Review of Regulatory Framework for the All India Financial Institutions (AIFIs)

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3 Annex I Review of Regulatory Framework for the All India Financial Institutions (AIFIs) I. Capital to Risk Weighted Assets Ratio (CRAR) Existing regulation 1. The AIFIs are currently governed by Basel I capital requirements. Under the Basel I framework the AIFIs are required to maintain a minimum Total capital of 9% of risk weighted assets and minimum Tier I capital of 4.5%, and Tier II capital not exceeding 50% of total capital. Revised regulation 2. Basel III Capital Framework as applicable to banks (Master Circular DBR.No.BP.BC.1/ / dated July 1, 2015) with modifications indicated in paragraph 1 of Part A of Annex II shall apply to the AIFIs. Please see Appendix 1 for summary of the main elements. Rationale 3. Currently, there is no alternative capital measurement standard for financial entities other than the Basel standards. While there is no requirement for non-banking financial institutions to follow Basel standards, almost in all countries, such institutions are being subject to exactly or broadly similar requirements. While definition of capital under Basel III is neutral to the risk profiles of the institutions, the risk weight measurement approaches are exposure and risk profile specific. Therefore, under Basel III framework, individual institutions can choose the risk measurement approaches according to their risk profiles and need to capitalise only those risks to which they are exposed. For example, an institution that does not have trading book exposures including derivatives or re-securitisation exposures, need not worry about the heavy capital requirements under Basel III to which these exposures are subjected. 4. Over the last 25 years, many development banks have migrated from Basel II to Basel III standards along with the commercial banks in their respective countries. While Basel I was obviously very crude in terms of risk sensitivity, during the 2008 global financial crisis Basel II was found deficient in many respects including inadequate coverage of financial risks. Internationally, the development banks have chosen to adopt Basel III because the micro-prudential elements of Basel standards generally measure and capitalise financial risks regardless of the entities that undertake them. Basel III strengthens the institution-level i.e. micro prudential regulation, with the intention to raise the resilience of individual financial institutions in periods of stress. Besides, the reforms have a macro prudential focus also, addressing system wide risks, which can build up across the banking/ financial sector, as well as the pro-cyclical amplification of these risks over time. These new global regulatory and supervisory standards mainly seek to raise the quality and level of capital to ensure

4 2 that financial entities are better able to absorb losses on both a going concern and a gone concern basis, increase the risk coverage of the capital framework, introduce leverage ratio to serve as a backstop to the risk-based capital measure, raise the standards for the supervisory review process (Pillar 2) and public disclosures (Pillar 3) etc. Why to leapfrog to Basel III? 5. Basel II was very sophisticated, much more risk sensitive, and resource intensive as compared with Basel I. It marked a completely new approach to measurement of capital adequacy with revised market risk framework and inclusion of operational risk. On the other hand, Basel III capital framework has two dimensions (i) Micro-prudential and (ii) Macro-prudential. Microprudential elements are essentially similar to Basel II, but completely revised (or under revision) to address the shortcomings observed during the crisis. Most of these revisions have been introduced in supersession of particular paragraphs of Basel II such that those provisions of Basel II remain no longer valid as an international standard. Implementing Basel II in such a situation would mean implementing a superseded international standard with known weaknesses, which is not likely to be seen as a positive move by the market. 6. The macro-prudential elements of Basel capital framework are considered an integral part of the capital framework for financial entities to protect them from the harmful effects of the systemic crises. Not extending this framework to the AIFIs would expose them to the macro-prudential shocks. II. Leverage Ratio Existing regulation 7. Under the current Resource Raising Norms (Master Circular DBR.No.FID.FIC.1/ / dated July 1, 2015), the AIFIs can borrow up to 10 times of their Net Owned Funds (NOF). Revised regulation 8. Minimum Basel III Leverage Ratio equal to 6% computed as ratio of Tier I capital to Total Exposure. The rules governing the computation of the exposure measure shall be the same as for banks (Master Circular DBR.No.BP.BC.1/ / dated July 1, 2015) with modifications indicated in paragraph 2 of Part A of Annex II. Consequently, the Master Circular DBR.No.FID.FIC.1/ / dated July 1, 2015 stands withdrawn The fall in the leverage ratio of the AIFIs from their current levels shall be constrained by not more than 2% each year until it declines to 6%. 1 This circular deals with limit on borrowings linked to the Net Owned Funds of the AIFIs, Umbrella Limit and related matters. Umbrella Limit also stands withdrawn as indicated in paragraph 38 of this circular.

5 3 Rationale 10. The extant limit on the borrowings of the AIFIs linked to their Net Owned Funds suffers from the following limitations: (i) It fails to capture the contingent liabilities and off balance sheet exposures of the AIFIs exposing them to the risk of breaching the limit as the contingent liabilities devolve and are funded by the on-balance sheet liabilities. (ii) It has no scientific basis and has been found to be constraining the asset growth of some of the AIFIs apart from compelling them to maintain a high level of capital despite their low risk profile. (iii) Basel III Leverage Ratio serves two objectives: (i) Constraining the build-up of leverage in the banking sector, helping avoid destabilising deleveraging processes which can damage the broader financial system and the economy; and (ii) To reinforce the risk based requirements with a simple, non-risk based backstop measure. Unlike this, the existing limit on borrowings only controls the leverage. Besides, since it is not calibrated in relation to the risk weighted assets density, it is not capable of acting as an effective counter-cyclical measure. III. Liquidity risk framework Existing Regulation 11. There is no liquidity risk standard for the AIFIs at present. However, RBI has issued instructions to AIFIs on asset liability management through structured liquidity statements vide circular Asset-Liability Management (ALM) System (Circular DBS.FID.No.C.11/ / dated December 31, 1999). This is mostly in the nature of guidance rather than a regulatory requirement. Revised regulation 12. The revised new liquidity risk framework - Liquidity Risk Coverage (LRC) - for the AIFIs is primarily based on regulatory prescriptions for minimum positive cumulative cash flow gaps upto 90 days. The framework is outlined in paragraph 1 of Part B of Annex II. The main elements of the LRC are as follows: (i) Cash Flow Gap limits 13. The AIFIs shall monitor the cumulative cash flow mismatches over different maturity buckets regularly and observe the following gap limits. (a) Regulatory limits Period Cumulative gaps 0-14 days Minimum positive gap equal to 25% of cash outflows

6 days Minimum positive gap equal to 20% of cash outflows 0-90 days No negative gap (b) Internal limits 14. The AIFIs shall prescribe internal gap limits with the approval of their boards for cumulative cash flow mismatches beyond 90 days upto one year. (ii) Treatment of Lines of Credit (LOCs) 15. Under Basel III- Liquidity Coverage Ratio (LCR) framework for banks, the LOCs availed by banks are deemed non-available for the purpose of computing cash inflows, as it is assumed that when a financial system is under stress, other institutions may fail to honour their commitments under LOC. However, as explained above, the liquidity risk framework for AIFIs is not intended to be calibrated for the same stress levels as applicable to banks. Therefore it is considered appropriate to treat the LOCs sanctioned by banks or any other financial institution available to the AIFI albeit, with a haircut. The Board of Directors of individual AIFIs shall determine the haircuts to be applied to the LOC taking into account various factors that might suggest the non-availability of LOC, full or partial, when required. (iii) Funding the required minimum positive gap 16. The AIFIs can fund the required minimum positive gap by a combination of excess of normal cash inflows over the cash outflows, Government securities and LOCs, subject to the conditions set out below: a. Stock of Central Government Securities 17. In cases where the normal cash inflows (i.e. cash flows excluding LOCs) are not sufficient to meet the minimum requirement of positive gaps as given in paragraph 6.4(i)(a) [Please see paragraph 1 of Part B of Annex II], the AIFI shall maintain a stock of liquid Central Government securities upto 5% of cash outflows (other than that maturing within 28 days). The procedure to calculate the requirement of maintaining the central government security is explained in Appendix A. b. LOC 18. If the normal cash flow excluding the LOCs is zero or positive, there shall be no minimum requirement of LOC or stock of government securities. However, as the normal cash flow turns negative, the minimum funding requirement in terms of government securities arises. However, it is capped to 5% of cash outflows and the remaining gap can be met with LOCs. The AIFIs shall also be free to hold stock of government securities of more than 5%. Rationale 19. Prior to the global financial crisis, no regulatory standard existed on the liquidity risk management by banks and other financial institutions. In India also we did not have any regulatory

7 5 requirement for banks and financial institutions with regard to liquidity risk management. However, RBI has issued instructions to both banks and AIFIs on asset liability management through structured and dynamic liquidity statements. This is mostly in the nature of guidance rather than a regulatory requirement. 20. The financial crisis underscored the need for the sound management of liquidity risk by banks and other financial entities. BCBS has formulated two liquidity standards for banks namely, Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). Of these, LCR has already been applied to banks with effect from January 1, The objective of the LCR is to ensure minimum amount of High Quality Liquid Assets (HQLA) in relation to the net cash outflows of a bank measured over a period of 30 days under stress situation. 21. RBI has implemented the LCR standards for banks with effect from January 1, However this has not been extended to the AIFIs. It is proposed not to extend the LCR standard to the AIFIs as a study undertaken by RBI showed that given very different business models of the four AIFIs, significant variations of the net cash outflows over a financial year, mandating a bank-like LCR standard for AIFIs maybe onerous for them. Further, in view of greater predictability and stability of the cash flows of the AIFIs as compared with those in case of banks, the cash outflows and inflows need not be measured at the same stress level as in the case of the banks. Nevertheless, the AIFIs, would still have some amount of liquidity risk associated with the secured and unsecured wholesale funding which is available and the possible draw down of the committed lines of credit over a target horizon. In addition, unlike banks, the AIFIs also do not maintain liquidity reserves in the form of SLR securities. Therefore, it would be necessary to have a regulatory framework to take care of the liquidity risks faced by the AIFIs. IV. Prudential limits a) Exposure Norms Existing regulation 22. The AIFIs exposures to a single borrower and a group of borrowers are limited to 15% and 40% of capital funds, respectively on par with banks (Master Circular DBR.FID.FIC.No.4/ / dated July 1, 2015). However, the refinance portfolio, which forms a major chunk of the operations of AIFIs, has been exempted from these limits while advising them to set their Board-approved limits for the same. In addition, there are limits on exposure to NBFCs on individual and aggregate basis. Revised regulation 23. The instructions on exposure to NBFC have been aligned with those applicable to banks. The mentioned circular is applicable with modifications as outlined in paragraph 2 of Part B of Annex II.

8 6 Rationale 24. Exposure limits are one of the fundamental tools to manage credit concentration risk. From the perspective of risk management, the AIFIs should attract lower exposure limits as compared with banks due to high sectoral concentration of their credit portfolios. However, this issue shall be dealt under Pillar 2 of capital framework rather than through lower exposure limits. b) Significant investment in non-financial/commercial enterprises 2 Existing regulation 25. No regulation is in place regarding the AIFI s significant equity investments in commercial enterprises. However, by practice, AIFIs have been discouraged to make significant equity investment in commercial enterprises unless these are mandated by their statutes. Revised regulation 26. The Exposure Norms for the AIFIs (Master Circular DBR.FID.FIC.No.4/ / dated July 1, 2015) shall be modified as outlined in paragraph 2.3 of Part B of Annex II. 27. Under Basel III, significant investments in commercial enterprises (exceeding 10% of the investee company s equity) are subject to 100% capital charge. This shall be applicable to the AIFIs as well, except where the investment is mandated by the statute. Rationale 28. Though the limit placed by RBI is not a Basel requirement, it has served a useful purpose. Under Basel III, such investments in excess of 10% of an investing bank s equity shall be deducted from its equity. In general, therefore, as in the case of banks, it is not desirable for the AIFIs to invest in the commercial enterprises due to high possibility of conflict of interest, their high illiquidity and high risk. However, when the equity investments are mandated in the statute in accordance with the objectives of the institutions, higher limits can be allowed. c) Significant equity investments in the financial entities Existing regulation 29. There is no regulation in place for equity investment by the AIFIs in their subsidiaries, joint ventures, associates and other financial services entities. By practice, the limits as applicable to banks have been applied. In the case of banks, these investments are restricted to 10% of the bank s paid up capital and reserves in a single entity and upto 20% of its paid up capital and reserves in all 2 For the purpose of this Circular, investment exceeding 10% of equity of the investee company shall be treated as significant investment.

9 7 financial entities including subsidiaries (Master Direction on Financial Services provided by Banks DBR.FSD.No.101/ / dated May 26, 2016). Revised regulation 30. The AIFIs strategic investments shall not be subject to any regulatory limit and the AIFIs may formulate their own Board-approved policies in this regard. The Master Direction on Financial Services for Banks (DBR.FSD.No.101/ / dated May 26, 2016) shall be modified as outlined in paragraph 3 of Part A of Annex II. Rationale 31. The intent of this regulation is to ensure that banking continues to be a bank s predominant activity. While limited diversification into other financial activities may be useful to manage volatility in the earnings of the group, substantial engagement in non-core areas could potentially distract the bank s board and management from banking business, affecting the safety and soundness of the bank. However, these concerns are not significant in the case of the AIFIs and so long as the investee entities are operating in the areas permissible under the AIFIs governing Act, there is no need for a regulatory limit, although RBI s prior permission for making such investments above a cut-off would be necessary. d) Capital Market Exposure (CME) Existing regulation 32. The aggregate exposure of an AIFI to capital market in all forms (both fund based and nonfund based) should not exceed 40 per cent of its net worth as on March 31 of the previous year (Master Circular DBR.No.FID.FIC.3/ / dated July 1, 2015). Within this overall ceiling, the AIFI s direct investment in shares, convertible bonds / debentures, units of equity-oriented mutual funds and all exposures to Venture Capital Funds (VCFs) [both registered and unregistered] should not exceed 20 per cent of its net worth. Given SIDBI s special mandate, its direct investment in shares, convertible bonds / debentures, units of equity-oriented mutual funds and all exposures to Venture Capital Funds (VCFs) [both registered and unregistered] has been permitted upto 40 per cent of its net worth within the overall ceiling. Revised regulation 33. Direct CME (treasury investments) should not exceed 10% of net worth of the AIFIs. This limit shall not include significant investments and other non-significant strategic investments made as part of equity financing for which there is no limit. Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by FIs- (Master Circular DBR.No.FID.FIC.3/ / dated July 1, 2015) would be applicable with modifications proposed in paragraph 2.3 of Part B of Annex II.

10 8 Rationale 34. Generally, the AIFIs, unlike banks, need not invest in equity as part of their treasury operations. However, they may like to do so as part of diversification strategy. So a small limit of 10% of Net Worth may be appropriate for such investments. (e) Investments in liquid/ short term debt schemes of mutual funds Existing regulation 35. The limit for investment by AIFIs in Non-Government Debt Securities, viz. 10 per cent of the AIFIs' total investment in debt securities, did not apply to money market mutual funds.(master Circular DBR.No.FID.FIC.3/ / dated July 1, 2015) Revised regulation 36. With effect from April 1, 2023, the total investment by AIFIs in liquid/short term debt schemes (by whatever name called) of mutual funds with weighted average maturity of not more than one year, shall be subject to a prudential cap of 10 per cent of their Net Worth as on March 31 of the previous year. Also, the AIFI s investments in unlisted non-government debt Securities, including in the liquid/ short term debt schemes of mutual funds, shall not exceed 10% of its total investment in non- Government debt securities. Rationale 37. The limit for banks in respect of the investments in liquid/ short term debt schemes of mutual funds was imposed from the perspective of systemic risk issues that arise from investments made by banks for short term liquidity management. In particular, sudden withdrawal by banks from the mutual funds during periods of liquidity stress in the market could lead to liquidity drying up for these mutual funds. The same concerns exist even for the AIFIs. However, given that some AIFIs actively use mutual funds for short term liquidity management, it has been decided to allow a five years period for AIFIs to reach the 10 per cent limit. f) Borrowings through specified instruments ( Umbrella Limit) Existing regulation 38. Currently, under the Umbrella Limit, the AIFIs can borrow upto 100 per cent of their Net Owned Funds (NOF) through five instruments viz., term deposits, term money borrowings, certificates of deposits (CDs), commercial papers (CPs) and inter-corporate deposits (ICDs). Revised regulation 39. No limit on borrowings through specified instruments.

11 9 Rationale 40. There shall be no limit on the AIFIs short-term borrowings in view of the revised LRC framework (Please see paragraph 12 above). The gap-based limits shall provide a better alternative to the existing framework. V. Risk Management Guidelines a) Credit risk management Existing regulations 41. No specific guidelines have been issued to the AIFIs on credit risk management as yet. Revised regulations 42. It is proposed to issue the same guidelines on credit risk management systems as applicable to Scheduled Commercial Banks (Circular DBOD.No.BP.520/ / dated October 12, 2002) with suitable modifications as indicated in paragraph 4.1 of Part A of Annex II to take care of the additional risks in the AIFIs balance sheets and excluding the portions which are not relevant to them. Rationale 43. A peculiarity of the credit portfolios of AIFIs is that unlike in the case of banks, the exposures tend to be large. A significant part of the portfolio consists of institutional borrowers, such as credit institutions, state governments, government agencies etc. It is felt that the risk management guidelines prescribed for banks shall work well for AIFIs as well, however emphasis should be on risks associated with lending to credit institutions, state governments, government agencies and risks associated with project finance. b) Market risk management and Asset Liability Management Existing regulations 44. No specific guidelines have been issued to the AIFIs on market risk management and Asset Liability Management (interest rate risk) as yet. Revised regulations 45. The guidelines as applicable to Scheduled Commercial Banks shall apply to the AIFIs for market risk management (Circular DBOD.No.BP.520/ / dated October 12, 2002) (paragraph 4.2 of Part A of Annex II) and for Asset Liability Management (interest rate risk) (Circular DBOD. No. BP. BC. 59 / / dated November 4, 2010) (paragraph 4.3 of Part A of Annex II).

12 10 Rationale 46. The market risk and interest rate risk management practices are exposure-specific and applicable to any institution which has these exposures. As the AIFIs also have market risk and interest rate risk in the banking book, the guidelines which already exist for banks can apply to the AIFIs. c) Operational Risk Management Existing regulations 47. No specific guidelines have been issued to the AIFIs on operational risk management as yet. Revised regulations 48. It is proposed to issue the same guidelines as applicable to Scheduled Commercial Banks for operational risk management (Circular DBOD.No.BP.BC.39/ / dated October 14, 2005) (paragraph 4.4 of Part A of Annex II). Rationale 49. Like any other financial institution, AIFIs also have operational risk. We are also issuing guidelines on capital charge for operational risk as mentioned in paragraph 2 above. Therefore, it is appropriate to issue guidelines to AIFIs on operational risk management with suitable modifications. d) Stress Testing Existing regulation 50. Currently, no guidelines exist for stress testing for the AIFIs. Proposed regulation 51. Guidelines based on similar guidelines on stress testing applicable to banks (Circular DBOD.BP.BC.No.75/ / December 2, 2013) shall be applicable to the AIFIs with modifications as mentioned in paragraph 4.5 of Part A of Annex II. The guidelines would, inter alia, cover appropriate methodologies for stress testing the risk factors that are most relevant for the individual AIFIs taking into account their sector-specific portfolios. Rationale 52. Stress testing is an integral part of risk management for any financial institution. Apart from getting a sense of the right amount of capital needed in a stress situation, it also helps the institutions to rebalance their portfolios and introduce appropriate risk management controls to survive in a stress scenario. Therefore, stress testing guidelines are considered necessary for the AIFIs.

13 11 e) Liquidity risk management Existing regulation 53. Existing guidelines on liquidity risk management (Circular DBS.FID.No.C.11/ / dated December 31, 1999) were issued to the AIFIs as part of the ALM guidelines. Proposed regulation 54. Liquidity risk management guidelines based on those applicable to banks (Circular DBOD.BP.No.56/ / dated November 7, 2012) shall apply to the AIFIs, with modifications as indicated in para 4.6 of Part A of Annex II. However, the same shall be fine-tuned to account for business profile of each of these institutions which differ from commercial banks as well as within the AIFI group. Also, since Basel III Liquidity Coverage Ratio is not being extended to AIFIs, the revised regulation prescribes certain gap limits. RBI s instructions dated November 07, 2012 on detailed liquidity risk management for banks cover principles for the management and supervision of liquidity risk, governance structure, measurement and management of liquidity risk, including disclosure. These guidelines are shall be made applicable to the AIFIs with suitable modifications as indicated in paragraph 4.6 of Part A of Annex II. Rationale 55. AIFIs being financial entities also face liquidity risk. Therefore, it is appropriate to issue guidelines to AIFIs on liquidity risk management with suitable modifications. f) Strategic and reputational risk management Existing regulation 56. At present no specific regulation exists for management of strategic and reputational risk. Revised regulation 57. The guidance for banks on these topics is contained in Pillar II of the capital adequacy framework (Master Circular DBR.No.BP.BC.4./ / dated July 1, 2015). These guidelines shall be extended to AIFIs with modifications as mentioned in paragraph 4.7 of Part A of Annex II. Rationale 58. AIFIs are important financial institutions which are expected to play an important role in furthering the economic development of the country through various initiatives, most of which involve frequent introduction of new products, new strategies and implementation of new projects. Some of the programmes are implemented as part of Government s initiatives. Considering these aspects, it is necessary that the AIFIs are conscious about the resultant strategic and reputational risks.

14 12 VI. Impact study 59. RBI has carried out a quick impact study. It shows that the present level of capital of most of the AIFIs shall be adequate to support the Basel III capital requirement. In fact, the capital ratios for three AIFIs shall improve if Basel III risk weights are applied. 60. In case an AIFI s capital is insufficient to meet the minimum requirement on the date of introduction of the Basel III framework, it shall be allowed time upto 2 years to achieve the minimum requirement. VII. Other regulations 61. The review of the remaining regulations will be undertaken as part of the issuance of Master Directions which largely involves consolidation of the existing instructions. We do not expect any significant changes in those directions. However, in case some changes in those instructions become necessary, the AIFIs will be given an opportunity to provide feedback before finalisation thereof. The AIFIs have already been consulted on the Master Directions on Disclosure Norms, Exposure Norms, Prudential Norms for Classification, Valuation and Operation of Investment Portfolio and Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances.

15 13 Appendix 1 Prudential requirements - Capital Pillar 1 Minimum Requirement Capital Capital conservation buffer Countercyclical capital buffer Pillar 2 Pillar 3 Capital Measurement Approaches Credit Risk Existing RBI directions Basel I Parameters of proposed revised directions Basel III 9% Total capital 9% Minimum 4.5% Tier 1 7% No minimum requirement Common Equity 5.5% Tier 1 Additional Tier 1 1.5% Not more than 50% of Tier 2 2% total capital Definition of capital Same as for banks Eligibility criteria for instruments Same as for banks Point of Non- Viability criteria Same as for banks No requirement under 2.5% Basel I No requirement under 0-2.5% ( as and when put in place) Basel I No requirement under Same as for banks Basel I No requirement under Same as for banks Basel I A simplified approach with three risk weights Exposure to sovereigns-0%, Exposure to banks - 20%, All other assets 100% Basel II Standardised Approach for credit risk which shall be replaced by Basel III Standardised Approach for credit risk along with commercial banks in due course. Market Risk The 1996 amendment of Basel I introducing capital requirements for market risk has been not made applicable to the AIFIs. Operational risk No operational risk capital requirements under Basel I Additional risk weights would be considered for foreign assets with risk mitigations based on their expected performance. Basel II Standardised Approach for market risk shall be implemented until April 1, 2019 at which time it would be replaced by Basel III version of the market risk approach as for banks. Basel II Standardised Approach for operational risk which shall be replaced by Basel III Standardised Approach for operational risk along with commercial banks in due course

16 Annex II Part A: Bank circulars extended to the AIFIs subject to specific instructions Sl. Specific instructions for the AIFIs No. 1. Capital to Risk Weighted Assets Ratio (CRAR) Basel III Capital Regulations- Master Circular DBR.No.BP.BC.1/ / dated July 1, 2015 will apply with the following modifications. 1.1 The following instructions may be read after paragraph of the circular Capital instruments already issued by the AIFIs which no longer qualify under Basel III will be allowed to be counted as Tier 1 or Tier 2, as the case may be, as per the existing rules until their maturity or the first call date. In the case of any perpetual instruments without call option, these will cease to be counted towards capital after April 1, All capital instruments issued by AIFIs after the date of this circular (circular Reference dated December, 2016) shall comply with the requirements set out in Master Circular DBR.No.BP.BC.1/ / dated July 1, Paragraph to be read as under All investments made by the AIFIs in the paid-up equity of non-financial entities (other than subsidiaries) made under their statutory mandate which exceed 49% of the issued common share capital of the issuing entity or where the entity is an unconsolidated affiliate as defined in paragraph (C)(i) shall receive a risk weight of 1250% 1. Equity investments equal to or below 49% paid-up equity of such investee companies shall be assigned a 125% risk weight or the risk weight as warranted by rating or lack of it, whichever higher. An AIFI can hold up to 49% of equity of a company as a pledgee. However, if the AIFI ends up acquiring this in satisfaction of its claims, it shall be brought down below 10% limit within 3 years. In the event of failure to comply with this requirement, the entire exposure shall receive a risk weight of 1250%. 1.3 The following instructions may be read after paragraph of the circular Foreign assets of the AIFIs guaranteed by Central Government may be appropriately risk weighted taking into account the risks 1 Equity investments in non-financial subsidiaries will be deducted from the consolidated / solo bank/ AIFI capital as indicated in paragraphs /

17 2 inherent in such exposures. AIFIs may formulate a policy with the approval of their Board in this regard. 1.4 The following instructions may be read after paragraph of the circular At their discretion, the AIFIs not having complex derivatives or options in their trading book, can calculate the market risk capital charge on their trading book exposures using a MS-Excel based calculator which can be obtained from the RBI on request. 1.5 Paragraph to be read as under The AIFIs shall adopt the Basic Indicator Approach (BIA) for calculating the Operational Risk capital charge. 1.6 The following instructions may be read after paragraph 13.6 of the circular Typically, the AIFIs are sector-specific institutions and have a relatively limited scope for diversifying their assets portfolio. As a result, as compared with banks these institutions have higher credit concentration risk. The ICAAPs prepared by these institutions must address this risk. One way to reduce overall credit concentration risk faced by the AIFIs is to limit their single name concentration by choosing to adopt lower large exposure limits. In addition, the AIFIs could consider diversifying their credit portfolios along the following dimensions: (i) Geographical spread within the country (ii) Domestic/ International/ across countries (e.g. in case of EXIM Bank) (iii) Industry segment (iv) Direct Lending/ Refinance (v) Production Credit/ Marketing Credit/ Investment Credit (e.g. in case of NABARD) (vi) Microfinance/ SMEs/ Mid-corporate/ Large Corporates (vii) Public Sector/ Private Sector Borrowers (viii) Financial sector entities- Public Sector Banks/ Private Sector Banks/ RRBs/ Cooperative Banks, etc. (ix) Residential/ Commercial Real Estate (e.g. in case of NHB) The sectoral concentration risk and the risk arising from the above mentioned dimensions of credit concentration of the individual AIFI will be specifically evaluated under SREP and the AIFI may be required to hold additional capital to mitigate this risk. 1.7 Footnote to paragraph Paragraph will not be applicable to the AIFIs considering their statutory nature.

18 3 2. Leverage Ratio Basel III Capital Regulations- Master Circular DBR.No.BP.BC.1/ / dated July 1, 2015 will apply with the following modifications Paragraph to be read as under In the case of AIFIs, the leverage ratio will be 6% from April 1, 2018 and will be reviewed after the final rules for banks are finalized by the Basel Committee by end Considering its current capital level, EXIM Bank shall comply with the requirement of leverage ratio of 6% not later than April 1, Significant equity investments in the financial entities Reserve Bank of India (Financial Services provided by Banks) Directions, Master Direction/DBR.FSD.No.101/ / dated May 26, 2016 will apply with the following modifications. Paragraph 5 to be read as under Prudential Regulation for Investments AIFIs shall formulate policies, with the approval of their Board of Directors, covering the following aspects of investments in financial entities to the extent these are not covered under the cross holding limits prescribed by RBI vide circular DBR.FID.FIC.No.4 / / dated July 1, 2015: (i) Limits in terms of percentage of the paid up capital and reserves of the AIFI a. Investment in equity of a single financial services entity which is not an affiliate of the AIFI b. Aggregate investment in equity of all financial services entities which are not affiliate of the AIFI c. Aggregate investment in equity of all financial services entities including the affiliates of the AIFI d. The aggregate of equity investment in factoring subsidiaries and factoring companies e. Investment in equity of a single deposit taking NBFC f. Equity/Units of a venture capital fund (VCF)/Category I Alternate Investment Fund (AIF-I).

19 4 (ii) Requirement for approval of Reserve Bank of India No AIFI shall, without the prior approval of RBI, make: (i) Investment in a subsidiary and a financial services company that is not a subsidiary. Provided that such prior approval shall not be necessary in the following circumstances: a. The investment is in a company engaged in financial services; and b. The AIFI has CRAR of 10 per cent or more as at the close of the immediate preceding financial year and has also made a net profit in that immediate preceding financial year; and c. The shareholding of the AIFI including the proposed investment is less than 10 per cent of the investee company s paid up capital; and d. The aggregate shareholding of the bank along with shareholdings, if any, by its subsidiaries or joint ventures or other entities is less than 20 per cent of the investee company s paid up capital. (ii) Investment in a non-financial services company in excess of 10 percent of such investee company s paid up share capital. 4. Risk Management Guidelines 4.1 Guidance Note on Credit Risk Management- Circular DBOD.No.BP.520/ / dated October 12, 2002 will apply with the following modifications Title of paragraph 5 to be read as under Para 5 - Managing credit risk in exposure to banks Para 9 and 10.3 No applicable The following instructions may be read after Chapter 10 of the circular: Please see Appendix F

20 5 4.2 Guidance Note on Market Risk Management- Circular DBOD.No.BP.520/ / dated October 12, 2002 will apply with the following modifications Chapter 1: Policy Framework Fully applicable Chapter 2: Organizational setup Fully applicable Chapter 3: Liquidity Risk Management- Not applicable Chapter 4: Interest Rate Risk Management: Not applicable Chapter 5: Foreign Exchange Risk Management Fully applicable Chapter 6: The Treatment of Market Risk in the Proposed Basel Capital Accord- Not applicable Annex I: BCBS Principles for the Assessment of Liquidity Management in Banks- Not applicable Annex II: BCBS Principles for Interest Rate Risk Management Fully applicable Annex III: Sources, effects and measurement of interest rate risk- Not applicable Annex IV: Value at Risk- Not applicable Annex V: Stress Testing- Not applicable 4.3 Guidelines on Banks Asset Liability Management Framework Interest Rate Risk - (DBOD. No. BP. BC. 59 / / dated November 4, 2010). Fully applicable 4.4 Guidance Note on Management of Operational Risk- Circular DBOD.No.BP.BC.39/ / dated October 14, 2005 will apply with the following modifications. Fully applicable except the guidance that is relevant for Advanced Measurement Approaches (model based approaches) for operational risk. 4.5 Guidelines on Stress Testing- Circular DBOD.BP.BC.No.75/ / December 2, 2013 will apply with the following modifications The following instructions may be read after paragraph of the circular. Stress testing is equally important for banks and AIFIs which may not be using Value at Risk or Economic Capital models for risk measurement. Though these institutions may not be able to use sophisticated, quantitative stress testing techniques, it may still be possible for them to use simpler sensitivity and scenario analysis effectively using normal methods.

21 The following instructions may be read after paragraph 3.1 of the circular. Additional shocks relevant for the AIFIs i. NABARD Shock 10: Impact on direct and indirect exposure (through refinanced banks) to agriculture sector, of drought (less than or equal to 25% deficit in the rainfall), moderate drought (26 to 50% deficit in rainfall) and severe drought (more than 50% deficit in rainfall). This may be further refined by dividing the refinanced banks into three categories, namely: Banks with net income marginally sensitive to performance of agriculture sector. Banks with net income moderately sensitive to performance of agriculture sector. Banks with net income substantially sensitive to performance of agriculture sector. Shock 11: Impact on the resource base of NABARD of fall in the contributions to various funds arising from the banks meeting the Priority Sector Lending targets by financing such loans themselves. Following scenarios can be considered: Contribution to Funds falls by 5% of the total resources. Contribution to Funds falls by 10% of the total resources. Contribution to Funds falls by 15% of the total resources. The impact of the above scenarios on business growth and profitability of NABARD may be assessed. Shock 12: Impact on the liquidity and profitability of NABARD due to a banking crisis. Failure of a major co-operative bank. A major financial crisis in co-operative banking sector that results in simultaneous failure of five or more cooperative banks. Failure of a major private sector bank Failure of a major public sector bank with a bailout from government. Failure of a major public sector bank without bailout from government.

22 7 ii. SIDBI Shock 13: Impact on the resource base of SIDBI of fall in the contributions to various funds arising from the banks meeting the Priority Sector Lending targets by financing such loans themselves. Following scenarios can be considered: Contribution to Funds falls by 5% of the total resources. Contribution to Funds falls by 10% of the total resources. Contribution to Funds falls by 15% of the total resources. The impact of the above scenarios on business growth and profitability of SIDBI may be assessed. iii. EXIM Bank Shock 14: Impact on the profitability of EXIM Bank due to appreciation/depreciation of Indian Rupee of 25% on an annual basis. Shock 15: Sovereign crisis or materialization of political risky events, including imposition of unexpected capital control, in the counterparties nation; Forming 10% of the portfolio of EXIM Bank Forming 15% of the portfolio of EXIM Bank Forming 25% of the portfolio of EXIM Bank. iv. Shock 16: National or international changes in the trade and cross border investment policies including sanctions on India impacting the existing exposures and business projections over next year. Following three scenarios maybe considered: Total volume of trade and cross border investment falls by 10% Total volume of trade and cross border investment falls by 25% Total volume of trade and cross border investment falls by 50% NHB Shock 17: Impact on the resource base of NHB of fall in the contributions to various funds arising from the banks meeting the Priority Sector Lending targets by financing such loans themselves. Following scenarios can be considered: Contribution to Funds falls by 5% of the total resources.

23 8 Contribution to Funds falls by 10% of the total resources. Contribution to Funds falls by 15% of the total resources. The impact of the above scenarios on business growth and profitability of NHB may be assessed. Shock 18: Impact on the profitability of NHB due to fall in housing prices and commercial real estate prices under three scenarios for each. Total fall in prices by 10% Total fall in prices by 20% Total fall in prices by 30% Shock 19: Impact on the liquidity and profitability of NHB due to a crisis in housing finance market. Failure of a major HFC. A major financial crisis in HFC sector that results in simultaneous failure of five or more HFCs.

24 9 4.6 Guidelines on Liquidity Risk Management to banks-rbi No /285/DBOD.BP.No.56/ / will apply with the following modifications Paragraph 20 to be read as under 20. In the case of banks, tolerance levels/prudential limits for various maturities may be fixed by the bank s Top Management depending on the bank s asset - liability profile, extent of stable deposit base, the nature of cash flows, regulatory prescriptions, etc. In respect of mismatches in cash flows in the near term buckets, say up to 28 days, it should be the endeavour of the bank s management to keep the cash flow mismatches at the minimum levels. The AIFIs are required to maintain minimum positive cumulative gaps equal to 25% for maturity upto 14 days, 20% for maturity upto 28 days and 0% for maturity upto 90 days. Depending upon the maturity profile of their assets and liabilities, the likelihood of drawdown of refinance facilities, the possibility of the banks not honouring their LOCs under stress scenarios, the AIFIs may consider maintaining higher positive gaps for period s upto 28 days Paragraph 24 to be read as under 24. Certain critical ratios in respect of liquidity risk management and their significance for banks and AIFIs are given in the Table 1 and 2 below respectively 2. AIFIs may monitor these ratios by putting in place an internally defined limit approved by the Board for these ratios. The industry averages for these ratios are given for information of banks. They may fix their own limits, based on their liquidity risk management capabilities, experience and profile. The stock ratios are meant for monitoring the liquidity risk at the solo bank level. Banks may also apply these ratios for monitoring liquidity risk in major currencies, viz. US Dollar, Pound Sterling, Euro and Japanese Yen at the solo bank level Paragraph 25 to be read as under 25. While the mismatches in the structural liquidity statement up to one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz. say, up to 28 days. AIFIs, however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / Risk Management Committee. For banks, the net cumulative negative 2 Table 2 is given in Appendix G

25 10 mismatches in the domestic and overseas structural liquidity statement (Refer Appendix II - Part A1 and Part B of Liquidity Return ) 3 during the next day, 2-7 days, 8-14 days and days bucket should not exceed 5%, 10%, 15%, 20% of the cumulative cash outflows in the respective time buckets. For AIFIs, there must be minimum cumulative positive gaps equal to 25%, 20% and 0% for 0-14 days days and 0-90 days respectively. Banks may also adopt the above cumulative mismatch limits for their structural liquidity statement for consolidated operations (Appendix II Part C) 3. AIFIs shall also adopt the above cumulative mismatch limits for their structural liquidity statement for consolidated operations Paragraph 27 & 28, 55 Not applicable. & 58 and 67 & Strategic and reputational risk management- Prudential Guidelines on Capital Adequacy and Market Discipline-New Capital Adequacy Framework (NCAF) DBR.No.BP.BC.4./ / dated July 1, 2015 will apply with the following modifications The following instructions may be read after paragraph 13.9 of the circular. Reputational risk management of by the AIFIs In general, the AIFIs do not engage in the structuring and sale of highly innovative financial products that may raise reputational risk concerns due to possible mis-selling to clients. However, the AIFIs that have subsidiaries may be called upon to provide unexpected capital or liquidity support to them in case the latter face financial/ liquidity stress. All the AIFIs are statutory organisations owned by government, RBI and public sector banks. Owing to such ownership structure, the AIFIs activities could potentially have implications for the reputation of the Government and RBI. The AIFIs need to take into account these factors while conducting their affairs The following instructions may be read after paragraph of the circular Strategic risk management for the AIFIs AIFIs may undertake new activities including the ones which are only indirectly related to their statutory mandates. Normally AIFIs would not have prior expertise in these areas. Due care needs to be taken to identify and manage the strategic risks arising from taking new initiatives for e.g. expanding the scope of their refinance activities to new set of institutions, and designing new refinance products, new investment/ financial products, entering into partnership with banks to introduce new products etc. 3 Relevant portion reproduced in Appendix H

26 11 1. Asset-Liability Management ( Liquidity Risk) Part B: Amendments to existing AIFI Circulars Asset-Liability Management (ALM) System- Circular DBS.FID.No.C.11/ / dated December 31, 1999 Paragraph 6.4 to be modified as under 6.4 Liquidity Risk Coverage The global financial crisis underscored the need for the sound management of liquidity risk by banks and other financial institutions. BCBS has formulated two liquidity standards for banks namely Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). Of these, LCR has already been applied to banks with effect from January 1, The objective of the LCR is to ensure minimum amount of High Quality Liquid Assets (HQLA) in relation to the net cash outflows of a bank measured over a period of 30 days under stress situation. A study undertaken by RBI showed that given very different business models of the four AIFIs, significant variations of the net cash outflows over a financial year, mandating a bank like LCR standard for AIFIs maybe onerous for them. Further, in view of greater predictability and stability of the cash flows of the AIFIs as compared with that in case of banks, the cash outflows and inflows need not be measured at the same stress level as in the case of the banks. Nevertheless, the AIFIs, would still have some amount of liquidity risk associated with the secured and unsecured wholesale funding which is available and the possible draw down of the committed lines of credit over a target horizon. In addition, unlike banks, the AIFIs also do not maintain liquidity reserves in the form of SLR securities. Therefore, it would be necessary to have a regulatory framework to take care of the liquidity risks faced by the AIFIs. The liquidity framework for the AIFIs shall be as follows: (i) Cash Flow Gap limits The AIFIs shall monitor the cumulative cash flow mismatches over different maturity buckets regularly and observe the following gap limits.

27 12 (a) Regulatory limits Period Cumulative gaps 0-14 days Minimum positive gap equal to 25% of cash outflows 0-28 days Minimum positive gap equal to 20% of cash outflows 0-90 days No negative gap (b) Internal limits The AIFIs shall prescribe internal gap limits with the approval of their boards for cumulative cash flow mismatches beyond 90 days upto one year. (ii) Treatment of Lines of Credit (LOCs) Under Basel III- LCR framework for banks, the LOCs availed by banks are deemed non-available for the purpose of computing cash inflows, as it is assumed that when a financial system is under stress, other institutions may fail to honour their commitments under LOC. However, as explained above, the liquidity risk framework for AIFIs is not intended to be calibrated for the same stress levels as applicable to banks. Therefore it is considered appropriate to treat the LOCs sanctioned by banks or any other financial institution available to the AIFI albeit, with a haircut. The board of directors of individual AIFIs shall determine the haircuts to be applied to the LOC taking into account various factors that might suggest the non-availability of LOC, full or partial, when required. (iii) Funding the required minimum positive gap The AIFIs can fund the required minimum positive gap by a combination of excess of normal cash inflows over the cash outflows, Government securities and LOCs, subject to conditions set out below: a. Stock of Central Government Securities In cases where the normal cash inflows (i.e. cash flows excluding LOCs) are not sufficient to meet the minimum requirement of positive gaps as given in paragraph 6.4(i)(a), the AIFI shall maintain a stock of liquid Central Government securities upto 5% of cash outflows (other than that maturing within 28 days). The procedure to calculate the requirement of maintaining the central government security is explained in Appendix A.

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