The Reserve Bank of India, through regulatory circulars issued in October 2023, strengthened the framework governing connected lending and related party transactions for banks and non-banking financial companies (NBFCs). The enhanced norms address the risk of preferential credit allocation to entities connected to the management, directors, or promoters of regulated entities, building on the existing prohibitions under Section 20 of the Banking Regulation Act, 1949 and prior RBI guidelines on lending to related parties.
Background
Connected lending — the extension of credit to entities with ownership, management, or governance links to the lending institution — has been a persistent regulatory concern in India's financial sector. Historical instances of related-party lending resulting in significant non-performing assets prompted the RBI to progressively tighten the framework. The existing restrictions under Section 20 of the Banking Regulation Act prohibit banks from making loans to directors and their firms, but the evolving corporate structures and complex group architectures have created avenues for circumvention.
For NBFCs, the regulatory framework on related party transactions has been less prescriptive than for banks, relying substantially on the Companies Act, 2013 framework and accounting standards for disclosure. The RBI's October 2023 interventions aim to bring greater parity between the bank and NBFC governance frameworks in this area.
Key Provisions
The regulatory strengthening encompasses the following elements:
Enhanced definition of connected parties: The framework expands the definition of connected parties beyond the traditional director and shareholder categories to capture entities with indirect economic interests, beneficial ownership links, and common management arrangements that may influence lending decisions.
Exposure limits: Quantitative limits on aggregate exposure to connected parties are reinforced, with regulated entities required to monitor and report their connected lending exposure as a percentage of total lending portfolio on a quarterly basis.
Board-level oversight: The Board of Directors of regulated entities is required to establish a specific policy on connected lending, with the Board's Audit Committee reviewing all transactions above prescribed thresholds. Individual connected lending decisions above specified limits require prior Board approval rather than mere management authorisation.
Disclosure requirements: Enhanced disclosure norms require regulated entities to report connected lending transactions in their annual reports with greater granularity, including the nature of connection, terms of lending, collateral obtained, and any deviations from standard lending terms.
Arm's length certification: All connected lending transactions must be certified as being on arm's length terms, with documented comparisons to lending terms offered to unconnected borrowers with similar credit profiles.
Implications for Practitioners
Banking and NBFC compliance teams must immediately review their connected party identification systems to ensure alignment with the expanded definitions. Many regulated entities may find that their existing related party frameworks, designed primarily for Companies Act compliance, require significant enhancement to meet the RBI's governance expectations.
For legal practitioners advising promoters and directors of banks and NBFCs, the strengthened framework necessitates careful structuring of any credit arrangements involving entities with direct or indirect connections to the regulated entity's management. The arm's length certification requirement introduces a documentation obligation that must be fulfilled at the time of transaction approval, not retrofitted during audit.
Corporate governance advisers should note that the Board-level oversight requirements create personal accountability for directors who approve connected lending transactions, adding to the existing fiduciary duties under the Companies Act and the RBI's fit and proper criteria for directors of regulated entities.