NBFCs - Classification and Regulation for UPSC

Non-bank financial companies have become integral to India's financial landscape. After episodes such as the IL&FS collapse, regulators tightened oversight to avoid systemic risks. The Reserve Bank of India's (RBI) scale-based regulatory framework (SBR) now classifies NBFCs into layers based on size and significance; larger entities face stricter prudential norms. This note explores the various types of NBFCs, highlights regulatory provisions, explains asset classification and provisioning rules, and discusses recent microfinance guidelines. It concludes with exam-oriented facts, practice questions and frequently asked questions to aid UPSC preparation.

Types of NBFCs

NBFCs are registered under the Companies Act and regulated by the RBI under the Reserve Bank of India Act, 1934. The central bank classifies NBFCs based on the nature of their activities and their scale of operations. Understanding these categories is essential as each faces different regulatory requirements.

1. Activity-based classification

• Investment and Credit Company (ICC) - This broad category includes companies engaged in lending (loans and advances), investment in securities and financing activities such as leasing or hire purchase. The earlier sub-categories like loan companies, finance companies and asset finance companies were merged into ICCs to simplify regulations.
• Housing Finance Company (HFC) - Specialised NBFCs that provide housing loans to individuals and developers. They must maintain at least 60 % of their net assets in housing finance and follow the National Housing Bank's guidelines.
• Infrastructure Finance Company (IFC) - Companies financing infrastructure projects. They must deploy at least 75 % of total assets in infrastructure loans and maintain a higher minimum capital adequacy ratio to absorb project-specific risks.
• Infrastructure Debt Fund (IDF-NBFC) - Set up to refinance the long-term debt of completed infrastructure projects. By providing long-term stable funding, IDFs help free up banks' balance sheets for new projects.
• Core Investment Company (CIC) - Parent holding companies that hold at least 90 % of their total assets as investments in shares of group companies and do not trade in these securities. Systemically important CICs (asset size >= Rs.100 billion) face enhanced capital and leverage norms.
• Microfinance Institution (NBFC-MFI) - Companies providing collateral-free loans to low-income households. At least 75 % of their assets must qualify as microfinance loans, defined as loans to households with annual income not exceeding Rs.3 lakh; repayment obligations cannot exceed 50 % of the household's income.
• NBFC-Factor - Firms engaged in factoring of receivables. They buy invoices from businesses at a discount and collect payments from customers, improving the liquidity of small enterprises.
• Mortgage Guarantee Company (MGC) - Guarantee the repayment of housing loans to lenders in case of borrower default. They operate like insurance companies but are regulated by the RBI.
• Standalone Primary Dealer (SPD) - Specialised institutions that underwrite and make markets in government securities. Their primary role is to support the government securities market.
• Non-operative Financial Holding Company (NOFHC) - A holding company that controls a bank and other financial entities. It cannot engage in any other business and must maintain strict ring-fencing to protect bank depositors.
• Account Aggregator (NBFC-AA) - Technology-driven entities that consolidate financial information from multiple sources and share it with customer consent. They are key enablers of open banking and financial data portability.
• Peer-to-Peer Lending Platform (NBFC-P2P) - Online platforms that match lenders with borrowers. They cannot mobilise public funds themselves and must maintain escrow arrangements to safeguard investors.

2. Deposit-taking vs. non-deposit-taking NBFCs

NBFCs are also categorised based on their ability to accept deposits:

3. Scale-Based Regulatory Framework

In October 2021 the RBI introduced the scale-based regulatory (SBR) framework, effective from 1 October 2022, to calibrate regulation based on an NBFC's size, complexity and systemic importance. The SBR places entities into four layers:

1. Base Layer (NBFC-BL) - Comprises non-deposit-taking NBFCs with asset size below Rs.1,000 crore, NBFC-P2P, NBFC-AA, NBFC-NOFHC and those without public funds or with limited customer interface. They face the least intrusive regulation but must maintain minimum net owned funds of Rs.10 crore.
2. Middle Layer (NBFC-ML) - Includes deposit-taking NBFCs, non-deposit-taking NBFCs with assets >= Rs.1,000 crore, housing finance companies, infrastructure finance companies, core investment companies, and standalone primary dealers. They are deemed systemically important and must adhere to stricter prudential norms such as a minimum capital adequacy ratio (CRAR) of 15 %, enhanced governance requirements and concentration limits.
3. Upper Layer (NBFC-UL) - Consists of the top 10 non-bank lenders by asset size and any other NBFC that the RBI believes poses systemic risk. They must meet even higher capital, governance and disclosure standards, including differential asset classification (90-day NPA norm) ahead of others. Currently around 15-16 NBFCs, including groups like LIC Housing Finance and Bajaj Finance, fall in this layer.
4. Top Layer (NBFC-TL) - This layer is envisaged for exceptional circumstances when the RBI identifies an NBFC in the upper layer that warrants significantly higher regulatory intervention; ideally it remains empty.

The SBR acknowledges that not all NBFCs pose equal risks. By calibrating norms such as capital adequacy, corporate governance, exposure limits and supervision frequency, the framework seeks to preserve financial stability without stifling innovation in smaller firms.

Regulatory Provisions for NBFCs

NBFCs must register with the RBI before commencing operations if they carry on financial activity (i.e., their financial assets constitute more than 50 % of total assets and income from financial assets accounts for more than 50 % of total income). Key regulatory aspects include:

• Capital Adequacy Requirements - Systemically important NBFCs must maintain a minimum capital to risk-weighted assets ratio (CRAR) of 15 %. For CICs and IDF-NBFCs the requirement may vary (up to 30 %). Higher layers under the SBR face stricter capital buffers to absorb potential losses.
• Leverage and Liquidity - Upper layer NBFCs must maintain a minimum leverage ratio of 5 %. They are also required to implement a liquidity risk management framework, including maintenance of a Liquidity Coverage Ratio (LCR) similar to banks over a phased manner.
• Exposure norms - NBFCs cannot lend more than 25 % of their owned funds to a single borrower (30 % in case of infrastructure finance companies) and must adhere to exposure limits on investments in capital markets, real estate and subsidiaries.
• Corporate governance - Larger NBFCs must appoint independent directors, form audit committees and risk management committees, rotate auditors periodically and comply with fit and proper criteria for directors.
• Fair Practices Code - NBFCs must ensure transparent loan terms, avoid coercive recovery, clearly communicate interest rates, and implement grievance redressal mechanisms. They must not offer products tied to unrelated goods or services and need to provide a cooling-off period for borrowers.
• Parallel Banking Prohibition - NBFCs cannot accept demand deposits or issue cheques drawn on themselves. They also cannot underwrite new issue of securities or provide facility for draw down of funds like banks.
• Returns and Supervision - All NBFCs file periodic returns on their financial position, deposit acceptance, asset quality and risk exposure. The RBI conducts on-site inspections and off-site surveillance; entities in the middle and upper layers are inspected annually or biennially.

The stringent norms have resulted in some NBFCs surrendering licenses. According to a 2024 analysis, the number of registered NBFCs declined from 9,443 in March 2023 to around 9,306 by June 2024 as the RBI cancelled registrations of dormant firms and penalised irregularities. Nevertheless, the sector's asset base has expanded rapidly, with assets under management expected to exceed Rs.48 lakh crore (Rs.48 trillion) by 2025 and credit growth projected at 15-17 % annually up to 2028.

Asset Quality and Provisioning Norms

Lending risk is central to NBFC regulation. The RBI prescribes prudential norms on income recognition, asset classification and provisioning. Understanding these norms is crucial for evaluating NBFC health.

1. Special Mention Accounts (SMA)

Accounts showing early signs of stress are classified as Special Mention Accounts before they slip into non-performing assets (NPAs). NBFCs must report SMAs to the central bank to facilitate monitoring and prevent contagion. The categories are:

• SMA-0: Principal/interest overdue up to 30 days. Although still standard, lenders must monitor these accounts closely.
• SMA-1: Overdue for more than 30 days but less than or equal to 60 days. According to the RBI's framework, such accounts warrant follow-up and early recovery action.
• SMA-2: Overdue for more than 60 days but less than or equal to 90 days. Intensified recovery efforts are required to prevent slippage into NPA.

2. Non-Performing Assets (NPAs)

An asset becomes non-performing when interest or principal remains overdue for more than 90 days (120 days for certain microfinance loans during transition). NBFCs must classify NPAs further:

• Sub-standard assets - Assets that remain non-performing for less than or equal to 12 months. They carry a higher risk of default but have some recovery prospects.
• Doubtful assets - NPAs that remain sub-standard for 12 months. Recovery becomes uncertain, so provisioning requirements increase.
• Loss assets - Assets identified by the auditor or RBI as uncollectible. They must be fully written off or provided for.

The RBI is moving NBFCs towards the 90-day overdue norm already applied to banks. Earlier, some categories of NBFCs used a 120-day or 150-day threshold, but by 31 March 2024 most have transitioned to 90 days. Upgradation from NPA to standard category requires full payment of overdue amounts.

3. Provisioning Requirements

Provisioning is the process of setting aside funds to cover potential loan losses. For general NBFCs, the RBI mandates minimum provisions on NPAs depending on their classification. For NBFC-MFIs, additional norms apply:

• General provisioning - All standard assets require a provision of 0.25 - 1 % depending on the asset class. For housing finance loans, the rate may be 0.4 %.
• Sub-standard assets - Provision of 10 % of the outstanding amount; 20 % if the asset is unsecured.
• Doubtful assets - 100 % provision for the unsecured portion; for the secured portion, 20 % if doubtful for up to one year, 30 % if for one to three years and 50 % thereafter.
• Loss assets - 100 % provision; such assets are essentially written off.
• Microfinance provisioning - NBFC-MFIs must make provisions equal to 50 % of the aggregate instalments overdue for 90-180 days and 100 % of instalments overdue for more than 180 days, with a general provision of 1 % on the outstanding portfolio.

The latest Financial Stability Report (June 2025) highlights an improvement in asset quality: NBFC gross NPA ratio declined to around 4.2 %, and capital adequacy stands at a comfortable 22 %. However, some NBFCs catering to micro, small and medium enterprises (MSMEs) still face elevated defaults due to pandemic-induced stress.

Microfinance: Collateral-Free Lending

The microfinance sector witnessed major regulatory changes in 2022 and 2023. With over 10 crore borrowers, microfinance loans are a key tool for financial inclusion. Important features include:

• Definition of microfinance loan - A loan (secured or unsecured) to a household with annual income up to Rs.3 lakh. All collateral-free loans to such households, regardless of end-use, are classified as microfinance loans. Loans backed by hypothecation of vehicles or gold are not treated as microfinance.
• Repayment cap - The aggregate monthly loan obligations of a household across all lenders must not exceed 50 % of monthly income. Lenders must obtain income assessment documents or rely on self-declarations and should not use expected income when computing this ratio.
• Pricing freedom - The RBI removed the 24 % cap on interest rates for NBFC-MFIs. Lenders can set competitive rates but must disclose their pricing methodology and margin cap (currently 10 % over cost of funds) in a format easy for borrowers to understand.
• Credit bureau reporting - All microfinance loans must be reported to credit bureaus within a day of disbursal. This prevents over-indebtedness and enables lenders to check borrowers' existing obligations.
• Customer protection - NBFC-MFIs must conduct doorstep service, provide clear loan sanction letters and avoid collection practices that embarrass or intimidate borrowers.

These reforms have spurred strong growth in microfinance. The sector's loan portfolio crossed Rs.3 lakh crore in 2024 and is expected to expand due to rising demand from women entrepreneurs and self-help groups. However, high interest rates and group lending structures continue to pose reputational risks. Aspirants should be aware of debates around borrower protection and the role of MFIs in the overall credit architecture.

NBFCs in India's Financial System: Trends and Challenges

NBFCs complement banks by extending credit to sectors often neglected by traditional lenders-such as micro, small and medium enterprises (MSMEs), used-vehicle financing, consumer durables, and affordable housing. Their ability to innovate and to deliver last-mile credit has enabled India's credit-to-GDP ratio to rise. Key trends include:

• Rapid asset growth - NBFC credit doubled from about Rs.24 lakh crore in 2021 to Rs.48 lakh crore by March 2025. CRISIL and ICRA project assets under management to exceed Rs.60 trillion by FY26 and maintain 15-17 % annual growth. Retail loans, particularly for vehicles and home loans, account for roughly 58 % of NBFC lending.
• Improving asset quality - Post-pandemic economic recovery and disciplined credit underwriting have lowered gross NPAs to around 4 %, while CRAR remains above 22 %.
• Digital transformation - NBFCs leverage fintech partnerships, e-KYC and account aggregation to onboard customers digitally. AI-driven underwriting has cut turnaround times and expanded reach.
• Structural challenges - Reliance on short-term market borrowings exposes NBFCs to liquidity risk, as seen during the IL&FS crisis. Asset-liability mismatch and exposure to real estate are key vulnerabilities. The SBR and liquidity coverage ratio requirements seek to mitigate these risks.
• Regulatory arbitrage - Historically, NBFCs operated under lighter norms compared to banks, leading to concerns of regulatory arbitrage. The SBR, 90-day NPA norm and harmonised provisioning aim to close this gap.
• Consolidation and mergers - Smaller NBFCs are merging or surrendering licences due to rising compliance costs. Meanwhile, large NBFCs such as HDFC Ltd merged with HDFC Bank in 2023, reshaping the financial landscape.

The RBI encourages collaboration between public sector banks and NBFCs through co-lending arrangements, enabling the sharing of risk and leveraging each other's reach. Policymakers intend NBFC credit to account for a larger share of total credit-rising from the current 25 % to 50 % by 2047.

For UPSC Prelims vs Mains

Prelims Perspective

• Know the basic definition of NBFC and understand that it cannot accept demand deposits or issue cheques.
• Remember the various categories: ICC, HFC, IFC, IDF, CIC, NBFC-MFI, Factor, MGC, SPD, NOFHC, Account Aggregator and NBFC-P2P.
• Be aware of the SBR layers and the asset threshold (Rs.1,000 crore) distinguishing base and middle layer NBFCs.
• Recall the 90-day NPA norm and the SMA categories (SMA-0, SMA-1, SMA-2).
• Understand microfinance definitions: household income cap (Rs.3 lakh) and the 50 % repayment cap.

Mains Perspective

• Analyse the importance of NBFCs in augmenting credit and achieving financial inclusion. Discuss how they complement banks and drive economic growth.
• Critically evaluate the SBR framework: does it balance financial stability with innovation? Are the thresholds appropriate?
• Examine asset liability mismatches and liquidity risks. Suggest measures such as the liquidity coverage ratio and improved supervision.
• Discuss the microfinance regulations with respect to borrower protection and interest rate deregulation. Are there concerns about over-indebtedness?
• Assess the impact of NBFC crises (IL&FS, DHFL) on trust in the sector. How have reforms addressed these issues?
• Identify opportunities for NBFCs in digital lending, green finance and co-lending with banks.

Quick Facts

• As of June 2024, about 9,306 NBFCs are registered with the RBI.
• Only around 50 NBFCs are permitted to accept public deposits; their deposits are not insured.
• NBFC assets under management are expected to surpass Rs.60 trillion (Rs.60 lakh crore) by FY26 with credit growth of 15-17 %.
• Retail loans constitute 58 % of NBFC lending.
• Microfinance NBFCs must ensure that the borrower's total obligations do not exceed 50 % of monthly household income.
• The SBR framework places NBFCs into four layers-Base, Middle (systemically important), Upper and Top.
• Gross NPAs of NBFCs improved to around 4.2 % and CRAR above 22 % according to the June 2025 Financial Stability Report.
• Loans become non-performing when overdue for more than 90 days; upgradation requires full payment of arrears.

UPSC Previous Year Questions (Selected)

1. UPSC Civil Services Prelims 2015: Consider the following statements about non-banking financial companies (NBFCs): (1) They cannot accept demand deposits; (2) They cannot use the call money market; (3) Their deposits are insured. Which of the statements is/are correct?
   Answer: Only statement 1 is correct. NBFCs cannot accept demand deposits and cannot issue cheques, but their depositors are not covered by the Deposit Insurance and Credit Guarantee Corporation.
2. UPSC Civil Services Prelims 2018: With reference to NBFCs in India, consider the following statements: (1) They are regulated by the RBI; (2) Housing Finance Companies and Core Investment Companies are NBFCs; (3) They can form part of the payments system. Which of the statements is/are correct?
   Answer: Statements 1 and 2 are correct. NBFCs such as HFCs and CICs are regulated by the RBI. However, NBFCs cannot issue cheques or operate current accounts and hence are not part of the payments system.
3. UPSC Civil Services Prelims 2024 (Mock/Practice): Which of the following would be classified as microfinance loans under the RBI's 2022 framework?
   (a) A Rs.1 lakh collateral-free loan to a rural household with annual income of Rs.2 lakh, used for dairy activities; (b) A Rs.4 lakh loan secured by hypothecation of a commercial vehicle to a household with income of Rs.2.8 lakh; (c) A Rs.50,000 personal loan to a household with income of Rs.3.5 lakh without any collateral.
   Answer: Only (a) is a microfinance loan since it is collateral-free and the household's income is within Rs.3 lakh.

Practice MCQs

1. Which of the following statements is not correct about NBFCs?
   A. NBFCs can issue cheques drawn on themselves.
   B. NBFCs are regulated by the RBI under the SBR framework.
   C. NBFCs cannot accept demand deposits.
   D. Housing finance companies are a type of NBFC.
   Answer: A
2. Under the SBR framework, a non-deposit-taking NBFC with assets of Rs.800 crore would fall in which layer?
   A. Base layer
   B. Middle layer
   C. Upper layer
   D. Top layer
   Answer: A
3. A borrower's loan obligations (including microfinance and non-microfinance loans) should not exceed 50 % of household income. This rule applies to:
   A. All bank loans
   B. Only NBFC-MFIs
   C. All lenders for microfinance loans
   D. Only deposit-taking NBFCs
   Answer: C
4. Which of the following qualifies as a loss asset under RBI norms?
   A. A loan overdue for 95 days
   B. An asset identified by auditors as uncollectible
   C. A standard asset with no default
   D. A housing loan repaid in advance
   Answer: B
5. In co-lending arrangements, NBFCs and banks typically share risk in the ratio:
   A. 100:0
   B. 80:20
   C. 50:50
   D. 20:80
   Answer: D (Banks retain 80 % of credit risk while NBFCs take 20 %.)

Frequently Asked Questions

What is an NBFC and how is it different from a bank?

An NBFC is a company engaged in financial activities such as lending, investment and credit facilitation. Unlike banks, it cannot accept demand deposits, issue cheques or offer payment accounts. NBFCs are regulated by the RBI but have a more flexible business model and typically serve niche segments.

Why did the RBI introduce the scale-based regulatory framework?

The SBR framework recognises that NBFCs are heterogeneous. It assigns entities to four layers based on their size and systemic importance. Larger NBFCs face stricter norms on capital adequacy, liquidity, governance and disclosure to protect financial stability without burdening small lenders.

What happens to depositors if an NBFC fails?

Deposits with NBFCs are unsecured and not covered by deposit insurance. In the event of failure, depositors may recover funds through liquidation proceedings, but there is no guarantee. Therefore, depositors rely on the NBFC's credit rating and regulatory oversight when investing.

How are microfinance loans regulated?

Microfinance loans are collateral-free loans provided to households with annual income up to Rs.3 lakh. Lenders must ensure that a household's total loan obligations do not exceed 50 % of monthly income and must disclose interest rates transparently. Default beyond 90 days classifies the loan as non-performing, requiring higher provisioning.

What led to the IL&FS crisis, and how have regulations changed since then?

The IL&FS crisis of 2018 occurred due to excessive leverage and poor risk management, leading to default on its debt obligations. The episode exposed the sector's vulnerability to liquidity shocks. In response, the RBI introduced the SBR framework, stricter liquidity management rules and improved supervision. Upper layer NBFCs now maintain liquidity coverage ratios and face periodic stress tests to ensure resilience.

Can NBFCs be converted into banks?

Yes. Qualified NBFCs may apply for a banking licence under the RBI's on-tap licensing regime. They must meet criteria such as a minimum paid-up voting equity capital of Rs.500 crore, diversified ownership and sound governance. Recent examples include the conversion of Suryoday Small Finance Bank and AU Small Finance Bank from NBFCs.

What is the outlook for NBFCs in India?

The outlook is positive due to rising credit demand, digital adoption and supportive policy frameworks. NBFC assets are projected to grow at 15-17 % annually and reach Rs.60 trillion by FY26. However, challenges such as asset-liability mismatch, regulatory compliance costs and competition from fintechs remain.