It's been 2 years since I wrote on this blog. Welcome back everyone! As the Trump presidency rolls into DC, I hope to be more regular. A colleague of mine, Shradha Sachdev wrote this excellent article on FDI in financial services sector (featured in Bar & Bench), with some inspiration and inputs from yours truly. I am setting it out verbatim below.
Liberalizing FDI in Financial Services - Need of the hour?
Introduction
Traditionally, India has had a bank-dominated financial services
sector. However, the
importance of non-banking financial companies (NBFCs) has been recognized, not
only as a supplement to mainstream banking in
meeting the increasing financial needs of the corporate sector but also for
delivering credit to the unorganized sector and to small local borrowers.
The
RBI Act defines a NBFC broadly as a financial institution that is into lending
or investment or collecting monies under any scheme or arrangement but does not
include any institutions which carry on agricultural activity, industrial
activity, trading and purchase or sale of immovable properties as their
principal business.
Contribution
of NBFCs to the economy has grown in leaps and bounds from 8.4% in 2006 to
above 14% in March 2015. In terms of financial
assets, NBFCs have recorded a healthy growth - a compounded annual growth rate
(CAGR) of 19% over the past few years - comprising 13% of the total credit and
expected to reach nearly 18% by 2018–19.
The
Indian government understands that industrial growth is impossible in an
environment where banks are reluctant to finance new businesses. The Pradhan
Mantri Mudra Yojana (PMMY) was launched for the benefit of bottom of the
pyramid entrepreneurs. Banks and NBFC-Micro Finance Institutions have reported
that the amount sanctioned under PMMY had reached about INR 100,000 crore to
over 2.5 crore borrowers by early February 2016, while the target next year is
raised to INR 180,000 crore.
To
complement various initiatives like Make-in-India, Start-up India, Smart
Cities, Housing for all, the government has announced a significant change for
NBFCs by liberalizing the existing foreign direct investment (FDI) regime in
India.
In addition to the
restricted ambit of activities open to FDI earlier, there were other challenges faced. Foe
example, asset management activity, even though technically a fee based
activity, was treated as a 'fund-based' activity for the purpose of capitalization,
thereby attracting prohibitively high capitalization norms linked to foreign
ownership. Further, since the list of permitted activities under the current
list did not specifically include 'investment activities', regulatory ambiguity
existed for FDI in a NBFC engaged in any investment activity. Separately, whenever
a majority foreign-owned NBFC created a step down joint venture or a
subsidiary, it attracted additional capitalization requirements; this
additional capital would have to be brought in through fresh infusion in the
parent, thereby further disturbing the foreign investment at the parent entity
level.
Expansion of Eligible Activities
Foreign
direct investment in NBFCs are no longer restricted to the 18 stipulated activities
but have been permitted across all regulated activities. This means that
as long as the NBFC is subject to a regulatory authority such as the Reserve
Bank of India (RBI), Securities and Exchange Board of India (SEBI), Pension
Fund Regulatory and Development Authority (PFRDA) etc., it is permitted to
raise 100% FDI under the automatic route, irrespective of the activity it
performs.
For
example, once a commodity broking license is approved by SEBI, a commodity
broking company will not require any further approval from the Foreign
Investment Promotion Board (FIPB) for bringing in foreign direct investment.
Prior
government approval will be required for bringing in foreign investment only in
such NBFCs that are not regulated or where only part of the financial services
activity is regulated or where there is doubt regarding regulatory oversight.
Until
now, one of the major difficulties faced by NBFCs while inviting foreign funds was
regarding the interpretation of the permitted 18 activities. Financial services
being a dynamic sector, the nature of financial services has been evolving and
there was no definition or basis for ascertaining the services from which these
18 activities evolved. Further, there was also no practical or reliable mechanism
for investors to ask questions relating to whether or not a certain activity is
covered within the permitted 18 activities. It would not be incorrect to say
that this ambiguity, at times, restricted highly potential businesses from
accessing foreign funds.
With
permission for inflow of foreign investment in “Other Financial Services” on
automatic route, the sector is poised to witness remarkable diversity of
players and businesses being intermediaries between mainstream banking and
unorganized sectors.
Capitalization Norms
The
Government has also done away with the minimum capitalization requirements
under the FDI policy.
While
NBFCs undertaking non-fund based activities were required to comply
with a minimum capitalization of USD 0.5 million upfront, those undertaking fund
based activities were required to comply with the following requirements;
(i)
USD
0.5 million for FDI upto 51%, to be brought upfront;
(ii)
USD
5 million for FDI more than 51% and upto 75%, to be brought upfront;
(iii)
USD
50 million for FDI more than 75% out of which USD 7.5 million to be brought up
front and the balance to be brought in within 24 months.
This
was in addition to and irrespective of the minimum capitalization requirements
fixed by the relevant sector regulatory authority. Moreover, it was unfair to
subject a merchant banking and custodian services to similar capitalization
norms without taking the market and investment environment into consideration.
To
eliminate the vexatious requirement of complying with multiple capitalization
norms, the FDI policy does not stipulate any minimum capital requirements anymore.
This means that an NBFC would need to comply with capital requirements fixed,
if at all, by the relevant sectoral regulatory authority only. The minimum
capitalization requirements shall be decided by the government for NBFCs when
raising FDI is falling under approval route.
Interestingly,
in view of Foreign Exchange Management (Transfer or Issue of Security by the
Person Resident Outside India) (Thirteenth Amendment) Regulations, 2016, for
activities that are regulated by a specific act, the foreign investment
limits shall be restricted to such limits as may be set out under the relevant
act.
The
impact of this change may be appreciated better by analyzing the capitalization
norms stipulated by the relevant regulator for some common financial sector
services:
S. No.
|
Financial Service
|
Regulator
|
Capitalization Norms
|
1.
|
Merchant
banking
|
SEBI
|
Net
worth of not less than INR 50 million.
“Net
worth” means the sum of paid-up capital and free reserves of the applicant at
the time of making application
|
2.
|
Underwriting
|
SEBI
|
Net
worth of not less than INR 2 Million.
However,
every stock-broker, who acts as an underwriter shall fulfil the capital
adequacy requirements specified by the stock exchange of which he is a
member.
“Net
worth” means,— (a) in the case of an applicant being a proprietary concern or
a firm or an association of persons or anybody of individuals, the value of
capital contributed to such business by the applicant and the free reserves
of any kind belonging to the business of the applicant; and (b) in the case
of a body corporate, the value of the paid-up capital and the free reserves
as disclosed in the books of account of the applicant at the time of making
the application under sub-regulation (1) of regulation 3.
|
3.
|
Portfolio
Management Services
|
SEBI
|
Net
worth of INR 30 Million;
Provided
that a portfolio manager, who was granted a certificate under these
regulations prior to the commencement of the Securities and Exchange Board of
India (Portfolio Managers) (Amendment) Regulations, 2008, shall raise its net
worth to not less than one crore rupees within six months from such
commencement and to not less than two crore rupees within six months
thereafter;
Provided
further that the portfolio manager shall fulfill capital adequacy requirement
under these regulations, separately and independently, of capital adequacy requirements,
if any, for each activity undertaken by it under the relevant regulations.
"Net
worth" means the aggregate value of paid up equity capital plus free
reserves (excluding reserves created out of revaluation) reduced by the
aggregate value of accumulated losses and deferred expenditure not written
off, including miscellaneous expenses not written off.
|
4.
|
Custodian
Services
|
SEBI
|
Net
worth of a minimum of INR 500 Million. Explanation-For the purposes of this
regulation, the expression "net worth" means the paid-up capital
and the free reserves as on the date of the application.
|
5.
|
Investment
Advisory
|
SEBI
|
Net
worth of not less than INR 2.5 Million.
"Net
worth" means the aggregate value of paid up share capital plus free
reserves (excluding reserves created out of revaluation) reduced by the
aggregate value of accumulated losses, deferred expenditure not written off,
including miscellaneous expenses not written off, and capital adequacy
requirement for other services offered by the advisers in accordance with the
applicable rules and regulations.
Further,
Investment advisers who are individuals or partnership firms shall have net
tangible assets of value not less than rupees one lakh. Provided that
existing investment advisers shall comply with the capital adequacy
requirement within one year from the date of commencement of these
regulations.
|
6.
|
Credit
Rating agencies
|
SEBI
|
Net
worth of not less than INR 50 Million.
Provided
that a credit rating agency existing at the commencement of these
regulations, with a net worth of less than rupees five crores, shall be
deemed to have satisfied this condition, if it increases its net worth to the
said minimum within a period of three years of such commencement.
|
7.
|
Collective
Investment Scheme
|
SEBI
|
Net
worth of not less than INR 50 Million.
Provided
that at the time of making the application the applicant shall have a minimum
net worth of rupees three crores which shall be increased to rupees five
crores within three years from the date of grant of registration;
|
8.
|
Stock
Broker and Sub-broker
|
SEBI
|
Base
Minimum Capital stipulated by SEBI as applicable for NSE:
(a)
Only Proprietary trading without Algorithmic trading (Algo) – INR 1 Million
(b)
Trading only on behalf of Client (without proprietary trading) and without
Algo – INR 1.5 Million
(c)
Proprietary trading and trading on behalf of Client without Algo – INR 2.5
Million
(d)
All Trading Members/Brokers with Algo – INR 5 Million
For
MCX, Base Minimum Capital requirements are:
(a)
A Member with Algo Trading – INR 5 Million
(b)
A Member without Algo Trading – INR 1 Million
|
9.
|
Angel
Fund
|
SEBI
|
net
worth of at least INR 10 Million; or
|
10.
|
Non-Banking
Financial Companies
|
RBI
|
INR
20 Million as the net owned fund (NOF) required for a non-banking financial
company to commence or carry on the business of non-banking financial
institution, except wherever otherwise a specific requirement as to NOF is
prescribed by the Bank;
(1)
Every applicable NBFC shall maintain a minimum capital ratio consisting of
Tier I and Tier II capital which shall not be less than 15 percent of its
aggregate risk weighted assets on-balance sheet and of risk adjusted value of
off-balance sheet items.
(2)
The Tier I capital in respect of applicable NBFCs (other than NBFC-MFI and
IDF NBFC), at any point of time, shall not be less than 8.5% by March 31,
2016 and10% by March 31, 2017.
(3)
Applicable NBFCs primarily engaged in lending against gold jewellery (such
loans comprising 50 percent or more of their financial assets) shall maintain
a minimum Tier l capital of 12 percent.
|
Needless
to say, downstream investment by NBFCs having FDI will be subject to the relevant
sectoral regulations and provisions of Foreign Exchange Management (Transfer or
Issue of Security by the Person Resident Outside India) Regulations, 2000, as
may be applicable.
Interpretational Issues
Remain?
There
seems to be a lack of clarity as to whether the financial services activity
needs to be 'regulated', or whether the entity needs to be licensed by a
regulator for it to avail the automatic route. For e.g. an AIF manager is
regulated by SEBI under the SEBI (Alternative Investment Funds) Regulations,
2012 even though the entity itself is not licensed by SEBI.
Further,
advisors question as to whether the above conditions could be seen as
'FDI-linked performance conditions', thereby making LLPs engaged in financial
services ineligible for receiving FDI. It is not clear if an AIF manager
incorporated as an LLP can have any foreign investment.
Additionally,
there is no uniformly accepted definition of ‘financial services’ in the Indian
context. The RBI definition of NBFCs covers certain entities and a number of
other activities are regulated by SEBI and other regulators. Traditional Indian
financial services entities such as ‘nidhis’, chit funds etc. are restricted
rather than regulated by general regulators such as the Ministry of Corporate
Affairs.
Conclusion
While
the above questions remain to be conclusively answered, a number of financial
services such as mutual funds, collective investment schemes, infrastructure
debt funds, that have remained largely inaccessible by foreign investors
precisely due to lack of clarity on the services included in the 18 stipulated
activities, are now open for FDI. With this recent liberalization of FDI norms,
India seeks to truly fuel economic growth and development by allowing greater financial
services sector penetration to support small and micro businesses. Even businesses
with low net worth would be able to take advantage of well-funded NBFCs.
In
the uncertain global economy emanating from the ‘Brexit’
from membership of the European Union, upcoming US elections and the slow-down
in the Chinese economy, the financial services sector of India is bound to get the
attention of global investors that will be lured by the liberalized FDI regime.