General Studies Paper 3 (Indian Economy): NBFCs & Banks

NBFC-Bank

IAS Junior Mains Answer Writing June-Sep 2019 Schedule (Click Here)

 

Syllabus: General Studies Paper 3 (Indian Economy)

 

How NBFCs are different from banks? Discuss their role on Indian economic growth and the issues currently being faced by the Indian NBFCs. (250 words)

 

Introduction:

Non-banking financial companies (NBFCs) are financial institutions that offer various banking services but do not have a banking license. Generally, these institutions are not allowed to take traditional demand deposits readily available funds, such as those in checking or savings accounts from the public. This limitation keeps them outside the scope of conventional oversight from federal and state financial regulators.

NBFCs can offer banking services such as loans and credit facilities, currency exchange, retirement planning, money markets, underwriting, and merger activities.

Body:

Differences between NBFC and Bank

NBFCs lend and make investments, and hence their activities are similar to that of banks; however, there are a few differences as given below:

  1. A government authorised financial intermediary that aims at providing banking services to the general public is called the bank. An NBFC is a company that provides banking services to people without holding a bank license.
  2. An NBFC is incorporated under the Indian Companies Act, 1956 whereas a bank is registered under Banking Regulation Act, 1949.
  3. NBFC is not allowed to accept such deposits which are repayable on demand. Unlike banks, which accepts demand deposits.
  4. Foreign Investments up to 100% is allowed in NBFC. On the other hand, only banks of the private sector are eligible for foreign investment, and that would be not more than 74%.
  5. Banks are an integral part of payment and settlement cycle while NBFC, is not a part of the system.
  6. It is mandatory for bank maintain reserve ratios like CRR or SLR. As opposed to NBFC, which does not require to maintain reserve ratios.
  7. The deposit insurance facility is allowed to the depositors of banks by Deposit Insurance and Credit Guarantee Corporation (DICGC). Such facility is unavailable in the case of NBFC.
  8. Banks create credit, whereas NBFC is not involved in the creation of credit.
  9. Banks provide transaction services to the customers, such as providing overdraft facility, the issue of traveller’s cheque, transfer of funds, etc. Such services are not provided by NBFC.

 

Financial activities of NBFCs:

NBFCs (Non Banking Financial Companies) play an important role in promoting inclusive growth in the country, by catering to the diverse financial needs of bank excluded customers.

  • NBFCs often take lead role in providing innovative financial services to Micro, Small, and Medium Enterprises (MSMEs) most suitable to their business requirements.
  • NBFCs do play a critical role in participating in the development of an economy by providing a fillip to transportation, employment generation, wealth creation, bank credit in rural segments and to support financially weaker sections of the society.
  • Emergency services like financial assistance and guidance is also provided to the customers in the matters pertaining to insurance.
  • NBFCs are financial intermediaries engaged in the business of accepting deposits delivering credit and play an important role in channelizing the scarce financial resources to capital formation.
  • They supplement the role of the banking sector in meeting the increasing financial needs of the corporate sector, delivering credit to the unorganized sector and to small local borrowers.
  • they do not include services related to agriculture activity, industrial activity, sale, purchase or construction of immovable property.
  • NBFC focuses on business related to loans and advances, acquisition of shares, stock, bonds, debentures, securities issued by government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business.

 

Role of NBFCs on Indian economy:

The NBFC sector has grown considerably in the last few years despite the slowdown in the economy.

  • Profitability :
    • NBFCs are more profitable than the banking sector because of lower costs. This helps them offer cheaper loans to customers. As a result, NBFCs’ credit growth is higher than that of the banking sector with more customers opting for NBFCs.
  • Infrastructure Lending :
    • NBFCs contribute largely to the economy by lending to infrastructure projects, which are very important to a developing country like India. Since they require large amount of funds, and earn profits only over a longer time-frame, these are riskier projects and deters banks from lending
  • Promoting inclusive growth :
    • NBFCs cater to a wide variety of customers both in urban and rural areas. They finance projects of small-scale companies, which is important for the growth in rural areas. They also provide small-ticket loans for affordable housing projects. All these help promote inclusive growth in the country.

NBFC’s aid economic development in the following ways

  • Mobilization of Resources – It converts savings into investments
  • Capital Formation – Aids to increase capital stock of a company
  • Provision of Long-term Credit and specialised Credit
  • Aid in Employment Generation
  • Help in development of Financial Markets
  • Helps in Attracting Foreign Grants
  • Helps in Breaking Vicious Circle of Poverty by serving as government’s instrument

 

Issues faced by NBFCs:

  • NBFC is passing through a turbulent period following a series of defaults by Infrastructure Leasing and Financial Services (IL&FS) and the subsequent liquidity crunch.
  • 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.
  • There are rising fears that the funding cost for NBFCs will zoom and result in a sharp decline in their margins.
  • Higher borrowing costs and narrowing options to raise funds will pose challenges for retail non-banking finance companies (NBFCs) in the fiscal year ending March 2019 .
  • The bond yields have gone up sharply to around the 8% mark. That is making borrowing costlier even at the short end of the yield curve.
  • NBFCs are likely to witness higher pricing pressure as competition in the retail segment intensifies going forward this is expected to be accentuated by narrowing funding avenues and higher systemic rates.
  • Higher fuel prices, weaker dollar and the trade war could hit the SME sector badly. This would mean defaults by SMES, which have been a traditional market for NBFC lending.
  • Investors are worried about a credit downgrade backlash on NBFCs. That could mean huge write-offs for investors.
  • Mutual funds who have invested in market instruments of NBFCs have faced increased redemption pressures.

 

Way forward:

  • Given the growing size and dominance of the NBFC sector, it is important that the threshold capital levels for entry be substantially increased. It may be prudent for RBI to evaluate the need to shore up minimum capital requirements for various NBFCs.
  • While RBI has identified systemically important NBFCs, it needs to step up the monitoring of NBFCs which belong to large, diversified groups. Checks and balances are needed to ensure that risks do not build up in the sector due to structures which are too-complex-to-manage.
  • RBI could consider re-visiting some of the unimplemented recommendations of the Working Group on Issues and Concerns in the NBFC Sector chaired by Usha Thorat in 2011.
  • One such recommendation was the introduction of a liquidity coverage ratio for NBFCs. The objective was to ensure that NBFCs have cash balances and holdings of government securities which may fully cover gaps between cumulative outflows and cumulative inflows for the first 30 days. This would be the buffer in times of stress.

 

Conclusion:

NBFC’s are mainly established to grant credit to the poor section of the society, whereas the banks are chartered by the government to receive deposits and grant credit to the public. With the increasing role of NBFCs in the Indian Economy, the Reserve Bank of India has issued the notification Master Direction – Information Technology Framework for the NBFC Sector to enhance safety, security, efficiency in processes leading to benefits for NBFCs and their customers. The NBFCs are playing significant role in meeting financial requirements of the medium sized and small sized industries and development of Indian economy indirectly.

 

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