Non-Banking System in India: NBFCs, Scale-Based Regulation, HFCs, MFIs and ARCs for RBI Grade B Finance
Last updated: 2026-11-13 · MockMentor
"Non-Banking System" is a separate line of the Financial System unit in the RBI Grade B Phase 2 Finance syllabus. Non-Banking Financial Companies (NBFCs) are now a large part of Indian credit, especially for vehicles, gold, housing, microfinance and small businesses, so RBI asks about them often: the difference between a bank and an NBFC, the principal business test, the layers of scale-based regulation and the lessons of the IL&FS crisis. This chapter covers the whole non-banking credit system, including housing finance companies, microfinance institutions, asset reconstruction companies and other entities.
In one line: NBFCs are companies that lend and invest like banks but cannot accept demand deposits or issue cheques; RBI regulates them under a scale-based framework that tightens rules as an NBFC grows larger and more connected to the rest of the system.
Basic concepts
- Non-Banking Financial Company (NBFC): a company registered under the Companies Act whose principal business is lending, investment in securities, hire purchase, leasing or insurance, but not agriculture, industry, trading or real estate.
- Principal business test (50-50 test): a company is treated as an NBFC if its financial assets are more than 50% of its total assets and income from financial assets is more than 50% of its gross income.
- Net Owned Fund (NOF): owned funds (paid-up capital and free reserves, less losses and intangible assets) minus investments in and loans to group companies beyond 10% of owned funds. Under scale-based regulation, the minimum NOF for most NBFCs is being raised in phases to ₹10 crore by March 2027.
- Shadow bank: a term for non-bank lenders that do bank-like work outside the full banking rules.
- Asset-liability mismatch: funding long-term loans with short-term borrowings such as commercial paper.
- Systemically important NBFC: an NBFC whose failure could affect the financial system because of its size or links with banks and markets.
Why in News?
- RBI rolled back from April 2025 the extra 25 percentage point risk weight it had placed in November 2023 on bank loans to NBFCs, as NBFC credit growth had slowed and their risk profile improved.
- RBI's co-lending directions, covering all banks and NBFCs and loans beyond the priority sector, came into force from 1 January 2026.
- RBI has continued to name NBFCs in the Upper Layer each year under scale-based regulation, and these must list on stock exchanges within three years of being so classified.
- Stress in microfinance loans rose in 2024 and 2025, leading the industry's self-regulatory bodies to cap the number of lenders and the total debt per borrower.
Difference between banks and NBFCs
| Basis | Bank | NBFC |
|---|---|---|
| Law | Banking Regulation Act, 1949 | Companies Act, 2013 and Chapter III-B of the RBI Act, 1934 |
| Demand deposits | Can accept | Cannot accept; only some can take fixed deposits under limits |
| Cheques | Can issue cheques drawn on itself | Cannot |
| Payment and settlement system | Part of it | Not part of it, though some can join specific systems |
| CRR and SLR | Must maintain | No CRR; deposit-taking NBFCs keep liquid assets under Section 45-IB |
| Deposit insurance | DICGC cover up to ₹5 lakh | Not available |
| Foreign investment | Limits apply | Up to 100% under the automatic route in most cases |
| Priority sector | Targets apply | No direct targets, but banks can on-lend through NBFCs and co-lend with them |
Why NBFCs matter
- They reach customers that banks find hard to serve: small businesses, used vehicle buyers, gold loan borrowers and people with thin credit histories.
- They often have specialised skills and faster processes, such as gold valuation or vehicle repossession.
- They compete with banks and lower costs for borrowers.
- They provide credit to sectors such as infrastructure, housing and microfinance.
NBFC credit is close to a quarter of the credit given by scheduled commercial banks, which makes them an important part of the system.
Types of NBFCs
By liabilities
- Deposit-taking NBFCs (NBFC-D): may accept public deposits for 12 to 60 months, within limits linked to their NOF and credit rating. New deposit-taking licences are no longer granted.
- Non-deposit-taking NBFCs (NBFC-ND): raise money through bank loans, bonds, commercial paper and equity.
By activity
| Type | Activity |
|---|---|
| Investment and Credit Company (NBFC-ICC) | Lending and investment; created in 2019 by merging asset finance, loan and investment companies |
| Housing Finance Company (HFC) | Housing loans; at least 60% of assets in housing finance, of which at least 50% to individuals |
| Microfinance Institution (NBFC-MFI) | Collateral-free loans to low-income households; at least 75% of assets in microfinance loans |
| Infrastructure Finance Company (NBFC-IFC) | At least 75% of assets in infrastructure loans |
| Infrastructure Debt Fund (NBFC-IDF) | Refinances infrastructure projects that have completed a year of operations |
| Core Investment Company (CIC) | Holds investments in group companies; at least 90% of assets in group companies |
| Factor (NBFC-Factor) | Buys receivables of firms; at least 50% of assets in factoring |
| Account Aggregator (NBFC-AA) | Moves financial data with consent |
| Peer-to-Peer lending platform (NBFC-P2P) | Online platform linking lenders and borrowers |
| Mortgage Guarantee Company | Guarantees housing loans |
| Non-Operative Financial Holding Company (NOFHC) | Holding company for a bank and other financial entities of a group |
| Standalone Primary Dealer | Deals in government securities |
| Government NBFC | Owned by the central or state governments, such as Power Finance Corporation and REC |
Bodies not regulated by RBI
Some entities do financial work but are regulated by others: insurance companies (IRDAI), stock brokers and mutual funds (SEBI), chit funds and nidhi companies (state governments and the Ministry of Corporate Affairs), and housing finance companies were with NHB until 2019.
Scale-based regulation (SBR)
RBI introduced scale-based regulation in October 2021, effective October 2022, after the IL&FS and DHFL failures showed that large NBFCs could threaten the system. It places NBFCs in four layers.
| Layer | Who falls in it | Main rules |
|---|---|---|
| Base Layer (NBFC-BL) | Non-deposit-taking NBFCs with assets below ₹1,000 crore, and NBFC-P2P, AA, NOFHC and NBFCs without public funds or customer interface | Lighter rules; NPA recognition at 90 days; board-approved policies |
| Middle Layer (NBFC-ML) | Deposit-taking NBFCs, non-deposit NBFCs with assets of ₹1,000 crore and above, HFCs, IFCs, IDFs, CICs and SPDs | Capital ratio of 15%, governance rules, compliance function, concentration limits |
| Upper Layer (NBFC-UL) | NBFCs identified by RBI on a scoring method (size, links with others, complexity), with the top 10 by size always included | Common Equity Tier 1 of at least 9%, large exposure limits, differential provisioning, mandatory listing within three years, close supervision similar to banks |
| Top Layer (NBFC-TL) | Ideally empty; for NBFCs in the Upper Layer that RBI sees as posing extreme risk | Highest supervisory intensity |
Government-owned NBFCs are placed in the Base or Middle Layer. An NBFC that moves into the Upper Layer stays under its rules for at least five years.
Other key rules for NBFCs
- Asset classification: NPA recognition at 90 days overdue for all NBFCs since March 2026, after a phased move from 180 days for smaller ones.
- Liquidity Coverage Ratio: for large NBFCs, to hold enough high-quality liquid assets for 30 days of stressed outflows.
- Prompt Corrective Action: applies to deposit-taking NBFCs and non-deposit NBFCs in the Middle and Upper Layers, and to government NBFCs from October 2024.
- Fair Practices Code: transparency in loan terms, fair recovery and grievance redress.
- Ombudsman: NBFC customers are covered by the RBI Integrated Ombudsman Scheme.
Housing Finance Companies
HFCs such as LIC Housing Finance, PNB Housing Finance and Bajaj Housing Finance are a major source of home loans. Regulation moved from NHB to RBI in August 2019 through amendments to the NHB Act, while NHB continues to supervise them and provide refinance. HFCs must keep capital of at least 15% of risk-weighted assets.
Microfinance
Features
Microfinance means small, collateral-free loans to low-income households, usually women, often through groups. It is provided by:
- Self-help groups linked to banks (SHG-Bank Linkage Programme).
- NBFC-MFIs, banks, small finance banks and non-profit lenders under the joint liability group (JLG) model.
RBI's framework of 2022
| Rule | Detail |
|---|---|
| Definition | A collateral-free loan to a household with annual income up to ₹3 lakh |
| Repayment limit | Total loan repayments of a household cannot exceed 50% of its monthly income |
| Uniform rules | The same rules for all lenders, not only NBFC-MFIs; the earlier interest rate cap for NBFC-MFIs was removed, and lenders set board-approved pricing policies |
| Prepayment | No penalty for prepayment |
| Recovery | No harsh recovery, and recovery only at a designated place |
The Andhra Pradesh microfinance crisis of 2010, in which over-lending and coercive recovery led to suicides and a state law that stopped repayments, led to the Malegam Committee (2011) and the first NBFC-MFI rules.
Asset Reconstruction Companies (ARCs)
ARCs buy bad loans from banks and NBFCs at a discount and try to recover more through restructuring, sale of assets or a change of management. They are registered with RBI under the SARFAESI Act, 2002, with a minimum NOF of ₹300 crore (raised from ₹100 crore in 2022). They usually pay a small part in cash and the rest in security receipts. The National Asset Reconstruction Company Limited (NARCL), set up in 2021, is the largest. RBI tightened ARC rules in 2022 and 2024 to stop banks from using them to hide bad loans.
Other non-banking entities
- Chit funds: groups in which members pay a monthly sum and one member takes the pot each month by auction or lot; regulated under the Chit Funds Act, 1982 by state governments.
- Nidhi companies: mutual benefit societies that take deposits from and lend only to members; regulated by the Ministry of Corporate Affairs.
- Credit Information Companies: TransUnion CIBIL, Equifax, Experian and CRIF High Mark, regulated by RBI under the Credit Information Companies (Regulation) Act, 2005.
- Payment aggregators and prepaid payment instrument issuers: regulated by RBI under the Payment and Settlement Systems Act.
- Unregulated deposit schemes: banned by the Banning of Unregulated Deposit Schemes Act, 2019, after many Ponzi frauds such as the Saradha scam.
The IL&FS and DHFL crises
IL&FS (2018)
Infrastructure Leasing and Financial Services (IL&FS), a large core investment company with more than 300 group firms, defaulted on its debt in September 2018. It had borrowed short term to fund long-term infrastructure projects, and its accounts hid the true level of debt. The default froze the commercial paper market for NBFCs, mutual funds that held IL&FS paper suffered losses, and NBFC lending slowed sharply. The government took over the board under the Companies Act.
DHFL (2019)
Dewan Housing Finance Corporation defaulted in 2019 after allegations of fraud. It became the first financial company to be resolved under the Insolvency and Bankruptcy Code, using a special window created in 2019 for systemically important NBFCs. Piramal Group acquired it.
Lessons
- Large NBFCs can be as systemically important as banks.
- Asset-liability mismatches are dangerous when funding markets freeze.
- Corporate governance and audit quality matter as much as capital.
- Regulation should be proportionate to size and risk, which led to scale-based regulation.
Co-lending and bank-NBFC partnerships
Co-lending lets a bank and an NBFC share a loan, typically 80% from the bank and 20% from the NBFC, combining the bank's low cost of funds with the NBFC's reach. It started in 2018 for priority sector loans and was widened in 2020. RBI's 2025 directions extended co-lending to all regulated entities and all types of loans, with each partner keeping at least 10% of each loan on its books, from January 2026.
Sources of funds for NBFCs
Because most NBFCs cannot take deposits, how they fund themselves decides how risky they are.
| Source | Features | Risk |
|---|---|---|
| Bank loans | The largest source; term loans and working capital lines | Links NBFC health to banks; rises in bank risk weights raise costs |
| Non-convertible debentures (NCDs) | Bonds of 1 to 10 years, sold to mutual funds, insurers and retail investors | Market access depends on credit rating |
| Commercial paper (CP) | Short-term funding of up to one year | Rollover risk if markets freeze, as in 2018 |
| Securitisation and direct assignment | Selling pools of loans to banks or investors | Frees capital; rules require minimum holding and retention |
| External commercial borrowings | Foreign loans and bonds | Currency risk unless hedged |
| Public deposits | Only for deposit-taking NBFCs within limits | Costly to manage and closely regulated |
| Equity | From promoters, private equity and public issues | Expensive but absorbs losses |
| Refinance | From NHB, SIDBI, NABARD and MUDRA for specific sectors | Limited to eligible loans |
Liquidity risk management framework
After the IL&FS crisis, RBI issued a Liquidity Risk Management Framework for NBFCs in November 2019. It requires board-approved liquidity policies, limits on mismatches in short time buckets, monitoring of concentration in funding sources, and a Liquidity Coverage Ratio (LCR) for deposit-taking NBFCs and non-deposit-taking NBFCs with assets of ₹5,000 crore and above, phased in to reach 100%. NBFCs must also publish their liquidity position.
Capital and provisioning rules compared with banks
| Rule | Banks | NBFCs (Middle and Upper Layers) |
|---|---|---|
| Minimum capital ratio | 9% total capital plus 2.5% capital conservation buffer | 15% capital adequacy, of which Tier 1 at least 10% |
| Common Equity Tier 1 | 5.5% plus buffer | At least 9% for Upper Layer NBFCs |
| NPA recognition | More than 90 days overdue | More than 90 days overdue (since March 2026 for all layers) |
| Standard asset provision | 0.25% to 1% depending on sector | 0.4% for most; higher for some Upper Layer exposures |
| Large exposure limits | Framework based on Tier 1 capital | Concentration limits; Upper Layer NBFCs follow a framework close to banks |
| Reserve fund | Statutory reserve under the BR Act | 20% of net profit transferred to a reserve fund under Section 45-IC of the RBI Act |
Gold loan NBFCs
Gold loans are a fast-growing segment, led by NBFCs such as Muthoot Finance and Manappuram Finance, along with banks. They are popular because they are quick and secured. RBI's directions on lending against gold and silver collateral, issued in 2025 and applicable from April 2026, set common rules for banks and NBFCs:
- A maximum loan-to-value ratio of 85% for loans up to ₹2.5 lakh, 80% for loans between ₹2.5 lakh and ₹5 lakh, and 75% above that.
- Standard methods for valuing gold and silver, and limits on the quantity of jewellery that can be pledged.
- Clear rules on auction of pledged gold after default, with notice to the borrower and return of any surplus.
- Return of the pledged gold within a set time after repayment, with compensation for delay.
Earlier, RBI had found irregularities in some gold loan practices, such as weak valuation and the use of agents, and had restricted one large NBFC from new gold loans in 2024 until it corrected them.
Government NBFCs and infrastructure finance
Several large NBFCs are owned by the central government and lend to infrastructure:
| Entity | Sector |
|---|---|
| Power Finance Corporation (PFC) | Power generation, transmission and distribution |
| REC Limited | Rural electrification and power; a subsidiary of PFC since 2019 |
| Indian Railway Finance Corporation (IRFC) | Rolling stock and railway assets |
| Indian Renewable Energy Development Agency (IREDA) | Renewable energy |
| India Infrastructure Finance Company Limited (IIFCL) | Long-term infrastructure loans |
| HUDCO | Housing and urban infrastructure |
They borrow at low cost because of government ownership and are classified in the Middle Layer. Since October 2024 they are covered by RBI's Prompt Corrective Action framework.
NBFCs and the economy
Contribution
NBFCs have been especially important in:
- Vehicle finance, including used commercial vehicles and two-wheelers.
- Loans to small businesses that lack collateral or credit history.
- Gold loans and microfinance in rural areas.
- Consumer durable loans at the point of sale.
- Affordable housing finance in smaller towns.
- Infrastructure lending by government NBFCs.
Links with the rest of the system
NBFCs borrow heavily from banks and mutual funds, and banks also co-lend with them and buy their loan pools. RBI's Financial Stability Reports track these links closely, since stress in a large NBFC can spread to its lenders. This interconnectedness is the main reason RBI increased the risk weight on bank loans to NBFCs in 2023 and introduced scale-based regulation in 2021.
Important committees on NBFCs
| Committee | Year | Contribution |
|---|---|---|
| A. C. Shah Committee | 1992 | Framework for regulating NBFCs, including registration and prudential norms |
| Khanna Working Group | 1995 | Supervisory framework for NBFCs |
| Malegam Committee | 2011 | Regulation of NBFC-MFIs after the Andhra Pradesh crisis |
| Usha Thorat Working Group | 2011 | Issues in the NBFC sector, including stronger capital and liquidity rules |
| Nachiket Mor Committee | 2014 | Role of NBFCs in financial inclusion and specialised lenders |
| Discussion paper on scale-based regulation | 2021 | Basis of the four-layer framework |
Challenges
- Dependence on bank loans and short-term market funding, which makes NBFCs vulnerable to liquidity shocks.
- Rising stress in unsecured loans, microfinance and some small business loans.
- Governance problems in some group-owned NBFCs.
- Competition from banks, which have lower funding costs.
- Regulatory arbitrage between NBFCs, fintech platforms and unregulated lenders.
- High interest rates for small borrowers.
Way forward
- Diversify NBFC funding through long-term bonds, securitisation and access to foreign borrowing.
- Strengthen governance, audit and risk management, especially in the Middle and Upper Layers.
- Use digital tools and credit bureau data to lend responsibly to new-to-credit customers.
- Keep co-lending simple and transparent, with clear responsibility for customer service.
- Bring all lenders under the same conduct rules, so that unregulated apps cannot exploit borrowers.
Possible exam and interview questions
- Explain the scale-based regulatory framework for NBFCs. Why did RBI introduce it? (620 words)
- "NBFCs are both a strength and a source of risk for the Indian financial system." Discuss with reference to the IL&FS crisis. (420 words)
- Distinguish between a bank and an NBFC. Why can an NBFC not issue cheques?
- What are the main features of RBI's microfinance framework of 2022?
- Interview: Should large NBFCs be required to convert into banks?
Related reading: banking system in India, financial inclusion, and technology in banking.
More in Finance
Prepare with MockMentor
RBI Grade A/B 2027 Super-Elite Course (₹7,500) – Complete Phase 1 and Phase 2 preparation with the Descriptive Writing Programme. 365 days validity.