[Burning Issue] What Ails the NBFC Sector

CONTEXT

  • India’s non-banking financial companies (NBFC) sector — also known as the shadow banking system that provides services similar to traditional commercial banks but outside normal banking regulations — is passing through a turbulent period following a series of defaults by Infrastructure Leasing and Financial Services (IL&FS) and the subsequent liquidity crunch.
  • The liquidity squeeze faced by NBFCs has led to a conflict between the government and the Reserve Bank of India, with the Finance Ministry pushing for easier fund flows while the RBI insists there’s enough money available in the system.

What is a Non-Banking Financial Company (NBFC)?

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property.

A non-banking institution which is a company and has a principal business of receiving deposits under any scheme or arrangement in one lump sum or in instalments by way of contributions or in any other manner is also a non-banking financial company (Residuary non-banking company).

Features of NBFCs

  • NBFC cannot accept demand deposits.
  • NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself.
  • Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs.

Major difference between Banks and NBFCs

Basic NBFCs Banks
Meaning They provide certain banking services without holding Bank License. It is government authorized financial intermediary which provides banking services to the public.
Regulated under Companies Act 2013 Banking Regulation Act 1949
Demand Deposit Cannot be Accepted Can be Accepted
FDI Allowed up to 100% Allowed up to 74% for Private Sector Bank
Payment and Settlement system Not a part of the System An Integral part of the System
Maintenance of Reserve Ratios Not Required Mandatory
Deposit Insurance Facility Not Available Available
Transaction Services Cannot be provided by NBFC Provided by Bank

Importance of NBFCs

  • NBFCs help attain the objective of macroeconomic policies of creating more jobs in the country by promoting Small and Medium scale Enterprises and private industries through lending them loans.
  • The financial market relies heavily on non-banking financial institutions for raising capital. The start-ups and small-sized businesses are dependent on funds offered by NBFCs.
  • NBFCs extend long-term credits to infrastructure, commerce and trade companies. The traditional banks expect timely, schedules and short-term repayment of loans that may not always suit the requirements of these industries.
  • Non-banking financial companies help in rotation of resources, asset distribution and regulation of income to shape the economic development. They enable converting savings into investments and thus, helps in the mobilisation of funds/resources in the economy.
  • NBFCs play an important role in promoting inclusive growth in the country, by catering to the diverse financial needs of bank-excluded customers. And very importantly, they also reach out to areas inaccessible to regular banking.
  • As NBFCs aim to build capital for several industries – private and otherwise – they aid in accumulating a capital stock for the country. This directly adds on to the National Income and results in the progression of Gross Domestic Product (GDP).
  • With quicker decision-making ability and prompt provision of services, NBFCs act as not just complements but also substitutes to banks.

How big is the NBFC industry?

  • NBFCs have been slowly moving into the space of commercial banking. When banks slowed down their lending business in the wake of huge bad loans, NBFCs continued to grow at a higher pace.
  • As of March 2018, there were 11,402 NBFCs registered with the RBI, of which 156 were deposit accepting NBFCs (NBFCs-D), and 249 systemically important non-deposit accepting NBFCs (NBFCs-ND-SI).
  • The aggregate balance sheet size of the NBFC sector as of March 2018 was Rs 22.1 lakh crore. There was a deceleration in share capital growth of NBFCs in 2017-18 whereas borrowings grew at 19.1%.
  • NBFCs in India include not just finance companies, but also a wider group of companies that are engaged in investment, insurance, chit fund, nidhi, merchant banking, stock broking, alternative investments etc. as their principal business.
  • NBFCs being financial intermediaries are supposed to play a supplementary role to banks. NBFCs, especially those catering to the urban and rural poor — including the micro-finance institutions (NBFC-MFIs) and asset finance companies — have a complementary role in the financial inclusion agenda of the country.
  • Further, some of the big NBFCs — infrastructure finance companies — are engaged in lending exclusively to the infrastructure sector, and some are into factoring business, thereby giving a fillip to the growth and development of various sectors. In short, NBFCs bring diversity to the financial sector.

What’s the fund source of NBFCs?

  • NBFCs were the largest net borrowers of funds from the financial system, with gross payables (loans) of around Rs 717,000 crore and gross receivables of around Rs 419,000 crore in March 2018.
  • A breakup of gross payables indicates that the highest funds were received from banks (44%), followed by mutual funds (33%) and insurance companies (19%). HFCs were the second largest borrowers with gross payables of around Rs 528,400 crore and gross receivables of only Rs 31,200 crore.
  • As of March 2018, HFCs’ borrowing pattern was quite similar to that of NBFCs except that financial institutions also played a significant role in providing funds to HFCs. Like NBFCs, long-term debt, loans and CPs were the top three instruments through which HFCs raised funds from the financial markets.
  • Now with the system facing a liquidity crunch, mutual funds, insurance companies and other big investors are unlikely to invest in NBFCs in a big way. The exposure of banks to NBFCs had shot up by 27%, or over Rs 1 lakh crore, to Rs 496,400 crore in a span of six weeks in March 2018.
  • However, banks started cutting their exposure since April this year, leading to a 4.6% decline in their exposure to NBFCs, according to RBI data. The outstanding credit of banks was at Rs 391,000 crore in March 2017. The sudden spike in bank exposure to NBFCs prompted the RBI to direct banks to bring down the exposure.

What is the crisis in the NBFC sector?

  • Several corporates, mutual funds and insurance companies had invested in short-term instruments such as commercial papers (CPs) and non-convertible debentures (NCDs) of the IL&FS group that has been defaulting on payments since August.
  • This has stoked fears that many of them could have funds stuck in IL&FS debt instruments which, in turn, could lead to a liquidity crunch in their own backyard. Liquidity conditions had tightened, with a deficit of Rs 1.37 lakh crore on October 22, 2018, though this has declined since.
  • There are rising fears that the funding cost for NBFCs will zoom and result in a sharp decline in their margins.

Problems Plaguing NBFCs

  • The decline in asset quality for select NBFCs has stemmed from cases where underwriters (a person or company that underwrites an insurance risk) are inexperienced, or with limited understanding of the local situation and dynamics that drive the demand for credit.
  • Misalignment in product offerings with customer needs: Small NBFCs, in an effort to capture markets, have expanded into new geographic locations and diversified their product portfolio but are misaligned with consumer needs. When products can’t get associated with consumer needs, they become outmoded.
  • Asset-liability mismatch: Several NBFCs are faced with a liquidity crunch (a time when cash resources are in short supply and demand is high), liabilities maturing and coming up for payment faster than loans in the same tenure.
  • Lack of a strong regulator, except for housing finance companies, is also one of the challenges faced by NBFCs.

There are three primary drivers of the current risk aversion for NBFCs

The first driver relates to short-term funding being used to finance long-term assets—an asset-liability mismatch (ALM).

  • For micro-finance, the average loan tenure ranges from eight to nine months, for commercial vehicle finance it is 16 to 18 months, while for small business finance it is 12 to 16 months. Thus, the asset side duration for these businesses is very short.
  • On the liabilities side, the duration either mirrors the asset side, or is longer, and generally ranges from one to two years. Thus, these small to mid-sized NBFCs run a positive ALM mismatch.
  • Even in the case of affordable housing finance, where one would expect a wide ALM mismatch, low asset duration for affordable housing financiers reduces the ALM gap to negligible. This is further aided by low leverage (debt to equity ratio) and high capital adequacy.

The second cause of current risk aversion towards NBFCs has to do with refinancing or rollover of short-term capital market borrowings.

  • This concern is linked to the ALM issue, as a smooth rollover of shorter duration liabilities when assets are of longer duration is key for business continuity.

The third cause for concern has to do with asset quality.

    • This primarily pertains to exposure of NBFCs to the real estate sector—either as builder funding or loan against property (LAP).

What did the RBI do to provide liquidity?

  • The Reserve Bank of India (RBI) has decided to increase the single-borrower exposure limit of banks for non-banking finance companies (NBFCs) which do not finance infrastructure, to 15% from the existing 10% of their capital funds.
  • This would be effective till December 31. This is taken in the context of the IL&FS imbroglio-induced liquidity crisis in the system.

    The Reserve Bank has also permitted banks to use government securities, equal to their incremental outstanding credit to NBFCs, over and above their outstanding credit to them as on October 19th to meet the liquidity coverage ratio requirement.

Way Forward

  • Efficient engagement of customers: NBFCs must distinguish between active and inactive customers to develop a focused engagement methodology and allocate resources efficiently.
  • Building effective reward and loyalty programmes to minimise bad debts: NBFCs must increase customer retention by building a strong loyalty programme, with discount, cashback benefits. The program must be customised according to the customer type and factor in the right data variables to provide meaningful incentives and value for customer loyalty.
  • Over the years, NBFCs have played an important role in providing growth capital to various sectors of the economy
  • A concerted effort across stakeholders is required to prevent a market contagion that can cut off the critical supply of capital to the grassroots of the nation.
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