Regulatory updates

Central Bank Digital Currency (CBDC) refers to a digital form of currency notes issued by a central bank. Many central banks across the globe are exploring the issuance of CBDC. Recently, RBI through its press release dated 7 October 2022 issued a concept note on CBDC (the concept note). It explains the key motivations and objectives, benefits, types and other related considerations of issuing a CBDC in India, referred to as e₹(digital Rupee). The e₹ would provide an additional option to the currently available forms of money.

The concept note comprises of the following eight chapters:

1. Introduction
2. CBDC-Conceptual Framework
3. Motivations for issuance of CBDC
4. Design considerations for CBDC
5. Technology considerations for CBDC
6. Other considerations
7. Policy implications of introduction of CBDC, and
8. Way forward.

Some of the key aspects specified in the Concept Note include:

• CBDC – Meaning: RBI defines CBDC as a legal tender issued by a central bank in a digital form. It is akin to sovereign paper currency but takes a different form, exchangeable at par with the existing paper currency and would be accepted as a medium of payment, legal tender and a safe store of value.
• Objective: The main objectives of introducing CBDCs are:
  1. Reduction in cost of physical cash management¹¹.
  2. To further the cause of digitisation to achieve a less cash dependent economy.
  3. Supporting competition, efficiency and innovation in payments.
  4. Exploring the use of CBDCs for improvement in crossborder transactions.
  5. Supporting financial inclusion¹², and
  6. Enhancing and restoring trust in central bank currency vis-à-vis proliferation of crypto assets.
• Types of CBDC: Based on the usage and functions performed by the CBDCs and considering the different levels of accessibility, CBDC can be classified into following two types:
  1. CBDC Wholesale (CBDC-W): CBDC-W would be broadly used for improving the efficiency of interbank payments and securities settlement. These would be designed for restricted access by the financial institutions, and
  2. CBDC Retail (CBDC-R): CBDC-R would be potentially available for use to all private sector, nonfinancial consumers and businesses (retail consumers for day-to-day transactions).
• Administration of CBDCs: RBI would create and issue CBDC tokens to authorised entities (Token Service Providers – TSPs) who would further distribute it to the end users for retail transactions. Many customer facing activities such as customer onboarding, KYC, etc. could be performed by intermediaries/ TSPs, instead of the RBI. In this regard, the concept paper has proposed three models for issuing CBDCs. These are Direct, Indirect and Hybrid models. The following table illustrates the overall administration of CBDCs and the roles of various parties involved:

(Source: RBI concept note on CBDCs)

• Design considerations: With regard to the design of the CBDCs, the concept paper discussed the following:
  1. The RBI is exploring the option of implementation of account based¹³ CBDC in CBDC – W and token based¹⁴ CBDC in CBDC – R.
  2. CBDC would be an alternative to cash, and it should imbibe all elements of cash. Thus, CBDCs should be nonremunerative (therefore, it should not be interest bearing)
  3. Some level of anonymity should be incorporated in the design of the CBDCs, however, it would be restricted to prevent illegal and shadow economy transactions.
• Technology considerations: There are two types of technology platforms – Conventional system and the Distributed Ledger Technology (DLT). In the conventional system, data is stored over multiple physical nodes, being ultimately controlled by one authoritative central entity i.e., the top node of the hierarchy. However, in a DLT system (Blockchain technology), data is managed jointly by multiple entities in a decentralised manner and each update has to be harmonised amongst the nodes of all entities without the requirement of any top node. RBI, through the concept note has highlighted the fact that DLT system, at this point in time, owing to the low volume of transactions and other scalability issues would not be suitable for implementing the CBDC framework across the country.
• Next steps: RBI has been exploring the pros and cons of introduction of CBDCs for some time. As mentioned above, since there are multiple compelling objectives for introducing CBDCs, RBI is currently engaged in working towards a phased implementation strategy, going step by step through the various stages of pilots followed by the final launch. Thus, further developments are expected around this space in near future.

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To access the text of the concept note, please click here

11. Cost of physical cash management includes printing, storage transportation and replacement of bank notes, etc.
12. By making financial services more accessible to the unbanked and underbanked population.
13. Account based system would require maintaining a record of balances and transactions of all account holders to indicate the ownership of the monetary balances. In this case, exchange of CBDCs would be transfer of balance from one account to another.
14. Token based CDBCs would involve a type of a digital token issued by the central bank with a unique token number (representing a claim on the bank), like a bank note. It would be a bearer instrument, i.e., whoever holds the token would be considered to be the owner.

Unhedged Foreign Currency Exposure (UFCE) of an entity is a significant area of concern not just for the individual entity, but for the entire financial system as well. This is largely due to the fact that entities which do not hedge their foreign currency exposures can incur high losses during the period of heightened volatility in foreign exchange rates. These losses may reduce their capacity to service the loans taken from the banking system and increase their probability of default thereby affecting the health of the banking system. Consequently, RBI has, from time to time issued various guidelines and instructions to the banks on UFCE of the entities which have borrowed from the banks¹⁵.

Consequent to banks seeking various clarifications on certain aspects related to UFCE, RBI undertook a review of the extant guidelines on UFCE, thereby clarifying and amending few aspects of the guidelines, and has also consolidated the existing instructions on the subject into the RBI (Unhedged Foreign Currency Exposure) Directions, 2022 (the Directions).

The Directions were issued on 11 October 2022 and would be applicable to all commercial banks¹⁶ (excluding payments banks and regional rural banks). Some of the key changes that have been introduced are stated below:

• Definition of Entity: Presently, banks are required to assess UFCE of all the entities. The term ‘entities’ has been defined as ‘those entities which have borrowed from banks including borrowing in INR and other currencies, irrespective of the size of exposure/entity’. This definition has now been amended. The revised definition of ‘entity’ states that ‘an entity means a counterparty to which bank has exposure in any currency’.
• Exemption from UFCE guidelines: At present, UFCE guidelines exclude a bank’s exposure to an entity arising from derivative transactions. This exemption has now been extended to include factoring transactions as well.
• Alternative method for exposure to smaller entities: Currently, banks have an option to follow an alternative method for exposure to ‘smaller entities’ which have:

1. UFCE, and
2. Are not in a position to provide information on their UFCE to the bank.

The Directions have now revised the applicability criteria of the alternative method. It would be applicable for exposure to ‘smaller entities’ which have Foreign Currency Exposure (FCE) (instead of UFCE), and are not in a position to provide information on their UFCE.

Additionally, the definition of smaller entities has been amended to include those entities on which total exposure of the banking system is INR50 crore or less (earlier INR25 crore or less).

• Incremental capital requirement: Banks are required to apply incremental capital requirement for certain exposures as given below:

It has been clarified that the incremental capital requirement for exposures in the last bucket is 25 percentage points increase in the risk weight. For example, if an entity which otherwise attracts a risk weight of 50 per cent falls in the last bucket, the applicable risk weight would be 75 per cent (50 per cent +25 per cent).

Effective date: The Directions would come into effect from 1 January 2023.

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To access the text of the Directions, please click here

15. As per these instructions, guidelines and directives, banks were required to maintain incremental provisioning and capital requirements for their exposures to entities with UFCE.
16. The Directions would also be applicable to overseas branches and subsidiaries of banks incorporated in India.
17. Earnings Before Interest and Depreciation – EBID is computed as Profit after tax + Interest on debt + Depreciation + Lease rentals (if any).

As per the guidelines enunciated in the RBI (Financial Statements – Presentation and Disclosures) Directions, 2021 (RBI disclosure guidelines), all commercial banks, other than the Regional Rural Banks (RRBs) are required to provide certain disclosures with respect to divergence in asset classification and provisioning¹⁸. The disclosures relate to the following areas:

The above mentioned disclosures are required to be provided in the notes to accounts in the annual financial statements, published immediately following the communication of such divergence by RBI to the bank.

With an aim to further strengthen compliance with the prudential norms on income recognition, asset classification and provisioning, RBI, vide a notification dated 11 October 2022 has expanded the purview of these disclosure requirements for Primary (Urban) Co-operative Banks (UCBs). Additionally, the existing thresholds specified for the commercial banks have also been revised. The key guidelines issued in this regard include:

• Applicability: Banks should provide the disclosures (as stipulated in the previous page) in the financial statements for the year ending 31 March 2023, if either or both of the following conditions are satisfied:

1. The additional provisioning with regard to the NPAs, as assessed by the RBI exceeds 10 per cent of the reported profit before provisions and contingencies for the period
2. The additional Gross NPAs, as identified by RBI exceeds 10 per cent of the reported incremental Gross NPAs¹⁹ for the period.

Note: In case of UCBs, the threshold for the reported incremental Gross NPAs would be 15 per cent, which would be reduced subsequently, after review by the RBI.

• Revised thresholds for the year ending 31 March 2024: The thresholds pertaining to profit before provisions and contingencies and Gross NPAs (as mentioned in ‘Applicability’ section above) would be revised in the annual financial statements for the year ending 31 March 2024, and onwards, as mentioned below:

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To access the text of the notification, please click here

To access the text of the updated RBI (Financial Statements – Presentation and Disclosures) Directions, 2021, please click here

18. Paragraph C.4(e) of Annexure III to the RBI (Financial Statements-Presentation and Disclosures) Directions, 2021 specifies disclosure requirements with respect to divergence in asset classification and provisioning
19. Reported incremental Gross NPAs refers to additions made during the year to the Gross NPAs, as disclosed in the notes to financial statements of the year.
20. Threshold may be subsequently reduced, after review by the RBI

In October 2021, RBI had introduced the Scale Based Regulatory framework (SBR framework) for NBFCs, which renders the regulation and supervision of the NBFCs to be a function of their size, activity, and perceived riskiness. The SBR framework classified the NBFCs into the following four layers:

• NBFC-Base Layer (NBFC-BL)
• NBFC-Middle Layer (NBFC-ML)
• NBFC-Upper Layer (NBFC-UL) and
• NBFC-Top Layer (NBFC-TL).

As per the SBR framework, NBFC-BL should inter alia comprise of non-deposit taking NBFCs below the asset size of INR1,000 crore, and NBFC-ML should inter alia comprise of non-deposit taking NBFCs with asset size of INR1,000 crore and above.

Paragraph 16 of the Master Direction – NBFC-Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions 2016 (Master Directions) states that applicable NBFCs that are part of a corporate group or are floated by a common set of promoters should not be viewed on a standalone basis. Instead, the total assets of all the NBFCs in a group would be consolidated in order to determine the threshold for their appropriate classification.

With a view to comply with the regulations stipulated by the SBR framework and the Master Directions, RBI, vide a notification dated 11 October 2022 (the notification) clarified on the grouping of NBFCs within the SBR framework. As per the notification, if the consolidated asset size of a group of NBFCs is INR1,000 crore and above, then certain entities in the group of NBFCs would be classified as an NBFC-ML. Consequently, regulations as applicable to the middle layer would become applicable to them. Following is the list of those entities:

1. Investment and Credit Company (NBFC-ICC)
2. Micro Finance Institution (NBFC-MFI)
3. NBFC-Factor and Mortgage Guarantee Company (NBFCMGC).

Further, it has also been specified that statutory auditors would be required to certify the asset size (as on 31 March) of all the NBFCs in the group each year and the same would be furnished to the Department of Supervision, RBI, under whose jurisdiction the NBFCs are registered.

It is to be noted that the provisions of the notification would not be applicable for classifying an NBFC in the upper layer, as that would be based on the supervisory filtering process.

Effective date: The guidelines are effective from 1 October 2022.

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To access the text of the notification, please click here