Overview:Non-Banking Financial Institutions

Non-banking financial institutions (NBFIs), a heterogeneous group of institutions, form an integral part of the Indian financial system and provide a range of financial services. These institutions are an important segment of India’s financial roadmap apart from commercial and co-operative banks. Within the non-banking financial institutions, development finance institutions (DFIs) are mostly government-owned and have been the traditional providers of long-term project loans. The NBFIs include a wide variety of intermediaries like insurance companies, non-bank financial companies (NBFCs), primary dealers (PDs) and capital market intermediaries like mutual funds.

The Indian financial sector has witnessed the emergence of a wide range of financial institutions over the years that cater to the economy’s diverse financial needs. The NBFIs play a very critical role among these financial institutions. The NBFIs along with the banking sector have immensely contributed to the inclusive growth and development of the economy by increasing the access to financial services, enhancing competition and diversifying the financial sector among others. These NBFIs are also increasingly being perceived to be complementary to the banking system as they are capable of absorbing shocks and spreading risks, particularly during times of financial distress. This chapter deals with the structure, performance and issues confronting NBFIs in India.

Structure and size

The segments in the NBFIs are multi-faceted; companies operating in this segment range from DFIs, SFCs, and other institutions actively engaged in lease finance, hire purchase finance, investments in securities, grant of loans, including bills discounting, insurance, stock broking, merchant banking and housing finance. Primary dealers in government securities also form an integral part of NBFCs. However, the number of PDs has come down to 9 in 2008 from 17 in 2006 due to the change in the structure of primary dealer system.

Financial institutions

A wide range of financial institutions (FIs) have evolved in the Indian financial sector over the years to meet the medium to long-term funding requirements of the different sectors in the economy. FIs can be classified as term lending, refinance or investment institutions. NABARD, SIDBI and NHB are refinance institutions that mainly extend refinance options to banks and NBFIs.

The distinct feature of all FIs is that they are all primarily government-owned, with either state or central control. SFCs and state industrial development corporations are some of the state-sponsored and controlled FIs. A sizeable portion of exposure of SIDBI is by way of refinance to SFCs.

Trends in Financial Institutions
Total disbursement by FIs rise during FY08

Financial assistance sanctioned by FIs accelerated sharply during FY08. The total disbursement by FIs was Rs 435.1 bn in FY08. Due to increase in the assets held by FIs, the combined balance sheet of select FIs (NABARD, NHB, SIDBI and EXIM Bank) expanded by 19.5% during FY08.

The uncertainty in global markets and loss of creditability of private players helped the FIs garner deposits from public. As a result, these FIs decreased their borrowings through relatively costly options like bonds and debentures, which declined by 3.5% during FY08 from FY07. The deposits and borrowings of these FIs, however, recorded a sharp increase of 54.1% and 56.7% while the investments declined by 9.3%.

Overall improvement in asset quality

The absolute value of NPAs of the two institutions (EXIM, NABARD) decreased sharply to Rs 830 mn and Rs 19 mn in FY08 from Rs 115 mn and Rs 23 mn respectively.However, that of SIDBI witnessed a marked increase. Although SIDBI’s net NPAs to net loans ratio increased as at Mar 2008 as compared with Mar 2007, the ratio was quite low otherwise. (NHB doesn’t report any NPAs during the year). Another remarkable feature was that none of the FIs had any loss asset in their portfolios.

Non-interest income grows

The interest income for FIs grew by 27% at Rs 115.4 bn in FY08 over the previous year. The growth in the non-interest income of FIs was as impressive as the previous years at 71.8%. The profits for the year grew by 22.7% while the operating expenses rose 46%.

Primary dealers account for 48% in primary auction allotments

The Primary dealers (PD) system facilitate Government’s market borrowing programme and improves the secondary market trading system by contributing to price discovery, enhancing liquidity and turnover and encouraging voluntary holding of Government securities amongst a wider investor base. It acts as an conduit for open market operations.

Performance and operation of Primary dealers

During 2007-08, the PDs offered to underwrite the auctions of Central Government dated securities to the extent of Rs 2,765.2 bn. Total assets of PD declined during FY08 by 19.7% due to the restructuring of their businesses. Three PDs hived off their PD operations to newly set up group entities with reduced capital.

The income earned by the PDs declined by 33% during FY08 as compared with that in FY07, due to restructuring of business by PDs and consequent decline in income from other activities that were not allowed to be undertaken by PDs. The total income stood at Rs 13.1 bn for FY08, while the net profit stood at Rs 3.7 bn.

Non-banking financial companies (NBFCs)

NBFCs have been competing with and complementing the services of commercial banks for a long time. Initially intended to cater to the needs of small savers and investors, NBFCs have turned into institutions that are on a par with banks. However, NBFCs are distinct from banks as their regulation and supervision is much lower as compared to banks. NBFCs, for instance, are not subject to cash reserve requirements but unlike banks they do not have deposit insurance coverage and refinance facilities from the RBI. These entities operate in the financial market. There are two broad categories of NBFCs, namely NBFC - deposit taking (NBFC-D) and NBFCs - non-deposit taking (NBFC-ND). The NBFCs on the whole constitute 9.1% of assets of the total financial system.

The NBFCs in India owe their roots to the highly-regulated banking sector in the 1980s as this tight regulatory framework led to the emergence of a host of NBFCs that were powered by factors like flexibility, timeliness in meeting credit needs and low operating cost. Over a period of time, these NBFCs evolved into a heterogeneous group of institutions that performed financial intermediation in a variety of ways like accepting deposits, making loans and advances, leasing, hire purchase, etc.

RBI classifies NBFCs into three groups viz.

1. Asset finance companies: AFCs are companies that finance real/physical assets for productive/ economic activity.
2. Loan companies: These companies include any financial institution whose principal business is to provide finance, whether through loans or advances or otherwise for any activity other than its own (excluding any equipment leasing or hire-purchase finance activity).
3. Investment companies: Investment companies mean any financial intermediary whose principal business is that of buying and selling securities.

Definition and Regulatory Framework

An NBFC is defined as a company registered under the Companies Act 1956 and engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/securities issued by the government or local authority or other securities like marketable nature, leasing, hire-purchase, insurance business, chit business but which does not include any institution whose principal business is agriculture, industrial, sale/purchase/construction of immovable property.

NBFCs are governed by the RBI under the section 45-IA of the RBI Act. The Act makes it mandatory for every NBFC to be registered with RBI to commence or carry on any business of non-banking financial institution. However, to avoid dual regulation, certain categories of NBFCs that are regulated by other regulators are exempted from the requirement of registration with RBI viz. venture capital fund/merchant banking companies/stock broking companies registered with SEBI, insurance company holding a valid certificate of registration issued by IRDA, Nidhi companies as notified under Section 620A of the Companies Act 1956, Chit companies as defined in clause (b) of Section 2 of the Chit Funds Act 1982 or housing finance companies regulated by the National Housing Bank.

For the purpose of regulation NBFCs are segregated into three distinct categories. These are deposit-taking NBFCs (NBFC-D), non-deposit taking NBFCs (NBFC-ND) and residuary nonbanking companies (RNBC). NBFCs in India are not permitted to accept demand deposits and are not part of the payment and settlement system. While the NBFC-D segment and the RNBCs have been monitored closely, NBFC-NDs were till recently subject to minimal regulation. In recent years, however, with a view to attaining a level–playing-field as also to reduce the systemic risk in their operations, the RBI has initiated steps to increase the scope of regulations for NBFCs-ND.

Trends in NBFCs
Number of registered NBFCs on a decline

As on end June 2008, the total number of NBFCs registered with the RBI was 12,809. These registered NBFCs include NBFCs-D (deposit-taking NBFCs), RNBCs (Residual non-banking company’s, mutual benefit companies (MBCs), miscellaneous non-banking companies (MNBCs) and Nidhi companies. The number of registered NBFCs declined by 159 from 12,968 at the end of June 2007. Among the NBFCs, the number of NBFCs-D declined from 401 as at June 2007 to 364 as at June 2008, mainly due to the exit of many NBFCs from deposit-taking activity.

Public deposits declined by Rs 3,040 mn in FY08 over the previous year, partly reflecting the decline in number of reporting NBFCs. The total assets increased by 32.1% to Rs 230.2 bn partly due to the restoration of IFCI Ltd and TFCI Ltd to the NBFC category.

High total income growth results in higher profit

The changed focus of companies in their marketing and target segments has paid off well. These companies benefited from the rising income levels in the economy along with the upwardly mobile young population. Many companies went into the retail segment and ventured into personal vehicle and housing loans. However, specialisation in different aspects of service and product offerings paid off well for these companies.

The NBFCs registered an impressive performance during FY08 as compared with the previous year. The total income for the group grew by more than 79.3% to Rs 102.6 bn in FY08. The growth in total income was driven by both fund-based income and fee-based income, which rose sharply by 79.8% and 56.6%, respectively.

Though total expenditure witnessed an increase of 45.4%, the phenomenal rise in total income led to a decline in the cost to income ratio. The cost to income ratio for the NBFCs declined from 84.4% in FY07 to 68.5% in FY08, which resulted in a 293.8% increase in net profits.

Asset quality may pose challenge in near future

During the boom time companies expanded their customer base and in the process exposed themselves to greater risks. The current global slowdown has resulted in lower growth in housing and real estate segments, and it has decreased individual income levels. Companies have reported higher delinquencies in their retail portfolios and this is likely to increase bad loans and non-performing assets in their books. In FY08, the net NPAs as a percentage of net advances and gross NPAs as percentage of gross advances of NBFCs-D declined over the previous year; however the companies in the NBFCs-D segment may find it difficult to maintain this progress.

Gross NPAs as percentage of gross advances of equipment leasing and hire purchase companies increased during FY08, due to reclassification of NBFCs, while those of AFCs and loan companies declined. Net NPAs as percentage of net advances increased marginally in case of AFCs, hire purchase companies and investment companies, while those of equipment leasing companies, and loan companies improved further.

Shift in asset class from hire purchase to loans and advances

In FY08, the total assets of NBFCs-D (excluding RNBCs) grew by 44.8% to more than Rs 702 bn as compared with the previous year. The total investments for FY08 increased by 55.2% as compared with 71.3% in the previous year. The total investments of NBFCs decelerated mainly due to fall in investments in approved securities. During FY08, investments in approved securities increased by around Rs 3.1 bn whereas in FY07, it increased by around Rs 3.9 bn. Other investments, which had declined during FY07, increased sharply by 33.1% during FY08. As the prices of all major asset classes tumbled in the previous year, the profitable realisation of these investments will be a challenge for these companies. Hire purchase assets witnessed a deceleration, while loans and advances witnessed a sharp rise during 2007-08.

Borrowings – Still the major source of funds

Further analysis of the balance sheet reveals the significance of borrowings as a major source of funds for the NBFCs. Borrowings as a percentage of total liabilities increased to 71.7% in FY08 as compared with 66.8% in the previous year. On a y-o-y basis, borrowings increased by 55.3% during FY08 as compared with 30.5% in FY07. Public deposits witnessed a decline of 1.9% to constitute around 2.9% of total liabilities in FY08 as compared with 4.3% of total liabilities in FY07.

AFCs hold the largest share in total liabilities

Among NBFCs, AFCs held the largest share in total liabilities of around 64.1%. AFCs were followed by the loan companies that had a 27.5% share, hire purchase companies with 7.5% share and investment companies with 0.6% share.

The increase in liabilities of AFCs was a result of reclassification of NBFCs, initiated in December 2006 and continuing even today. On the other hand, the loan companies’ liabilities increased mainly on account of restoration of IFCI Ltd and TFCI Ltd from FIs category to the loan category of NBFCs. The share of equipment leasing companies declined below 1% in FY07 and FY08 from a considerable share of 9.2% in FY06 upon the re-classification of NBFCs in 2006-07. The relative significance of various NBFC groups reflected largely the pattern of their borrowings as deposits constituted a small share of their total liabilities.

Loan companies see a phenomenal rise in deposits due to reclassification

Public deposits held by NBFCs declined moderately during FY08, continuing the trend of the previous year. This trend was indicative of the shift in preference of NBFCs from public deposits to bank loans/ debentures. In the meanwhile borrowings continued to increase in FY08.

The decline in public deposits was mainly evident in the case of equipment leasing companies and hire purchase companies, mainly due to reclassification of some of these companies as AFCs. In FY08, of the total deposits held by all NBFCs, AFCs held the largest share of around 56.7% in total deposits of NBFCs, followed distantly by hire purchase companies with a 26.2% share and by loan companies with a share of 15.8%. At the same time, deposits of AFCs increased by 521.5%. The deposits of loan companies also increased by 174.3%, mainly reflecting the inclusion of IFCI Ltd and TFCI Ltd in this category.

Southern Region dominates in terms of deposits

A region-wise analysis of deposits of NBFCs revealed that the southern region had a dominant share of 80% in deposits in FY08 followed by the northern and western region with 14% and 4% shares, respectively. However in terms of number of NBFCs, the northern region took the lead with 181 NBFCs present in the region. There were no NBFCs operating in the north-eastern region during the year.

The way ahead for NBFCs

The sudden slowdown in the economy caused many NBFCs to hold on to their expansion plans. Moreover incremental sanctions and disbursements were also put on hold, considering the falling income levels. Many companies saw rising delinquencies in their retail portfolios pressurising their profit margins. Also, with the prevailing credit crunch companies were finding it hard to meet their repayment obligations. As companies went in for high interest loans to repay their obligations, their margins were further pressurised.

Major segments can take time to recover

With initial sign of pick up in the economic environment, companies will try to grow their business. However, it may take some time for the major segments to pick up in which NBFCs operate:

Housing loan segment: Rising interest rates and overall slowdown hit the housing loan segment a lot. Companies were not willing to extend these loans considering the rise in delinquencies and customers were also not going in for these loans anticipating a dip in real estate prices. The real estate has seen some correction in prices. With interest rates going down in the economy, companies can look forward for a recovery in this segment. However, the recovery will be a slow process.

Personal loans segment: Due to the nature of loans in this segment, companies are more vulnerable to defaults in this category. Personal loans are normally extended without any collateral and are difficult to recover. The slowdown has affected the income levels in the economy and the unemployment rate has increased. Already companies are seeing rise in delinquencies and they may be wary of extending loans in this category.

IPO and secondary equity market financing: The slowdown had an adverse impact on the equity markets all over the world. Indian stock markets also suffered. As the stock markets tumbled, the IPO market dried up and left no place for lending. Secondary equity market is another segment where the proceeds from personal loans were deployed during the bull run. However, the crash turned away investors due to heavy losses. Also, the stringent requirement by the RBI to check the flow of money in stock markets companies did not lend heavily in this segment. However, in recent times, the markets have again started rising up and some companies also have plans to go public. In future, NBFCs can finance IPOs.

Infrastructure finance: This sector was affected by the slowdown but not as much as the real estate sector. The government’s focus on infrastructure lending has kept the money flowing in this sector. The companies operating in this segment may see rise in their business.

Vehicular financing: High interest rates and slowdown in economy marred the flow of credit to this sector. Commercial vehicle financing saw a dip in line with the slowdown in broad economic conditions. With the dip in interest rates demand may revive in the sector.

NBFCs are expected to play a major role in the inclusive growth of the economy by partnering with the banks or even serving as a delivery channel to provide last mile connectivity to reach the currently untapped demand base particularly in rural India.