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Understanding the NBFC Conundrum

Saon Ray (sray@icrier.res.in) is a senior fellow at the Indian Council for Research on International Economic Relations, New Delhi.

Till recently, non-banking financial companies were the poster boys of the financial sector, with loans from the sector growing at phenomenal rates. An examination of what NBFCs are and their activities shows how they are regulated, what the sources of their funds are, and the recipients of the credit issued by them.

Non-banking financial companies (NBFCs) are companies registered under the Companies Act, 1956 and, as per Section 45 (I) of the Reserve Bank of India (RBI) Act, 1934, are

engaged in the business of making loans, advances, acquisition of shares, stock, bonds, debentures, or securities issued by the government or local authority or other securities of marketable nature, leasing, hire-purchase, insurance and chit business.1

The RBI Act, 1934 was amended on 1 December 1964 by the Reserve Bank Amendment Act, 1963 to include provisions relating to non-banking institutions receiving deposits and financial institutions. Ever since the default of the Infrastructure Leasing and Financial Services (IL&FS) on its debt obligations, the spotlight is on NBFCs in India. This article discusses what NBFCs are, their activities, how are they regulated, what the sources of their funds are and the
recipients of the credit issued by them.

NBFCs comprise mostly private sector institutions providing a variety of financial services that are regulated by the RBI.2 According to the RBI (2017a), NBFCs are categorised (i) in terms of the type of
liabilities into deposit (NBFC–D) and non-deposit3 accepting NBFCs, (ii) non-deposit-taking NBFCs by their size into systemically important (NBFC–NDSI) and other non-deposit holding companies (NBFC–ND), and (iii) by the kind of activity they conduct. By activity, there are 12 categories of NBFCs. These are: (i) Asset Finance Company (AFC); (ii) investment company; (iii) loan company; (iv) NBFC–Infrastructure Finance Company (NBFC–IFC); (v) NBFC–Systemically Important Core Investment Company (CIC–ND–SI); (vi) Infrastructure Debt Fund–NBFC (IDF–NBFC); (vii) NBFC–microfinance institutions (NBFC–MFI); (viii) NBFC–factors; (ix) mortgage guarantee company; (x) NBFC–Non Operative Financial Holding Company (NOFHC); (xi) NBFC–Account Aggregator (NBFC–AA); and (xii) NBFC–Peer to Peer Lending Platform (NBFC–P2P).

At the end of March 2018, 11,402 NBFCs were registered with the RBI, of which 156 were NBFC–D and 249 were NBFC–ND–SI (RBI 2018).4Table 1 shows the growth in the NBFC entities from 2012 to 2018.

The aggregate balance sheet size of the NBFC sector was ₹ 22.1 trillion as on March 2018 (RBI 2018). As on September 2016, the outstanding credit to NBFCs stood at $55.27 billion, growing at 25% on year-on-year basis. Bank credit to NBFCs has touched the highest in three years. In 2017, NBFCs increased their share in the total credit market to 16%, from 13% in 2015. The share of public sector banks (PSBs) reduced to 51%, from 57% in 2015 (Palepu 2017).

Activities of NBFCs

NBFCs are largely involved in serving those classes of borrowers generally excluded from the formal banking sector. NBFCs are historically involved in providing financial services such as offering of small ticket personal loans, financing of two/three wheelers, truck financing, farm equipment financing, loans for purchase of used commercial vehicles/machinery, secured/unsecured working capital financing, etc. Further, they also often take the lead role in providing innovative financial services to micro, small, and medium enterprises (MSMEs). The characteristics of NBFCs’ financial services include simpler processes and procedures in sanction and disbursement of credit; timely, friendly and flexible terms of repayment aligned to the unique features of its clientele, albeit at a higher cost. Progressively over the years, the difference between banks and NBFCs has blurred in India. More recently, NBFCs are competing with banks in providing financial services such as infrastructure and housing finance among others (RBI 2014).

Services provided by banks include receiving of deposits and lending of funds. NBFCs lend and make investments, and their activities are similar to those of banks. However, there are differences between banks and NBFCs. These are:

(i) NBFCs cannot accept demand deposits; (ii) NBFCs do not form part of the payments and settlement system and cannot issue cheques upon themselves; (iii) Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs.

NBFCs have specialised in different areas: financing commercial vehicles (Shriram Transport Finance), offering loans against gold (Manappuram Finance or Muthoot Finance), infrastructure financing (Srei Infrastructure Finance, IDFC Bank, etc), or consumer durables (Bajaj Finance or Capital First). The emergence and rapid spread of finance institutions dedicated for retail finance—like Tata Capital Financial Services, Bajaj Finserv, HDB Financial Services, etc—has given much visibility of the sector especially in urban areas. The retail segment has not only expanded in the last few years, but also has been largely responsible for the impressive growth rates of credit of NBFCs.

NBFCs have also evolved in terms of their operations, reach and profitability. They provide end-to-end online personal loans solutions, right from obtaining information, applying for the loan, assistance with eligibility criteria and documentation, approval application, and loan disbursal. NBFCs also accept deposits from customers, but, unlike banks, these are in the form of insurance premiums and shares listed on stock markets or held privately. They are not authorised to offer savings bank and other deposit schemes.

According to the Boston Consulting Group–Confederation of Indian Industries report (2015), NBFC credit growth will further accelerate in the next five to 10 years in India. The NBFC sector will evolve and transform to serve the latent credit needs of the emerging India. For this, NBFCs will have to embrace digital tools to dramatically enhance internal productivity (sales, operations and pricing). The emerging NBFCs (called NBFC 2.0) will augment the strengths of the existing NBFCs (called NBFC 1.0) in various areas highlighted in the report.

Regulation of NBFCs

The regulation of NBFCs is done by the RBI (2010). All NBFC–D and NBFCs–ND–SI are subjected to prudential norms such as capital adequacy requirements and exposure norms along with reporting requirements (Palepu 2018).5 Capital adequacy norms have been done away with for all NBFCs–ND and customised according to whether the NBFC–ND had access to public funds and/or customer interface.6 The regulations for NBFC–D have been strengthened with asset classification and provisioning norms. For NBFCs–ND–SI and NBFCs–D, the minimum Tier I capital has been increased to 10%.

Source of Funds

In the Financial Stability Report, 2018, RBI (2018) notes that in terms of inter-sectoral exposure, NBFCs were the dominant receivers of funds in the banking sector (this does not include transactions among entities of the same group). NBFCs were the largest net borrowers of funds from the financial system with gross payables of ₹ 7,170 billion against gross receivables of ₹ 419 billion. Of the funds received, the highest was from scheduled commercial banks (SCBs) (44%), Asset Management Companies–Mutual Funds (33%), and insurance companies (19%). Other sources of funds included long-term debt, loan-term loans and commercial papers.

The consolidated balance sheet of NBFCs as of March 2017 showed that the borrowings of NBFCs (which is 70% of the liabilities in 2017) have the following share: debentures (32%), bank borrowings (15%), other borrowings (14%), and commercial paper (6%). Hence, the primary source of funds for NBFCs is debentures, followed by bank borrowings. In the 2012 Financial Stability Report, it was noted that NBFCs were largely dependent on banks for their funds (RBI 2012). Since then, NBFCs have started borrowing from other sources as noted above.

Deployment of Funds

The deployment of funds by the NBFC segment in 2017 was largely to the industry, followed by retail loans, as can be seen in Figure 1.

Though housing loans and vehicle loans form the biggest chunk of the personal/retail credit sector, other loan products—like consumer durable loans, credit cards, education, individual advances, etc—are also showing impressive growth. Retail credit increased at the highest pace during 2016–17 due to consumer durables and credit card receivables.7 Interestingly, within the retail sector, it was the consumer durables and credit card receivables that registered impressive growths. While the former grew by 83.9% in 2016–17, the latter had a percentage variation of 50%. Vehicle loans, the largest component within the retail sector (41.5%), had, in fact, declined in this period. While the reason for decline of vehicle loans is largely attributed to the transient impact of demonetisation (RBI 2017b), credit to agriculture and allied activities also contracted during 2016–17.

Liquidity versus Stressed Assets

The RBI has noted that net profits of NBFC–ND–SI declined in 2016–17 due to increased expenditure and provisions for tax purposes. Gross non-performing assets (NPAs) also increased during the year. Further, all categories of NBFC–ND–SI except AFCs reported deterioration in their asset quality during this period, and this was particularly the case of NBFC–MFI. As far as asset quality is concerned, the Financial Stability Report, 2014 notes that the asset quality of the NBFCs–ND–SI had been deteriorating since 2011 (RBI 2014). Gross NPAs of NBFCs (as percentage of total advances) increased from 2.49% in December 2011, to 3.5% in September 2015 and to 4.9% in September 2017.

The current problem faced by NBFCs seems to be that of liquidity, and so the State Bank of India has stepped in to bail them out the situation by buying assets worth ₹ 45,000 crore. There are indications of asset liability mismatch of some NBFCs.8 Currently, every NBFC–NDSI (systemically important non-deposit taking NBFC) has to report their Capital to Risk Assets Ratio, exposure to real estate, both direct and indirect, as well as the maturity pattern of assets and liabilities in their balance sheet.9 The RBI has announced recently that it will review its guidelines regarding asset liability reporting by NBFCs.

In Conclusion

Till recently, NBFCs were the poster boys of the financial sector, with loans from the sector growing at phenomenal rates. What went wrong? The NBFC sector borrows from debentures and banks, and lends to the industry. In the latter function, they seem to be no different from banks (40% of credit of banks goes to industry [Chandrasekhar and Ghosh 2018]). However, it is thought that NBFCs primarily lend to small, and medium-sized enterprises rather than large infrastructure projects that banks fund. While NPAs of banks have growing and widely discussed, NPAs of NBFCs have also been growing. Indeed, if PSBs start buying assets of NBFCs that are stressed (while they have stressed assets of their own), it is doubtful how far this can go in solving the problem. The current crisis also reflects the interconnectedness of the banking system. The latest Financial Stability Report, 2018 points out that while the SCBs are the dominant players in the financial system accounting for 46% of bilateral exposure, NBFCs were at 12% (RBI 2018). In terms of intersectoral exposure, NBFCs were the dominant receivers of funds. Hence, repercussions of the IL&FS default were felt throughout the financial system. However, what was the reason for this episode? Was it due to regulatory oversight? More research is needed on this issue before firmer conclusions can be reached.

Notes

1 “A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lumpsum or in installments by way of contributions or in any other manner, is also a non-banking company (Residuary non-banking company)” (RBI 2017a). Principal business is defined as follows: “financial activity as principal business is when a company’s financial assets constitute more than 50 per cent of the total assets and income from financial assets constitutes more than 50 per cent of the gross income.” They do 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 services and sale/purchase/construction of immovable property.

2 NBFCs constitute 76% of total assets of non-banking financial institutions, while all-India financial institutions constitute 23% and primary dealers 1% respectively. NBFCs have also been called “shadow banks” in the extant literature.

3 Non-deposit accepting NBFCs cannot accept deposits from public.

4 NBFC–ND–SI constitutes 86% of total assets of the NBFC sector. While non-government NBFCs held 63% of total assets of this group, the rest was government companies. These include IFCI, Power Finance Corporation, Indian renewable Energy Development Agency (IREDA), and Housing and Urban Development Corporation. The NBFC sector is very diverse.

5 Till June 2018, the regulation for privately owned NBFCs was different from government owned ones. Privately owned NBFCs have to maintain a minimum Capital to Risk Assets Ratio (CRAR) of 15%, if Tier-1 capital is 10%. As per the RBI’s notification, government NBFCs have to raise their CRAR to this level by 2022. Further, they have to maintain a minimum of 15% of their outstanding deposits, in compliance with the RBI’s existing statutory provisions (Palepu 2018).

6 Discussion of the recent regulatory changes pertaining to the sector can also be found in Assocham-PwC (2016).

7 Credit card receivables, also known as credit card factoring, is a type of financing available to businesses that are paid by customers with credit cards (Lending Tree nd).

8 The Financial Stability Report, 2010 had noted that NBFCs could be prone to asset liability mismatches and hence exposed to liquidity risks due to their funding from mutual funds. In the third quarter of 2008-09, such a liquidity crunch was faced by the NBFCs.

9 RBI Notification No DNBS, 200/CGM (PK)-2008, dated 1 August 2008.

References

Assocham-PwC (2016): “Non-Banking Finance Companies: The Changing Landscape.”

Boston Consulting Group-Confederation of Indian Industries (2015): “NBFC 2.0: Enormous Potential in Non-Banking Finance and Ways to Make It Happen.”

Chandrasekhar, C P and J Ghosh (2018): “The Banking Conundrum: Non-Performing Assets and Neo-liberal Reform,” Economic & Political Weekly, 31 March.

Lending Tree (nd): “Credit Card Receivables,”https://www.lendingtree.com/glossary/credit-card-receivables/.

Palepu, Advait Rao (2017): “NBFCs to Have 19% of Credit Market by 2020: Crisil,” Business Standard, 23 November, https://www.business-standard.com/article/markets/nbfcs-to-have-19-of-cr....

— (2018): “RBI Withdraws Rule Exceptions for NBFCs Owned by Govt,” Business Standard, 1 June, https://www.business-standard.com/article/finance/rbi-withdraws-rule-exc....

RBI (2010): “Financial Stability Report,” Reserve Bank of India, March.

— (2012): “Financial Stability Report,” Reserve Bank of India, No 6, December.

— (2014): “Financial Stability Report,” Reserve Bank of India, No 10, December 2014.

— (2017a): “Frequently Asked Questions: All You Wanted to Know about NBFCs,” Reserve Bank of India, 10 January.

— (2017b): “Report on Trend and Progress of Banking in India 2016–17,” Reserve Bank of India.

— (2018): “Financial Stability Report,” Reserve Bank of India, No 17, June.

Updated On : 8th Apr, 2019

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