RBI’s New Framework on Investments by Regulated Entities in AIFs: A Shift Towards Prudential Regulation

The Reserve Bank of India (RBI) has recently notified the Reserve Bank of India (Investment in Alternative Investment Funds) Directions, 2025. This development represents a decisive shift in the regulatory architecture governing the exposure of banks, non-banking financial companies (NBFCs), housing finance companies (HFCs), and other regulated entities (REs) to Alternative Investment Funds (AIFs). The new framework, which will come into effect from 1 January 2026, repeals the earlier circulars of December 2023 and March 2024. While the earlier regime was largely prohibitory, the new Directions are designed to be prudential, providing limits, provisioning norms, and capital treatment that balance risk containment with investment flexibility.

Scope and Definitions

The Directions apply across a broad range of regulated entities, including scheduled commercial banks, small finance banks, local area banks, regional rural banks, co-operative banks, all-India financial institutions, and NBFCs (including housing finance companies).

A critical concept introduced is that of the “debtor company”. This term captures any company to which the RE has or has had a loan or investment exposure (other than equity instruments) in the preceding twelve months. For this purpose, equity instruments are explicitly defined to include equity shares, compulsorily convertible preference shares (CCPS), and compulsorily convertible debentures (CCD). The treatment of CCPS and CCD as equity is a notable clarification and significantly alters the scope of provisioning obligations.

Prudential Caps on AIF Exposure

The new regime imposes quantitative ceilings on RE participation in AIF schemes. An individual RE cannot hold more than ten percent of the corpus of any AIF scheme. In addition, all REs taken together cannot contribute more than twenty percent of the corpus of a scheme. This collective cap is an important change from the draft directions of May 2025, which had proposed a tighter fifteen percent ceiling.

These limits are designed to prevent concentration of systemic capital from regulated financial institutions in privately managed pooled vehicles, thereby reducing contagion risks in case of adverse performance.

Provisioning Requirements and Look-Through Approach

The most substantive element of the new framework is the provisioning regime. If an RE invests more than five percent of a scheme and that scheme has a downstream exposure in the non-equity instruments of the RE’s debtor company, the RE must create a one hundred percent provision. The provision is required on the RE’s pro-rata look-through exposure to the debtor, but capped at the level of its own direct exposure to that company.

This approach is materially different from the December 2023 circular, which required REs to exit such positions within thirty days or make a blanket provision, creating significant disruption in the AIF market. The current structure allows REs to participate in AIFs, but subjects them to risk-sensitive provisioning aligned with their exposure levels. Importantly, where the downstream investment is in equity instruments, no provisioning obligation arises.

Treatment of Subordinated Units

The Directions also address the issue of subordinated or junior units in AIFs, which typically bear losses first in waterfall distributions. Any subordinated units held by an RE must be fully deducted from its capital funds. This deduction is to be applied proportionately from Tier 1 and Tier 2 capital, where applicable. This measure effectively discourages REs from subscribing to such risk-heavy units, given the adverse impact on regulatory capital.

Transition and Repeal

The new Directions will come into force on 1 January 2026, though REs may choose to adopt them earlier subject to board-approved policy. From that date, the December 2023 and March 2024 circulars stand repealed.

For existing commitments made before the effective date, REs are permitted to either continue under the earlier circulars or adopt the new Directions, but must do so consistently for each commitment. Where a commitment has already been fully honoured before the issuance of the Directions, the earlier circulars will continue to apply.

This transitional flexibility recognises the long-term nature of AIF commitments and avoids forcing retrospective changes on exposures already contracted.

Exemptions

The Directions exempt investments that had been specifically approved under the 2016 Master Directions on “Financial Services by Banks”. Moreover, RBI retains the discretion, in consultation with the Government of India, to notify further exemptions for certain categories of AIFs. This creates room for policy-driven carve-outs, particularly in areas where the government may wish to channel institutional capital.

Market Implications

The introduction of hard prudential caps and risk-based provisioning signals RBI’s preference for calibrated oversight, rather than absolute prohibition. For banks and NBFCs, this means that investments in AIFs remain possible, but must be carefully monitored against debtor overlap and capital impact. The five percent threshold for provisioning is likely to function as a de facto ceiling for many REs, since avoiding downstream overlap with debtor companies is operationally challenging without granular disclosures from AIF managers.

For AIF managers, the new framework imposes a clear duty to track RE participation and portfolio composition closely. They will be expected to provide timely, instrument-level disclosures to their RE investors to allow compliance. Structuring decisions also acquire greater importance: downstreaming into debtor companies through equity instruments (including CCPS and CCD) avoids triggering RE provisioning, while debt or hybrid exposures invite scrutiny and potential provisioning.

Comparative Perspective

In contrast to the earlier regime of 2023–24, which created abrupt market dislocation, the 2025 Directions appear more balanced. They align with international best practices, where prudential limits and capital treatments are preferred over prohibitions. They also reflect RBI’s responsiveness to industry feedback, particularly the raising of the collective cap to twenty percent and the clarification on equity instruments.

Conclusion

The Investment in AIF Directions, 2025 mark a significant recalibration of RBI’s stance. By shifting from a prohibitionist to a prudential framework, the regulator has acknowledged both the systemic risks and the market realities surrounding AIF participation by regulated financial institutions. The new regime requires REs to exercise heightened diligence, establish robust monitoring systems, and maintain strong governance around investment decisions. For AIF managers, greater transparency and investor reporting will be central to attracting and retaining institutional capital.

This framework is likely to stabilise RE participation in AIFs, provide clarity on provisioning, and ensure that risks remain within manageable prudential bounds. At the same time, it demonstrates RBI’s willingness to refine regulatory design in response to industry dynamics, signalling a more mature phase in the oversight of alternative investment markets in India.