Topic: What ails the NBFC sector?
Topic in Syllabus: GS Paper 3: Indian Economy
- 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.
Non-Banking Financial Company (NBFC):
- A NBFC is a financial institution that provides banking services without meeting the legal definition of a bank, i.e. one that does not hold a banking license.
- It is established as a company registered under the Companies Act, 1956 but its operations are often still covered under a country’s banking regulations.
- NBFCs may be engaged in the business of loans and credit facilities, savings products, investments and money transfer services.
- The Reserve Bank of India is entrusted with the responsibility of regulating and supervising the Non-Banking Financial Companies by virtue of powers vested under Reserve Bank of India Act, 1934.
Types of NBFCs:
- NBFCs can broadly be divided into three segments—asset financing, personal loans and business loans
- The predominant asset financing NBFCs are commercial vehicle financiers
- The remaining NBFCs provide a range of personal and business loans with widely varying business models
- Housing finance companies (HFCs), which provide housing loans, can be considered as specialized NBFCs that have a separate regulator
- Within these broad classifications, there are further differentiation based on the borrower segment the NBFCs target.
Difference between banks and NBFCs
- NBFCs business activities are akin to that of banks as they can lend and make investments; however there are a few differences between them.
- NBFCs cannot accept demand deposits.
- They cannot issue cheques as they do not form part of the payment and settlement system.
- Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.
- Unlike Banks which are regulated by the RBI, the NBFCs are regulated by multiple regulators; Insurance Companies- IRDA, Merchant Banks- SEBI, Micro Finance Institutions- State Government, RBI and NABARD.
- The norm of Public Sector Lending does not apply to NBFCs.
- The Cash Reserve Requirement also does not apply to NBFCs.
- As of March 2018, there were 11,402 NBFCs registered with RBI.
- 156 are deposit taking NBFCs, 249 are systemically important non-deposit taking NBFCs.
- The aggregate balance sheet was Rs. 22 lakh Cr.
- There was deceleration in the share capital growth of NBFCs in 2017-18 whereas, borrowings grew at around 19%.
The role of NBFCs in the Indian Economy
- 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.
- Further, 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, and 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.
- However, they do not include services related to agriculture activity, industrial activity, sale, purchase or construction of immovable property. In India, despite being different from banks, NBFC are bound by the Indian banking industry rules and regulations.
- 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.
- The banking sector would always be the most important sector in the field of business because of its credibility in supporting manufacturing, infrastructural development and even being the backbone for the common man’s money. But despite this, the role of NBFCs is critical and their presence in a country would only boost the economy in the right direction.
NBFC companies are very important to the economy because:
- Size of sector: The NBFC sector has grown considerably in the last few years despite the slowdown in the economy.
- Growth: In terms of year-over-year growth rate, the NBFC sector beat the banking sector in most years between 2006 and 2013. On an average, it grew 22% every year. This shows, it is contributing more to the economy every year.
- 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 – the increase in the amount of money being lent to customers – 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. In the last few years, NBFCs have contributed more to infrastructure lending than banks.
- 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.
NBFCs 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 specialized 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
Fund sources for NBFCs:
- NBFCs were the largest net borrowers of funds from the financial system.
- Highest funds were received from Banks (44%), followed by mutual funds (33%) and insurance companies (19%).
- The exposure of Banks to NBFCs has shot up by 27% to Rs. 5 lakh Cr in a span of 6 weeks in March 2018.
- This is because mutual funds, insurance companies and other big investors have turned back.
Issues associated with NBFCs:
Asset-liability mismatch (ALM):
- Short-term funding is being used to finance long-term assets
- The asset side duration for these businesses is very short ranging from eight to eighteen months
- On the liabilities side, the duration either mirrors the asset side, or is longer, and generally ranges from one to two years
- Thus, the small- to mid-sized NBFCs run a positive ALM mismatch
- This is further aided by low leverage and high capital adequacy
Refinancing or rollover of short-term capital market borrowings:
- This concern is linked to the ALM issue discussed above as smooth rollover of shorter duration liabilities when assets are of longer duration is key for business continuity
- Commercial paper funding (of up to 90 days) for NBFCs from mutual funds has increased from ₹50,000 crore in March 2016 to ₹1.2 trillion in September 2018
- Recently mutual funds have withdrawn from the market for NBFC paper
- This has led to heightened refinancing risk for those who are dependent on such funding
- It is estimated that NBFC and HFC debt of about ₹2.5 trillion is due for roll-over in the next six months
- This primarily pertains to NBFC exposure to the real estate sector—either as builder funding or loan against property (LAP)
- Builder funding is non-existent in the loan book of NBFCs
- In the case of LAP portfolio of affordable housing financiers or small business loan financiers, the asset quality continues to be above par as the sourcing of these loans has been outside the ultra-competitive urban LAP market
- The property underlying the LAP loans is typically self-occupied and not purchased for investment purposes
- IL&FS Finance, a group company, defaulted in late August this year, on a commercial paper repayment.
- This was followed by a default by IL&FS on repayment of Rs. 1,000 Cr to Small Industries Development Bank of India (SIDBI).
- A series of defaults by the holding company and group outfits followed in the subsequent weeks.
How RBI can empower NBFCs to face challenges:
- In 1996, following the collapse of a large NBFC, RBI mandated that no new NBFC would be permitted to raise deposits from the public. Subsequently, when the NBFC sector began relying heavily on the banking system for funding, RBI put in place exposure limits for lending to the NBFC sector. RBI also introduced asset side prudential guidelines for NBFCs.
- RBI is likely to tighten the guidelines for NBFCs, bringing them almost on par with commercial banks in terms of regulation.
- After the 2008 financial crisis, the RBI has prescribed tighter prudential norms for NBFCs. The minimum tier-I capital requirement was raised to 10% from 7% in a phased manner by the end of March 2017.
- Asset classification norms were revised from 180 days to 90 days in a phased manner by the end of March 2018, in line with that of banks. Analysts say NBFCs are facing a liquidity squeeze and not a new credit shock.
- The RBI opened a three-day special liquidity window of Rs 25,000 crore for banks to meet the cash requirements of debt mutual funds facing redemption pressures after bond prices fell leading to lower Net Asset Values.
Way forward to strengthen the regulatory framework for NBFCs over the longer-term
- Currently, depending on the type of NBFC, minimum capital requirements range from as low as Rs 2 crore in the case of certain NBFC-Micro Finance Institutions, Rs 100 crore for asset reconstruction companies and Rs 300 crore for infrastructure NBFCs. 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. When there are multiple entities, the ability to shift assets from one balance sheet to another increases, leading to opaqueness in determining the actual quality of the asset.
- 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. At that time, this recommendation may have been resisted by the industry under the guise of being too onerous for a sector that was just recovering as it does entail additional costs. Yet, with the benefit of hindsight, one does wonder if the present crisis might have been averted if this recommendation had been accepted.
What do understand by non-banking financial companies (NBFC)? How they are different from Regular banks? And critically evaluate the role of the NBFCs in Indian economy.