NBFCs in India are poised for Major Growth despite Past Setbacks:

Non-banking financial companies (NBFCs) are steadily cementing their place in India's financial landscape, overcoming past crises and regulatory challenges. M. Rajeshwar Rao, Deputy Governor of the Reserve Bank of India (RBI), dispelled any lingering doubts about their importance on February 9 this year.

“It’s time the NBFC sector comes out of its own shadow as well as that of the banking sector. I am sure NBFCs will play a significant role in achieving the dream of a $5-trillion economy,” he stated.

The Financial Stability Report of December 2023 supported his optimism, revealing that by end-March 2023, NBFC credit to GDP ratio was 12.6% and NBFC credit accounted for 18.7% of the banking sector’s assets, compared to 13% a decade ago.

Almost six years after the blowouts at Infrastructure Leasing & Financial Services (IL&FS) and the erstwhile Dewan Housing Finance Corporation (DHFL) — taken over by Piramal Capital and Housing — and regulatory changes since, NBFCs are back in business.

End of Misplaced Narrative

There were no major issues at the industry or systemic level. There have been periodic concerns at the individual firm level. Some NBFCs were not up to the mark on governance or had an aggressive business model.

That there was nothing inherently askew with NBFCs was evident even immediately after the mess at IL&FS and DHFL. Professionals from various financial institutions had raised close to ?5,000 crore during that period, showcasing the sector’s resilience. It was the biggest pool of capital to back professionals in this space even as some legacy entities were being put through the wringer. In fact, a private equity firm bought a 37% stake in one such financial institution a month after the IL&FS fiasco.

However, challenges remain !

Funding continues to be a concern. Banks, too, are increasingly tapping the same clientele. And given that a banking licence is hard to come by, some may be forced to sell themselves to banks. This raises a question: Will these trends intensify following Mint Road’s move last November to increase risk weights on bank exposure to NBFCs by 25 percentage points? Though this will reduce their reliance on bank credit to grow the book and force them to tap the bond market, large, well-rated NBFCs are not perturbed. They continue to diversify funding sources across banks, bonds (non-convertible), external commercial borrowings, multilateral institutions, and mutual funds.

The appetite for NBFC bonds will be selective, and a lot will depend on ratings and business models, especially after the increase in risk weight. There is a need to develop the market for AA and lower-rated bonds. This is possible only through coordinated efforts by Mint Road, Securities and Exchange Board of India, Insurance Regulatory and Development Authority of India, and Pension Fund Regulatory and Development Authority.

For now, NBFCs are going strong, as is evident from data on securitisation (sell-down of assets to raise funds, mainly by NBFCs). In FY24, volumes were back to record highs of ?1.9 lakh crore, last seen in two fiscals before the pandemic. This is despite the fact that HDFC Ltd. has merged with HDFC Bank and is no more a player in the NBFC space. Adjusted for this, growth is 27%, as HDFC Ltd. had accounted for 23% of ?1.8 lakh crore volumes in FY23. Issuance diversity also rose in FY24: 165 originators and 1,100 transactions compared to 160 and 1,000 in FY23.

Traversing Regulations

Regulation is another area NBFCs are skilfully negotiating. There are at least eight categories of NBFCs of varying sizes and vintage. Painting them all with the same brush is wrong. The regulator recognises this and has introduced SBR (scale-based regulation).

RBI’s four-tiered SBR approach cuts out arbitrage between banks and NBFCs, detrimental to orderly growth and systemic stability. The layers being “base” (NBFCs with assets ?1,000 crore and below); “middle” (assets of ?1,000 crore and above); “upper” (to be specifically identified); and “top” (to be left empty, unless the banking regulator feels an NBFC poses systemic risk). The idea is to enhance transparency and governance while avoiding a heavy regulatory burden. On governance, NBFCs in “middle” and “upper” layers have been put on a par with private sector banks. On April 29, 2022, RBI issued guidelines for fixing the compensation of key managerial personnel and senior management. To address issues arising out of excessive risk-taking caused by misaligned compensation packages, RBI asked NBFCs to put in place a board-approved compensation policy. The guidelines shall include: a) constitution of a remuneration committee, b) principles for fixed/variable pay structures, and c) malus/claw-back provisions. These came into effect from April 1 last year. As of September 30, 2023, “base”, “middle”, and “upper” layers accounted for 6%, 71%, and 23% assets of NBFCs, respectively.

Some say RBI is preparing some large NBFCs for transition to banks. RBI’s Internal Working Group (IWG) to ‘Review the extant ownership guidelines and corporate structure for private banks’ had, on November 20, 2020, made a case for large corporate and industrial houses promoting banks. Large NBFCs, with assets of ?50,000 crore and above (including those owned by corporates), may be considered for conversion to banks, it said. RBI accepted 21 of IWG’s 31 recommendations and said “the remaining are under examination.” A few large NBFCs are again weighing their bank licence ambitions now that the merger of HDFC twins is through. Setting up IWG was “in alignment with the agenda set for economic growth of the country to become a $5-trillion economy,” according to RBI. Rao was spot on: NBFCs have a big role to play as we shift gears on the way to becoming a $5-trillion economy.