Basel Guardrails must Balance Stability, Innovation for NBFCs

The Indian financial landscape carries a distinct duality between banks and non-banking financial companies. Banks operate as demand deposit-taking institutions with access to central bank liquidity and deposit insurance, anchoring the payment system. They are bound to prioritise depositor protection, solvency, liquidity, and systemic risk management. 

NBFCs, by contrast, serve as vital credit intermediaries without these privileges. They do not create money, yet their growing role in credit delivery makes them central to financial stability. 

The way Basel guidelines are adapted across these two segments is therefore crucial.

The 2008 global financial crisis was a turning point. Regulators worldwide realised that shadow banking entities, even without a deposit base, could transmit systemic risks.

Basel principles, initially crafted for banks, began to be extended selectively to large non-banks engaged in maturity transformation and leveraged credit intermediation. Jurisdictions such as the United States, European Union, Singapore, and China have since applied Basel-like capital and liquidity standards to broker-dealers and investment firms.

The Reserve Bank of India, with its dual mandate under the Banking Regulation Act and the RBI Act, 1934, oversees both banks and NBFCs. Its July 2025 update to the Master Direction of 2023 reflects a structural shift, a scale-based framework that divides NBFCs into four layers: base, middle, upper, and top. This replaces the earlier “systemically important” categorisation with a more granular assessment of size, activity, and risk.

As of December 2024, India counted 9,291 registered NBFCs. A vast 93.76% sat in the base layer—small, non-deposit-taking entities with minimal public interface. The middle layer, which includes all deposit-taking NBFCs regardless of size, covered 569 firms. Only 11 entities qualified for the upper layer, facing the most stringent regulatory obligations.

The top layer is expected to be empty, to be filled only if an upper-layer NBFC poses exceptional systemic risk. This pyramid captures activity diversity, inter alia, investment and credit companies, core investment companies, microfinance institutions, peer-to-peer lenders, and infrastructure finance companies.

For upper-layer NBFCs, Basel alignment is visible. They must maintain minimum capital adequacy ratios, adhere to exposure norms, and follow strict asset classification rules. Liquidity Coverage Ratios, mirroring Basel III, require them to hold sufficient high-quality liquid assets to withstand 30-day net cash outflows. Such measures strengthen resilience but highlight how far regulation has drifted from the earlier light-touch approach.

The framework has commendable breadth, and it links to over 20 specialised directions on matters ranging from Know Your Customer and transfer of loan exposures to digital lending, project finance, gold-backed loans, and microfinance norms. Yet the breadth has become a weakness. The master direction itself runs to 400 pages, with key provisions often buried as hyperlinks to other circulars. This creates redundancies and compliance hurdles, practical difficulties especially for smaller firms lacking regulatory infrastructure. A more accessible approach would embed core requirements directly, with annexures tailored to specific categories.

A deeper issue is the ambiguity around “perceived riskiness.” Size and activity are currently the only clear classification criteria, even though nearly 99% of NBFCs fall outside the upper tier. Risk profiles vary sharply across business models, product complexity, customer interfaces, and interconnectedness with the financial system.

An NBFC relying heavily on digital lending or artificial intelligence-driven underwriting may face far greater operational and technology risks than its balance sheet size suggests. Without sharper definitions, regulators risk both over-regulating low-risk entities and under-estimating vulnerabilities in more complex ones.

International experience offers useful parallels. Payment banks in India for instance, operate under differentiated norms reflecting their limited mandate and application of Basel standards are customised. A similar approach is needed for NBFCs: Basel-like rules should be calibrated to the business model rather than applied uniformly. Separate, focused directions for each NBFC category would improve clarity and reduce compliance friction.

Technology adds urgency to this debate. Digital platforms, AI-based lending, and new data-driven business models expand financial access but introduce novel risks. Cybersecurity vulnerabilities, data protection failures, and opaque algorithmic credit decisions can undermine both consumer trust and systemic stability. The framework may be twitted to explicitly account for these risks. A purely balance-sheet approach, centred on capital and liquidity, is insufficient in a digitalised ecosystem. AI governance is taking centre stage. Hence, regulations consistent with the recently released report on the ‘Framework for Responsible and Ethical Enablement of Artificial Intelligence’ (FREE-AI Report) propounded by the FREE-AI Committee (Committee) may be dovetailed into the NBFC directions.

The Reserve Bank’s scale-based framework is a significant step towards proportionate regulation. By aligning large NBFCs with Basel principles while allowing lighter requirements for the smallest players, it recognises diversity. Yet refinements are needed. Simplification, better readability, and sharper criteria for risk assessment will help align compliance with real vulnerabilities. Greater integration of technology and cyber-risk management is essential as NBFCs increasingly operate as digital-first entities.

The broader challenge remains the same: balancing stability with innovation. Excessively rigid regulation can stifle new business models, but an under-regulated sector risks crises that damage both financial stability and credit access. Application of Basel norms on differential basis depending upon the interconnected riskiness may be attempted.

As India’s NBFC sector grows in scale and sophistication, the test for policymakers will be whether the regulatory framework can adapt swiftly enough. The stakes are high: NBFCs provide critical credit to small businesses, households, and underserved segments. A resilient yet flexible framework can allow them to continue driving growth while containing systemic risks. The success of this balance will define how effectively India’s financial system supports its economic ambitions in an increasingly interconnected world.