Dealing with NBFC risks: Loosen the bank strings
About seven decades ago, as British India grappled with challenges brought about by the Second World War, a handful of entrepreneurs in the southern peninsula began the business of financing the unorganised sector, or those that lacked access to the venerable banking system. In three decades, those early-stage ‘startups’ would become sufficiently important to grab the central bank’s mind space, with the Reserve Bank of India (RBI) accepting in the 1970s crucial gearing ratio proposals of a special purpose study group established for these ‘financial’ companies.
About 30 years since India began integrating its economy with the global order, these financiers – non-banking finance companies (NBFCs) – have become even more systematically significant and numerically important, accounting for a third of the loans advanced in the world’s second-most populous nation. That has prompted Mint Road to introduce additional norms to harmonise the sector with high-street banks and bring in greater oversight on their operations.
To be sure, from NPA recognition at the NBFCs to capital requirements, the norms have been tightened for the para banks that are considered essential to help organised financing reach the consumer’s doorstep in the hinterland. Some large NBFCs, important for their geographic reach and market share, are also allowed to raise public deposits.
At this juncture, the question is whether systematically important NBFCs be mandatorily directed to convert into banks. NBFCs up-down cycle is anywhere between 3 and 5 years. The recent liquidity crisis is not the first of the challenges faced by the NBFC sector. Banks became cautious and mutual funds wary after the IL&FS default. Banks refused to release the sanctioned limits, starving the para banks of much needed liquidity flows.
“The reason for converting into bank should not be liquidity alone,” said Dinanath Dubhashi, MD and CEO, L&T Finance. “It should be left for NBFCs to decide whether they want to convert into a bank. Large NBFCs anyway have to go through regular RBI inspections and those accepting deposits have to maintain statutory liquidity ratios.”
Some entrepreneurs in the financing business have always favoured such a transition.
Auto conversion into banks
“We have been proposing this to the regulator that systematically important NBFCs should have an option of automatic conversion into banks,” said Hemant Kanoria, chairman, Srei Infrastructure.
“They should be allowed to convert into banks and be allowed to raise public deposits.
Large NBFCs have to depend on banks so that they can on-lend. Stronger ones have corporate governance and been in existence for long time. Many are larger than many small banks. The main raw material… is funds by way of retail deposit.”
Innovators in the financing business also want the ‘systematically large’ NBFCs treated differently than the 10,000 others that make up the sector.
“The regulator and government should support these entities while monitoring them in a reasonably stringent manner rather than clubbing them with over 11,000 NBFCs in the country,” Sanjiv Bajaj, MD, Bajaj Finserv, had said in an interview in November. “There can be an individual supervision criterion for very large NBFCs.
Banks are lending to these NBFCs because NBFCs can gather consumer assets in a profitable manner, which banks are either not interested in or cannot. One must understand that these large NBFCs are helping the economy.”
Banking license on tap
RBI did try to allow NBFCs to convert into banks when they opened small banking and universal banking licenses.
While the banking license is available on tap basis, only one entity has filed for it. In the last round, RBI had given two universal bank licenses to Bandhan Bank and IDFC Bank. Bandhan Bank has successfully raised public deposits with 40% CASA, IDFC Bank got merged with an NBFC Capital First to form IDFC First Bank.
Eight micro finance institutions were given small finance bank licenses.
L&T Finance and Bajaj Finance lost out last time because they are backed by corporate houses, which the regulator is averse to. “Converting to a bank will be a logical step, but NBFCs would want some exemptions in terms of maintaining CRR and SLR when they convert into banks,” said Prakash Agarwal, director & head, financial institution, India Ratings. “Given a choice, NBFCs would like to convert into banks. The funding cost can drop drastically as market confidence goes up. RBI would want NBFCs to gain confidence. They would want NBFCs to convert into small finance banks and gradually convert into universal bank as they gain experience.”
Costs out of WACC
The weighted average cost of capital (WACC) for NBFCs is high, especially for financiers seeking long-term funding, but rated below A. The size of the capital market is rather small. Besides, asset and liability profiles for most NBFCs don’t match.
“The current crisis is because some of asset-liability mismatch,” said V P Nandakumar, MD and CEO, Manappuram Finance. “With more regulations around ALM, the issue can be addressed… During the last two decades, there have not been many issues. Today, the issue is not because of credit quality. It is because of irregularity in payments.”
Of the NBFCs that recently converted into banks, very few could mobilise reasonable amount of CASA, a source of lowcost money.
Ujjivan and Equitas have been loss-making after converting into small banks.
Operating expense for the NBFCs goes up because as banks, they must maintain cash reserve ratio and statutory liquidity ratio. They have to bring the entire operations under the core banking system and branches must face RBI’s inspection.
Banks will have to raise CASA to lower their funding costs. Bulk deposit is easy to get, but retail deposit is difficult.
“Operating expenses are higher for banks since they have to meet prudential norms,” said Digant Haria, an analyst with Antique Broking. “Recovery methods are different for banks and NBFCs.
One reason why banks do not get into usedvehicle segment is because banks cannot recover money the way NBFCs can.”
Deterrents and challenges NBFCs will have to transfer all leading activities into a bank and those that cannot be part of the bank will have to be divested.
AU Small Finance Bank sold three of its subsidiaries, including AU Home Finance and insurance broking business to be able to convert into a bank.
Similarly, Shriram Group, Aditya Birla Capital and Bajaj Finance have step-down subsidiaries among NBFCs which need to be merged for a banking license.
For companies such as Edelweiss and India Infoline, the rules of having 10% income from broking or real estate activities may come in the way of conversion.
“The key question that the RBI should address is whether we should have the same set of regulations for all NBFCs even as they vary widely in their business focus and sources of funding,” said Nandakumar.
Whether the regulator likes it or not, big industrial houses like L&Ts, Tatas, Birlas and Bajajs have lending firms and mutual funds which are all inter-connected in the financial system.
These firms need to convert for the safety of the financial system in general. While the regulator should retain all its prudent norms, it should avoid the blanket ban on conglomerates and ring fence finance business from the rest with toughest possible penalties for any violation.