Q. State the current state of NBFCs in India?

A. NBFCs are an integral part of India’s financial system and have been instrumental in delivering credit to those segments of the economy which have remained underserved by the banks and financial institutions (FIs). The significance of NBFCs in India is underscored by their contribution to the Government’s agenda of financial inclusion, for being a source of finance for un-organised and under-banked segments and for originating priority sector assets. NBFCs, alongside banks, have played a very useful role in funding India’s economic growth. In particular, NBFCs are the principal conduit for credit delivery for the micro, small and medium enterprises (MSMEs), and the backbone of the India Growth Story. In many ways, they have been leaders in financial product innovation and have played an effective role in funding economic growth, especially in terms of meeting financing needs of the under-served and unbankable class, small enterprises and rural segments of society.

In 2006, the Reserve Bank of India (RBI) re-classified the NBFCs based upon the companies’ financing of real / physical assets for productive / economic activity. They were put under 3 broad categories:

a) Asset Finance Company (AFC)
b) Investment Company
c) Loan Company

The NBFCs are further classified as deposit-taking and non-deposit taking companies. Companies with a net worth of Rs. 100 crore and above were further categorised as systemically important entities

Indian NBFCs for quite sometime have been undergoing a phase of consolidation. The number of NBFCs registered with RBI has declined from 12,968 in June 2007 to 12,809 a year later. The number of deposit taking NBFCs decreased to 364. However, though there has been a fall in public deposits of NBFCs, during this period their total assets increased significantly by Rs. 23,019 crore (a 32% rise) while their net owned funds increased by Rs. 3,974 crore (a
48% rise).

Q. What was the impact of the going on downturn in the economy on your business operations? Most of the industries have been affected by the current downturn and also the default rate has been rising. In such a scenario, what kind of a recovery mechanism has been deployed by your company?

A. During the third quarter of the last financial year, Given the fact that the economy had slowed down, we very appropriately decided to go slow on disbursements and focus more on maintaining a healthy portfolio instead. This strategy has proved to be extremely beneficial for us since through this move, we have been able to avoid risky assets on our book. It also provided us ample time to revisit our customers to affirm our trust in them, especially in times of economic downturn. And now that the economy is showing clear signs of recovery, we are hopeful that with the new government in power, the focus would be on bolstering activity in the infrastructure sector.

Q. Would you agree that NBFCs’ share in the overall retail credit disbursements has reduced over the years and that banks have achieved dominance in the retail segment? In your opinion, what were the factors which led to the demotion of NBFCs’ share?

A. NBFCs emerged as an important part of the Indian financial system and grew rapidly in the second-half of the ‘eighties and the first-half of the ‘nineties. However, the erstwhile lax regulations encouraged a lot of non-serious players to enter the NBFC business, mostly in the deposit taking business. The unhindered entry of numerous fly-by-night operators led to a massive shake-out in the NBFC sector during the late 90s. Depositors incurred huge losses and the credibility of the entire NBFC sector took a severe blow. Thereafter, RBI put in place tough regulations and the NBFCs which survived the shake-out emerged stronger. However, NBFCs still continue to play an important role in disbursement of retail credit. It is difficult to state whether the overall share of NBFCs has declined over the years or not, especially there being a big unorganised NBFC sector in operation. Bulk of financing requirement of non-corporate sector has been met by NBFCs.

Q. Though NBFCs face tough competition from banks but which are those features of NBFCs which provide them an egde over to banks?

A. NBFCs are able to fill the gap of supplying credit to retail customers in the relatively under-served areas and the fast growing proprietorship and partnership sectors. The ability of NBFCs to take quicker decisions, their better customer orientation and grass-roots knowledge of local market conditions have enabled them to carve a niche for themselves in the credit delivery business. And they are able to provide these services at competitive prices. A robust feedback mechanism, which was only possible because of their smaller size and more flexible approach compared to banks, helped them develop tailor made products matching specific needs of the segment being served while maintaining a favourable risk and reward ratio in their credit dispensation. It is therefore, not surprising that NBFCs, have time and again shown the way to banks as adaptive as well as efficient lending institutions through their core strengths of strong underwriting norms, penetrative market knowledge, cost-effective operations and highly personalised good quality customer service.

NBFCs have been pioneers on several fronts. Financing of small town truck operators with limited means for buying used trucks and equipment and tractor financing in less banked/unbanked areas has proved the agility and enterprise of the NBFCs. The NBFCs, other than serving the un-banked customers, also had a positive impact on some of the underlying sectors viz., auto sector, construction sector, etc. Their success in businesses which were earlier considered risky has actually encouraged the banks to follow suit.

NBFCs were quick to notice that repayment of such lendings has to be based on cash flows rather than the underlying asset. The banks had traditionally lent on the strength of the underlying asset and mostly ignored the timing and amount of cash flows while determining the product feasibility.

NBFCs also ventured into areas like retail asset backed lending, where they remained predominant for a period of time. With the large scale entry of banks, the situation has now changed but still NBFCs have not only sustained their own growth but are also complementing the growth of the banks by becoming their conduits for credit delivery through Portfolio Buyouts, Securitization and Acting as Channel Partners.

NBFCs have also played a pioneering role in the business of securities-based lending such as Loan against Shares (LAS), Margin Funding, Initial Public Offering (IPO) Financing, Promoter Funding, etc. These customized credit products have added liquidity and encouraged retail participation in public issues in particular and equity markets in general, resulting in better price discovery. A CRISIL analysis shows that timely availability of IPO financing has resulted in a substantial increase in subscription levels in IPOs, and broadbasing of equity markets.

Like their counterparts internationally, NBFCs in India also play a very significant role in the country’s economic development even though the support and nurturing they have received from the entire system is far less than in most other financial systems.

Q. What are the challenges faced by the NBFCs? In your opinion, what steps should be taken by the government and RBI in order to provide sustained development of NBFCs in India.

A. The principal challenges that NBFCs presently face are essentially on 3 fields :

a) Tax structure
b) Access to asset recovery facilities
c) Access to funding

Q. The gloomed economic scenario has made banks reluctant in lending to NBFCs which has further dried up the sources of funds for the NBFCs. What steps or changes in regulations are you expecting the government to make in order to increase the liquidity condition. In your opinion, what would be the factors which would lead to the sustained growth of NBFCs in the long term? Do you think in the long term, there would be some change in the business model of the NBFCs due to strong competition of banks? State your outlook on the NBFCs for the next two years. Which of the industries would provide sustained and lucrative returns in the long term?

A. With infrastructure creation emerging as a national priority, there is an urgent need to provide NBFCs, especially those into financing of infrastructure assets such as construction equipment (such as earth-moving equipment, material handling equipment, etc.) and general purpose industrial machines) and / or active in infrastructure project financing, a different framework of rules and regulations so that they can actively contribute to the process of speedy infrastructure creation. Recommendations for overcoming the hurdles that NBFCs face (as mentioned in Q 6) are given below:

(A) Tax Issues

(i) Direct Tax : Though the NBFC-AFCs are regulated by the RBI just like banks and other FIs, they are saddled with various taxation incongruities, unlike banks and other FIs. In this context, three vital Direct Tax issues need to be reviewed :

a) Section 194A (3) (iii) of the Income Tax Act

Banking companies and Cooperative societies engaged in banking business are exempted from the purview of section 194A of the I.T.Act. Therefore, the borrower is not required to deduct TDS out of the interest payment made to these entities. Since, this is benefit is not available to NBFCs, their margins and cash flow are severely affected. Therefore section 194A (3) (iii) of the I.T.Act, may be suitably amended to grant exemption from TDS on interest payment to
‘NBFC-AFCs’ also.

b) Section 194-I of the I.T.Act

Hire charges, Lease rents are also being subjected to deduction of income tax at source under section 194-I, besides being subject to Service Tax and VAT. Due to lower Net Interest margins in Hire-purchase/Lease transactions, such deductions make the entire gamut of Hire-purchase and Lease transactions unviable and has in effect killed a widely accepted method asset creation for MSMEs. Therefore section 194-I of the I.T.Act, may be suitably amended to exclude Hire-purchase/Lease transactions of Plant and machinery done by ‘NBFC-AFCs’.

c) Section 36 (1)(viia) of the I.T.Act

Under this section, provisions for bad and doubtful debts made by banks and FIs, following RBI guidelines, are allowed as a deduction to the extent of 7.5% of gross total income (applicable to all lending institutions) and additional 10% of aggregate of average rural advances (applicable to public sector lenders). The benefits under the section 36 (1)(viia) of I.T.Act may also be extended to NBFC-AFCs. This will provide them a level playing field vis-à-vis banks and other FIs.

(ii) Indirect Tax : Multiplicity of indirect taxes on various financial transactions acts as a severe deterrent mostly for the MSME infrastructure players. When it comes to procurement of assets like equipment by way of rent or finance (from NBFC-AFCs mostly), the same transaction gets taxed multiple times at both central and state authorities. Equipment rental is a typical example of such a transaction. As per the Service Tax Act, state VAT cannot be imposed on a rental transaction for which service tax has already been paid. Constitutionally and logically too, any transaction can either be a ‘Sale’ or a ‘Service’, but cannot be both. Thus, such treatment is causing huge harassment for players who are going for such mode of asset procurement. This affects the MSMEs all the more because they are not in a position to cough up the resources. Neither do they have the wherewithal to enter into litigation which will again be a timeconsuming process. They are basically left at the mercy of the tax authorities.

This issue needs to be addressed on an urgent basis. Effective co-ordination between Ministry of Finance at the Centre and the State Finance Ministers on this subject is therefore a must. An ideal platform for taking up this matter can be the high-powered Committee on VAT which is headed by Mr. Asim Dasgupta, Finance Minister of West Bengal. This forum looks after the implementation of VAT across states and regularly co-ordinates with Ministry of Finance at the Centre.

(B) Repossession Facilities

NBFC-AFCs find it extremely challenging to repossess assets when a loan goes bad. Repossession of construction equipment, in particular, is very problematic. The present situation needs to be addressed by bringing NBFC-AFCs under laws which equip banks and other FIs to deal with defaulting customers:

(i) Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act 2002 :

Banks and FIs have been notified under the Act, giving them the ability to move against defaulting borrowers and secure their assets. Subsequently, specified housing finance companies (HFCs), have also been notified under the act. NBFCs are the only segment of the financial sector that has not been notified under the Act. It is submitted that in order to protect interests of investors, NBFC-AFCs be brought within the purview of the SARFAESI Act.

(ii) Debt Recovery Tribunals (DRTs)

RBI had favourably considered access of NBFCs to DRTs and it was proposed that number of DRTs in the existing set-up be increased. This would fulfill a long felt need of the NBFC-AFCs and lead to speedier realisation of their dues. However, action on this front is still awaited.

(C) Funding
(i) External Commercial Borrowings (ECB)

Following the government decision to ban ECB access to banks and NBFCs in November 2003, the NBFC sector made numerous representations to the government so that the decision was reconsidered. Thereafter, the policy underwent several amendments. Infrastructure financing NBFCs are now allowed to access ECBs. However, there are certain conditions, mentioned below, which make ECB route difficult :

(a) ECB can be sourced only from multilateral / regional FIs and government owned DFIs.

(b) Infrastructure financing NBFCs are allowed to obtain ECB under the ‘approval route’.

The conditionalities are discussed in detail to highlight the inherent flaws :

(a) ECB from multilateral/ regional/ government owned development FIs only

As it is, presently there are very few lending agencies willing to invest have their unique set of problems. Institutions like International Finance Corporation (IFC) – the private lending arm of The World Bank Group and Asian Development Bank (ADB) have their elaborate appraisal procedures which take a long time from sanction to disbursement, many a time spanning over a period of one to two years. Regional lending organisations and government sponsored FIs like Germany’s KfW and Japan Bank for International Co-operation (JBIC) prefer lending to primarily those projects which would source inputs from the lender country. Such aspects often reduce the number of options from which ECB can be sourced.

In this backdrop, RBI should allow tapping ECB funds from reputed international banks and bilateral FIs. Making available a wider choice of lenders will also facilitate the borrowers to work out favourable loan terms and conditions.

(b) ECB under ‘approval route’ only

It is worthwhile to note that infrastructure building firms are allowed to access ECB under the ‘automatic route’. Thus, it is only logical to keep the ECB window open to both infrastructure building firms and infrastructure financing firms under the ‘automatic route’. Thus, infrastructure financing NBFCs will be better placed in servicing the credit needs of the MSME players in an expeditious manner.

(ii) Refinance Facility from IIFCL

The Indian Infrastructure Finance Corporation Ltd. (IIFCL) has been formed as a dedicated funding vehicle for providing long term funds to Indian infrastructure projects in India. IIFCL raises its debt from bilateral and multilateral institutions and in foreign currency through ECB. IIFCL’s borrowings are generally backed by sovereign guarantee. IIFCL has also been permitted to raise Rs. 30,000 crore through tax-free bonds for onward lending to infrastructure projects.

The resources thus raised are used by way of :

(a) long term debt
(b) refinance to banks and FIs for loans with tenor of more than 10 years
(b) any other mode approved by GoI

The Government wants to ensure that these funds are expeditiously disbursed and utilised in infrastructure projects. The MSMEs, spanning across urban and rural India, do not have access to institutional credit, nor are they in a suitable position to access external commercial borrowings (ECBs) of their own. NBFCs help bridge this gap by financing MSMEs, in a timely and efficient manner.

Timely and cheaper credit to these MSMEs is essential for the commercial viability of the infrastructure projects. Besides credit delivery, NBFCs can reach out to numerous MSMEs catering to large infrastructure projects across the country, which a single institution, like IIFCL, alone may not be in a position to achieve. Therefore, to expand the coverage of the funds and expedite credit delivery to infrastructure projects, government should extend refinancing facility to infrastructure financing NBFCs through the IIFCL window.

(ii) Tapping funds from Insurance companies and Provident Funds (PFs)

Funds from insurance and provident fund are long-term domestic funds. So far insurance and PF agencies have been allowed to invest in mutual funds. If government allows them to invest in infrastructure financing NBFCs, that would go a long way in addressing the asset-liability mismatch problem for this class of NBFCs, besides opening a safe long term investment avenue to Insurance companies and PFs. This would lead to a win-win situation for both.

Since Insurance companies and PFs look for safe long term investments to sustain their periodic payouts to small investors, by investing in infrastructure financing NBFCs, insurance companies and PFs can to not only get higher returns in the long-run but also sustained cash-flow. At the same time, infrastructure financing NBFCs would also have access to long-term funds and thus would be in a position to enhance their activities in the field of infrastructure financing.

Government should allow insurance firms and provident funds to invest in infrastructure financing NBFCs.

(iii) Special Credit Lines and high cost of funds

In order to enable cheaper loans to MSMEs, banks and FIs may be advised to provide credit lines and funds to NBFCs at concessional rates by classifying it under ‘priority sector lending’.

Although the Government has been asking the banks to reduce rate of interest on lending to NBFCs, the effective cost of borrowed funds continue to remain exorbitantly high, because the banks charge a high up-front fee and processing fee on loans disbursed to NBFCs, thereby on-lending cost to MSMEs also become very high.

In order to enable cheaper loan to MSMEs, we humbly suggest that, banks may be requested to:
a) charge maximum interest rate of PLR + 1% on loans to NBFCs and,
b) put a cap on upfront fees, processing charges, and all other charges on loans to NBFCs. (say 0.1% on the sanctioned loan amount, with a ceiling of Rs.2 lakh).