrastructure sector.

    Unlike a regular loan sanction, which would depend on the character, capital, and capacity of the borrower, the loan structure of project financing predominantly depends on the project’s cash flow for repayment. The project’s assets, rights, and interests form part of the collateral. Additionally, the lender assesses the project sponsors and their experience in handling and commissioning the project. Project funding could be through a consortium of several lending institutions or include loan syndication. It could have any sort of funding proposition. A project has three distinct phases: design, construction, and operation.

    Banks and lending institutions primarily become involved during the construction and operational phases, where money is lent, and out standings appear in the books of accounts. After this, the extant prudential framework of income recognition, asset classification, and provisioning comes into effect.

    The draft prudential framework recently released by the RBI pertains to loans and advances for projects. The regulator has proposed stricter regulations for project financing, which makes it more expensive for lenders to provide loans for infrastructure and industrial projects like roads, ports, and power. The main question is: what has changed and why?

    WHY HAVE THESE CHANGES BEEN PROPOSED?

    During the infrastructure lending boom of 2008 to 2015, banks whitewashed their books of bad loans and defaults, which forced RBI to launch an asset quality review. This led to the unearthing of thousands of crores of hidden bad loans, causing investors to lose money. NPAs in banks shot up to an all-time high of ₹6.11 lakh crores, and the government had to invest more than ₹3 lakh crores in capital to bring banks back into shape.

    Furthermore, facts show that most project loans have been categorized as standard assets, even though there were some projects delayed beyond the planned schedule and were not yielding cash flows. This gave rise to the necessity for more stringent lending standards with extra provisions, which were directed towards avoidance of accounting shocks that might adversely affect the balance sheets of such entities. These actions are cautious from a risk management point of view, based on the regulator’s experience in the last credit cycle. Experience, after all, is a good teacher.

    WHAT ARE THESE NEW REGULATIONS?

    Under the new norms, there will be a broad provisioning of 5% of the funded outstanding on all existing and new exposures at a portfolio level. The new norms also demand a 1% provision even post-completion of the project, well over double the current requirement.

    The central bank has created a provisioning timeline of: “2% by March 31, 2025 (spread over four quarters of 2024-25); 3.50% by March 31, 2026 (spread over four quarters of 2025-26); 5.00% by March 31, 2027 (spread over four quarters of 2026-27)”

    Further, the allowable deferment periods for date of commencement of commercial operations (“DCCO”) are: “Up to 1 year for exogenous risks (including CRE projects); Up to 2 years for infrastructure projects with endogenous risks; Up to 1 year for non-infrastructure projects with endogenous risks; Up to 1 year for litigation cases”.

    Perhaps the RBI’s proposal to impose a 5% provision requirement on project loans has been triggered by the Expected Credit Loss (“ECL”) norms, which require banks to make provisions based on past default experiences.

    The ECL approach provides for the recognition of losses on loans as soon as they are anticipated, even if the borrower has not defaulted. These are prudential standards in accordance with international best practices. Every time the ECL norms are notified, banks will be required to reserve provisions for defaults accordingly.

    HOW WILL THIS IMPACT LENDERS?

    These new norms will significantly increase the provisioning requirements for banks and NBFCs, particularly those involved in large-scale infrastructure lending. Since the 5% provisioning mandate applies uniformly across all infrastructure projects, regardless of their inherent risk profiles, it may create a deterrent effect for lower-risk projects. Lenders could become more cautious in financing even relatively safer infrastructure ventures, as the increased provisioning costs may reduce the overall attractiveness of such exposures. This one-size-fits-all approach could inadvertently constrain credit flow to viable projects.

    The higher provisioning during the construction phase will directly impact the profitability of lenders, as a substantial portion of their capital will be locked in provisions rather than being available for lending.

    For lenders heavily engaged in project financing, such as PFC, REC, and IIFCL, this could mean a reduction in their lending appetite, thereby slowing down infrastructure development in the country.

    IMPACT ON BORROWERS AND PROJECT DEVELOPERS

    Project developers, especially in sectors like power, roads, ports, and renewable energy, will face tighter credit conditions. The cost of borrowing is likely to increase as banks and NBFCs factor in the higher provisioning costs into their lending rates. This could lead to:

    • Higher interest rates on project loans
    • More stringent lending criteria, making it harder for some projects to secure funding
    • Potential project delays, as financing becomes more expensive and risk-averse

    While these measures may enhance financial stability and prevent a repeat of the bad loan crisis of the past decade, they could also create bottlenecks in infrastructure development.

    POSSIBLE MARKET REACTIONS AND POLICY ADJUSTMENTS

    The sharp decline in banking and financial sector stocks following the release of this draft indicates that the market anticipates lower profitability and slower loan growth in the sector. Industry feedback is likely to request risk-weighted provisioning (lower rates for low-risk projects), extended implementation timelines, and carve-outs for strategic sectors like renewables. Developers may also seek clearer DCCO extension guidelines for projects delayed by regulatory hurdles.

    Objections from banks, NBFCs, and infrastructure developers may include requests for tiered provisioning rates based on project risk (e.g., sectors with historically low defaults). There may also be appeals to adjust quarterly provisioning targets to ease short-term liquidity pressures. Additionally, there could be demands for exemptions in renewable energy or other priority sectors to align with national development goals.

    However, the RBI may recalibrate its stance after engaging with industry stakeholders. Potential adjustments could include phased implementation of the 5% norm, reduced rates for priority infrastructure projects, or dynamic provisioning linked to project milestones. Maintaining financial stability remains paramount, but such refinements could ease credit flow to viable projects and mitigate short-term market shocks.

    Given India’s ambitious infrastructure goals under initiatives like Gati Shakti and the National Infrastructure Pipeline, a balance must be struck between financial prudence and the need to maintain momentum in project execution.

    CONCLUSION

    The RBI’s draft prudential framework is definitely a step in the right direction to strengthen financial stability and prevent systemic risks in project financing. However, it also raises concerns about credit availability, borrowing costs, and infrastructure development. It is true that the primary focus remains on the increased provisioning requirements, but the norms also raise broader concerns about their potential impact on credit availability and infrastructure growth, which may have cascading effects. By necessitating higher capital buffers, the norms risk reducing credit availability and increasing borrowing costs, which are unintended consequences that could slow infrastructure development despite their prudential benefits. If implemented as proposed, these norms will fundamentally alter the project financing landscape, making lending more conservative and expensive.    

    Albeit the proposed norms will likely make lending more conservative and expensive, they also offer important benefits, such as improved risk management, better asset quality for lenders, and long-term sustainability of infrastructure financing. The framework could potentially reduce NPAs in the banking system.

    Looking ahead, if implemented as proposed, we may see a short-term slowdown in infrastructure lending followed by more sustainable, risk-adjusted growth. A phased implementation approach could help mitigate transitional challenges, which would allow lenders and developers time to adapt. The framework could be complemented with sector-specific risk weights and credit enhancement mechanisms for priority infrastructure projects.

    The final framework, once confirmed, will be crucial in determining the future trajectory of infrastructure lending in India. Whether the market’s initial reaction is justified or premature remains to be seen, but one thing is clear, i.e., the era of easy project finance is over, and a more cautious, risk-averse approach is here to stay.

  • Navigating SEBI’s Upstreaming Clients’ Funds Framework

    Navigating SEBI’s Upstreaming Clients’ Funds Framework

    BY AISHANA AND NIKITA SINGH, THIRD-YEAR STUDENTS AT GNLU, GUJARAT

    Introduction 

    In the past few years, The Securities and Exchange Board of India (SEBI) has taken several steps to safeguard investors’ securities and funds, but a significant amount of investor funds may still be vulnerable to the risk of potential misuse. To mitigate the same, in a recent regulatory move, it has released a circular that lays out a crucial framework for stock brokers (SBs) and clearing members (CMs) to upstream their clients’ funds to clearing corporations (CCs). The circular is a strategic step to protect customers’ money and guarantee its prudent use, with important ramifications for investors and the securities market alike.

    The SEBI circular mandates the upstreaming of all client funds received by SBs and CMs to CCs in the form of cash, lien on fixed deposit receipts (FDRs), or pledge of units of mutual fund overnight schemes (MFOS). Specific conditions are outlined for creating FDRs, including the requirement that FDRs should be pre-terminable on demand and lien-marked to one of the clearing corporations (CCs) at all times. Guidelines for pledging MFOS units are introduced to ensure minimal risk transformation of client funds and exposure to risk-free government securities. The circular also emphasizes measures to improve operational efficiency and reduce transaction costs, along with compliance and monitoring mechanisms for stock exchanges and CCs. 

    In this article, the authors will explain the conditions outlined for creating FDRs including the guidelines introduced for pledging MFOS units, aiming to mitigate risk transformation and limit exposure to risk-free government securities, which will be examined in detail. Moreover, the article also encompass the circular’s overarching goals of improving operational efficiency, reducing transaction costs, and establishing robust compliance and monitoring mechanisms for both stock exchanges and CCs. 

    The Purpose and Rationale of the Framework

    The principle behind the framework for upstreaming of clients’ funds by SBs and CMs to CCs is that no clients’ funds should be retained by SBs and CMs on end of the day basis. This means that all the clear credit balances of the clients, i.e., the funds that are not required for meeting the margin or settlement obligations of the clients, should be transferred to the CCs every day. The CCs are the entities that facilitate the clearing and settlement of trades in the securities market. They act as the central counterparties and guarantee the settlement of trades, thereby reducing the counterparty risk and enhancing the market integrity. The sole purpose of the framework is to protect client funds from abuse or misappropriation on the part of SBs and CMs. Additionally, it seeks to guarantee that the clients’ money is placed in low-risk or risk-free products, like government bonds, and that it is accessible to fulfil their obligations as needed. By including procedures for collateral utilisation and margin adjustment, the framework also aims to lower transaction costs and increase operational efficiency for market players. In addition, it also aims to improve upstreaming process compliance and oversight by requiring reporting and audits from stock exchanges, CMs, CCs, and SBs.

    The Forms and Conditions of Upstreaming

    The framework allows three forms of upstreaming of clients’ funds to CCs: cash, lien on Fixed Deposit Receipts, or pledge of units of MFOS. It also specifies certain conditions for creating FDRs out of clients’ funds such as FDRs must be pre-terminable on demand, allowing redemption without any penalty or loss of interest. Secondly, it should be consistently lien-marked to one of the CCs, serving as collateral and necessitating CCs’ consent for withdrawal or transfer by SBs or CMs. Thirdly, It also must be issued by scheduled commercial banks with a minimum A1+ credit rating, excluding co-operative and regional rural banks and should be in the name of the SB or CM, explicitly mentioning “client funds.” Furthermore, these FDRs should exist in dematerialized form within a depository, with daily reports sent to CCs by the depository, ensuring transparent oversight and compliance with the SEBI circular. These stringent conditions underline SEBI’s commitment to meticulous risk management and client fund protection within the securities market. 

    Moreover, the guidelines are also laid down for the pledging of Mutual Fund Overnight Scheme (MFOS) units derived from clients’ funds. To ensure transparency and effective oversight, these MFOS units must exclusively exist in dematerialized form within a depository, with daily reports dispatched to CCs by the depository. Pledging procedures involve the units being pledged in favour of CCs through the depository system, with the pledge remaining valid until released by the CCs. Valuation of the MFOS units is pegged at the previous day’s net asset value , and the application of a haircut by CCs is capped at 10% of the unit’s value, exemplifying a cautious approach to risk management. Crucially, upon the release of the pledge by CCs, the redemption of MFOS units must occur on the same day, with the proceeds seamlessly credited to the client nodal bank account of the SB or  CMs. These guidelines underscore SEBI’s commitment to meticulous risk mitigation, transparency, and ensuring the seamless utilization of clients’ funds within the regulatory framework of the securities market.

    The Applicability and Monitoring Mechanisms of the Circular

    The framework applies to all SBs and CMs in all segments of the securities market but also holds some noteworthy exceptions include Bank-CMs, encompassing clearing members that are banks providing clearing and settlement services, and the proprietary funds of SBs and CMs, specifically reserved for their individual trading pursuits. Augmenting the effectiveness of this framework are various monitoring mechanisms outlined within the circular. To ensure meticulous implementation, stock exchanges and CCs are tasked with creating systems capturing daily details of clients’ funds received and upstreamed by SBs and CMs, with reconciliation against reports from depositories and banks. Periodic inspections and audits of SBs and CMs, conducted by stock exchanges and CCs, serve as a means to verify compliance, with a commitment to take appropriate action against any defaulters. Additionally, these regulatory bodies are obligated to submit quarterly reports to SEBI, offering insights into the circular’s implementation status, any deviations encountered, and the corresponding corrective measures taken. Simultaneously, SBs and CMs are entrusted with maintaining meticulous records of clients’ funds, readily providing them to stock exchanges, CCs, and SEBI upon request. With an effective date set for July 01, 2023, this framework reflects SEBI’s proactive stance in fostering transparency, accountability, and adherence to regulatory norms within India’s dynamic securities market.

    The Impact and Implications of the Circular

    The framework also necessitates the compliance of SBs and Clearing Members (CMs) in upstreaming all clients’ funds to CCs on a daily basis, following prescribed forms and conditions. This requirement curtails the flexibility and discretion of SBs and CMs in managing clients’ funds, potentially impacting their liquidity and profitability. They are also burdened with the operational costs and risks associated with the upstreaming process, including charges for creating FDRs or pledging MFOS units, and the risk of default or delay in the redemption of these instruments. Furthermore, they must adhere to the reporting and audit requirements imposed by the circular, facing consequences for non-compliance.

    On the other hand, CCs stand to benefit from an increased inflow of funds from SBs and CMs in the form of cash, FDRs, or MFOS units, thereby expanding their collateral pool and enhancing their risk management capabilities. However, they are tasked with building mechanisms for collateral utilization and margin adjustment to facilitate the upstreaming process and reduce transaction costs for market participants. Additionally, they are responsible for monitoring the compliance of SBs and CMs with the circular and reporting the same to the Securities and Exchange Board of India (SEBI).

    From the clients’ perspective, the framework offers several advantages. Their funds are safeguarded from misuse or misappropriation by SBs and CMs and are invested in risk-free or low-risk instruments. The pre-terminable nature of FDRs and MFOS units ensures that clients have access to their funds whenever required, with the possibility of same-day redemption. Moreover, the oversight of stock exchanges, CCs, and SEBI over the upstreaming process ensures greater transparency and accountability in the management of their funds. Thus, while the framework imposes certain constraints on SBs and CMs, it ultimately serves to protect the interests of clients and enhance the robustness of the financial system.

    Concluding thoughts 

    It can be concluded that the implementation of the circular’s guidelines will require concerted efforts from all stakeholders in the securities market. SBs and CMs must ensure strict adherence to the conditions for creating FDRs and pledging MFOS units. Stock exchanges and CCs, on the other hand, must bolster their compliance and monitoring mechanisms to ensure the effective implementation of these guidelines. Moreover, continuous dialogue and feedback mechanisms should be established to address any challenges that may arise during the implementation phase. This will not only ensure the smooth execution of the circular’s mandates but also contribute to the overarching goal of safeguarding investors’ securities and funds. The circular represents a significant step towards a more secure and efficient securities market. By ensuring the prudent use of customers’ money and reducing potential misuse, it paves the way for a more robust and investor-friendly securities market in India.

  • PCA Framework as an Effort to Contain the Contagion Effect

    PCA Framework as an Effort to Contain the Contagion Effect

    by Abhishkha Moyal, 5th year law student at RGNUL, Patiala.

    Introduction

    A non-banking financial company (“NBFC”) means, (i) a financial institution which is a company; (ii) a non-banking institution which is a company, with principal business of receiving deposits under any scheme or arrangement or in any other manner, or of lending in any manner;; (iii) such other non-banking institution or class of such institutions, as the Reserve Bank of India may, with the previous approval of the central government and by notification in the official gazette, specify.

    Every NBFC in India deals with substantial number of customers as well as with other NBFCs. NBFCs also partners with digital lenders who have restrictions on lending funds on their own accounts by reason of regulatory issues. Hence, the NBFCs form an important part of the financial system of India and enormously impact the economy as a whole. Any default made or any financial discrepancy caused by a single NBFC can create a substantial risk for the financial system of our country, thereby causing a ‘contagion effect’, that is, escalation of economic crisis in one market or region leading to economic downturn in other national or international markets or regions due to interconnectivity between them. . However, the regulatory framework for NBFCs is lenient in comparison to that for the banks due to which the financial system of India in recent times has suffered various jolts like the collapse of Infrastructure Leasing & Financial Services group in 2018, and bankruptcy of Dewan Housing Finance Corporation in 2019 and Reliance Capital in 2021.

    The Reserve Bank of India (“RBI”) introduced the Prompt Corrective Action (“PCA”) framework for NBFCs on December 14, 2021 in order to intervene at the appropriate time to initiate and implement remedial measures in a timely manner, so as to restore financial health of NBFCs which are at risk. The framework will be effective from October 1, 2022, on the basis of financial position of NBFCs on or after March 31, 2022.

    Working of the PCA Framework

    The applicability of PCA framework shall extend to all deposit taking NBFCs (except government companies), and all non-deposit taking NBFCs in middle, upper and top layers
    (except- NBFCs not accepting or intending to accept public funds; government companies; primary dealers; and housing finance companies). The key areas for monitoring in PCA framework will be capital and asset quality, and indicators to be tracked would be Capital to Risk Weighted Assets Ratio (“CRAR”), tier I capital ratio and net non-performing assets (“NNPA”) ratio. The NBFCs will face restrictions when such indicators fall below the stipulated levels.

    The PCA framework provides for three risk thresholds for NBFCs, violation of any of which by any NBFC may lead to invocation of PCA framework by the RBI against such NBFC. The norms which RBI may impose on such NBFC will get stricter as and when such NBFC moves from the first to the third threshold. First risk threshold will be invoked for the NBFCs when the CRAR of such NBFC falls 300 basis points (“bps”) below the regulatory minimum of 15% or when tier I capital ratio falls 200 bps below the regulatory minimum of 10% or in cases where NNPA ratio exceeds 6%. In such cases, it will be mandatory for the NBFC to restrict dividend distribution/remittance of profits. Further, it will be mandatory for promoters/shareholders of such NBFCs to infuse equity and reduce leverage. 

    Similarly, the second risk threshold will be invoked when CRAR falls up to 600 bps below regulatory minimum of 12% or when tier I capital ratio falls up to 400 bps below the regulatory minimum of 8% or in cases where NNPA ratio exceeds 9%. In such cases, it will be mandatory for the NBFCs to restrict their branch expansion, in addition to the restrictions imposed after breach of first risk thresholds. 

    Further, the third risk threshold will be invoked when CRAR falls more than 600 bps below regulatory minimum of 9% or when tier I capital ratio falls more than 400 bps below the regulatory minimum of 6% or in cases where NNPA ratio exceeds 12%. In such cases, it will be mandatory for the NBFCs to impose restrictions on their variable operating costs and capital expenditure, except capital expenditure on technological upgradation within limits approved by their board of directors. In addition to the above restrictions, the PCA framework gives discretionary powers to the RBI to take certain other actions against the defaulting NBFCs relating to governance, capital, credit risk, profitability etc. 

    NBFCs can exit from the PCA framework and the restrictions imposed against them and the PCA framework can be withdrawn under two conditions. Firstly, there should have been no violations of risk thresholds in any of the parameters for four continuous quarterly financial statements, one of which should be annual audited financial statement (subject to assessment by RBI); and secondly, on the basis of supervisory comfort of the RBI, including an assessment on sustainability of profitability of NBFCs.

    Impact

    The PCA framework was introduced for the banking companies in 2002. Eleven public sector unit banks and some private banks were put under the framework; restrictions were imposed on such banks to improve their financial health as a result of which their financial health improved over the years. At present only the Central Bank of India is governed by the PCA framework, however, it has also enhanced its financial position and no longer requires working under the framework. 

    As mentioned earlier, the PCA framework will come into effect from October 1, 2022, based on the financial position of NBFCs on or after March 31, 2022. This will give NBFCs sufficient time to strengthen their financial position, which may have been affected by the Covid-19 pandemic, and avoid any other issues. 

    Imposition of the PCA framework will enable the RBI to (i) regulate NBFCs struggling with financial issues; and (ii) help such NBFCs to resolve such issues in a timely and effective manner. Moreover, empowering the RBI to intervene with the working of struggling NBFCs in order to strengthen their financial position will prevent such NBFCs from advancing risky loans and will encourage them to be more cautious in undertaking lending and other activities. However, this may have a negative impact on the growth of the NBFCs, as imposition of the PCA framework on the NBFCs will tighten their credit norms and their operational focus may shift towards collection activities.

    Conclusion 

    The PCA framework for banks has already been in place since 2002 and has helped the RBI and many other banks to improve their financial health. As NBFCs have become closely integrated with the banking and financial system of India, hence, regulating them is the need of the hour in order to maintain a stable financial system. 

    Moreover, as the Covid-19 pandemic has adversely affected many businesses around the world, it would be rational for NBFCs to lend their funds discreetly in order to avoid financial difficulties at later stages. When remedial measures are implemented in a timely manner for NBFCs at financial risk, it will help in containing the contagion effect on the economy.