Why NBFCs need ICAAP

Regulatory concerns on capital assessment and risk management need to be addressed

It is quite clear that Middle Layer and Upper Layer NBFCs' risk-management has been properly aligned with their commercial banks counterparts.
It is quite clear that Middle Layer and Upper Layer NBFCs' risk-management has been properly aligned with their commercial banks counterparts.

By Arindam Bandyopadhyay

RBI, in its circular dated October 22, 2021, has stated that the Upper and Middle Layer NBFCs will have to follow Internal Capital Adequacy Assessment Process (ICAAP). In terms of size and complexity of business, some of the larger NBFCs are equivalent to smaller, new generation private banks. There is a regulatory concerns about Asset Liability Management (ALM) and credit risk for individual NBFCs. NBFCs will need to establish a board-approved policy and framework of ICAAP and assess their existing and future capital requirements based on credit, market, operational and other residual risks. The purpose of the ICAAP is to inform the board of the ongoing assessment of the entity’s risks, how management intends to mitigate those risks and how much current and future capital is necessary. NBFCs will have to make a realistic internal assessment of risk (credit, market, operational and all other residual risks). The ICAAP policy and framework laid down by the NBFCs will be subject to regulatory oversight. The objective is to ensure NBFCs hold adequate capital to support the relevant risks in their business.

The key elements of ICAAP policy are: Risk Appetite Statement, Risk Profile Analysis, Capital Management, Capital Strategy and Targets, Use test, ICAAP reporting and Independent Review. The implementation of ICAAP requires strict changes in internal governance structure and a good information base. The risk appetite defined by the board has to be reviewed periodically to take into cognizance the changing business perspective of the environment and hence of the NBFC. It entails an assessment of the current and desired risk profile that entails the level of risk the NBFC is willing to take and an action plan to achieve it.

The accompanying graphic makes a comparison of regulatory requirements between NBFCs and banks. It is quite clear that Middle Layer and Upper Layer NBFCs’ risk-management has been properly aligned with their commercial banks counterparts.

As evident from the graphic, the impact of pandemic is prominently visible on asset quality, profitability, and capital position of NBFCs. The profitability of NBFCs dipped in the first quarter of 2021 since business suffered due to nationwide lockdown situations. As per RBI’s Financial Stability Report July 2021, the deterioration in credit quality in the MSME portfolio of NBFCs has drawn regulatory attention. RBI has permitted restructuring of temporarily impaired MSME loans of size up to `25 crore. It has been further boosted by Emergency Credit Line Guarantee Scheme (ECLGS) disbursements to eligible categories. The loss of income and livelihoods due to Covid-19 has led to substantial reduction in consumption demand as well as spending behaviour of household which have resulted in slowdown in credit growth.

The regulator is concerned about the growing size of NBFCs and their interconnectedness with other segments of the financial system. As part of Supervisory Review Process, RBI has now put in place a PCA framework for NBFCs which will be effective from March 31, 2022. The objective is to enable supervisory intervention at an early stage to prevent deterioration in its financial health. This is why the supervisor requires detailed information about NBFCs risk profiles so that timely intervention is possible. It is essential for the major NBFCs to implement their ICAAP in a duly prescribed and timely manner and establish their capital assessment and risk management processes and methods in line with the regulatory requirements.

The author is Associate professor and dean (education),NIBM, Pune
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