Tuesday, April 3, 2012

Whether Bank Deposits are financial assets - RBI circular creates problems for NBFCs and non-NBFCs

The circular dated 15th March 2012 of the Reserve Bank of India stating that bank deposits will not be treated as financial assets for NBFCs was highlighted in an earlier post by Mr. Satyajit Gupta who has explained its background and rationale. The author has raised a valid concern that the RBI may have about the trading in shell-NBFCs which are dormant and which keep their assets in bank deposits. Perhaps Reserve Bank of India has also the concern of the added burden of monitoring such dormant NBFCs.
However, there are some other worrisome implications of this circular that may create problems even to running NBFCs and even non-NBFCs. The following paragraphs highlight some problems arising out of these new requirements.
Essentially, one may recollect that, as Satyajit points out in his post, the Reserve Bank of India has now de-recognized bank deposits as financial assets. Income from bank fixed deposits is also de-recognized as income from financial assets. Thus, investing in bank fixed deposits will not be treated as carrying on the business of financial institution. The circular further states, quite harshly I think, that if a newly registered NBFC does not commence business of a financial institution – other than of course investing in bank fixed deposits – their certificate will be deemed to be automatically withdrawn.
The problem with making such a general rule is that, instead of applying only to newly registered NBFCs, it will apply to any NBFC and even a non-NBFC creating problems for some and perhaps unintended relief for others.
Thus, this will create confusion to existing NBFCs already engaged in the business of finance. Bank Deposits are part of the portfolio of any NBFC. It may be recollected that the RBI had, vide its circular dated October 19, 2006, created a deeming condition regarding when a Company becomes an NBFC. It stated that, for a Company to qualify as an NBFC, at least 50% of its assets should be financial assets and 50% of its income should be from financial assets. If bank fixed deposits are excluded as financial assets for all companies, it may create problems for some NBFCs particularly in lean times and their auditors may have to qualify their reports.
And this circular may help out those companies who unwittingly became NBFCs on account when at a yearend, they found that their assets consisted of financial assets including fixed deposits with banks being more than 50%. Since bank FDs are no more treated as financial assets, they may escape one or both of the conditions and thus escape the deeming provision which otherwise may have resulted in their requiring to apply for registration as NBFC.
RBI says that bank fixed deposits constitute near money and investing in such assets does not amount to carrying on of business of financial institution. However, one would think that this should actually support the argument that it should be included since an NBFC would keep the amount fixed deposits giving low taxable returns only if they need the monies quickly to deploy in its regular business.
Interestingly, only fixed deposits with banks have been excluded and not other liquid assets of similar nature. This may sound anomalous since NBFCs actually prefer in investing in other similarly liquid assets which yield more tax-efficient returns.
The six month limit to commence the business of NBFC may be an unduly strict requirement considering that this would mean that at least 50% of its assets and 50% of its income will need to be from financial assets within six months of grant of Certificate of Registration (CoR). An NBFC raising funds from various sources at one stroke and deploying them over a period of time may find this difficult to comply. The requirement that the CoR stands automatically withdrawn is particularly harsh as no notice is required to be given and there is no scope for any waiver or extension based on facts of each case.
This would also mean that that effectively the CoR has a validity period of six months only. It is not clear whether this would apply to NBFCs that have obtained CoR in the last six months. It is also not clear what would be the fate of those companies that have obtained registration earlier than six months but who are not in compliance with the condition that the business should have commenced within six months. If the intention is to apply this condition prospectively, this needs to be explicitly stated.
There is a valid concern that some NBFCs may be formed for selling. NBFCs have to undergo a fairly rigorous scrutiny for registration and sale of such “shell” NBFCs may defeat the point. However, a better solution to this may be to require that the buyers of such NBFCs be subjected to the same scrutiny rather than that such restrictions be placed on newly formed NBFCs and existing NBFCs.
The law relating to NBFCs has thus become just a little more complex, harsh and arbitrary. This is also in contrast with the report of the Working Group that liberally recommended that NBFCs having assets upto Rs. 1000 crores (Rs. 50 crores if they access public funds) should not require registration at all as compared to the present requirement of registering all companies engaged in the business of finance. Unlike this realistic and forward looking report, the circular of the Reserve Bank of India is backward looking and even otherwise creates more problems while only partly solving the targeted problem.

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