Industry AnalysisIndustry

: Finance - NBFC

NBFCs continue to consolidate; outlook remains stableThursday,July 31,2014

NBFCs have rapidly emerged from a period of concentrated regional operations, low credibility and poor risk management practices to the one which is highly sophisticated of operations, has pan-India presence to emerge as an alternate option of financial intermediation. The segment, which has witnessed considerable growth in the last few years, has been recognized as complementary to the banking sector due to implementation of innovative marketing strategies, introduction of tailor-made products, customer-oriented services, attractive rates of return on deposits and simplified procedures, etc. Today, the sector, which accounts for around 12.5% of the assets of the total financial system, is present across many competing fields of vehicle financing, housing loans, hire purchase, lease and personal loans.Further, given that bank assets as a percentage to GDP is approaching 100% mark, NBFC sector has a tremendous potential to scale up and increase its contribution to the Indian economy. Globally also, the NBFC sector is accorded great importance and has even surpassed the size of GDP in developed economies including the US, the UK and the Euro Area.However, under present conditions, NBFCs are faced with a number of issues, which remain unaddressed for the sustainable growth of the sector relating to unmet demand for funds, raising core capital, proposed NPA classification norms, lack of legislative framework for safeguarding depositors' interest and strengthening customer protection and non-parity with banks on taxation.Owing to the prevailing economic downturn, the NBFC sector is also showing signs of stress as evident from the steep rise in NPAs. Further, with high interest rates and reduction in lending by banks, NBFCs are facing the dual impact of rising credit costs and tight liquidity situation.It may be pointed out that the NBFC sector has been witnessing a consolidation process in the last few years, wherein the weaker NBFCs are gradually exiting, paving the way for a stronger sector. Presently, 12,029 NBFCs are registered with Reserve Bank of India (RBI) as on March 31, 2014, which were 12,225 at the end of June 2013, as per RBI.

Change Indust

Of the total number of registered NBFCs, 241 firms were deposit-taking; 465 firms were non-deposit-taking with asset size of Rs 100 crore and above; 314 firms were non-deposit taking NBFCs with an asset size between Rs 50 crore and Rs 100 crore and finally, 11009 firms were the ones with the asset size of less than Rs 50 crore.Performance of NBFC-ND-SICapital Adequacy:Capital to risk-weighted assets ratio (CRAR) norms were made applicable to NBFCs-ND-SI with effect from April 2007, in terms of which every systemically important non-deposit taking NBFC is required to maintain a minimum capital, consisting of Tier-I and Tier- II capital, of not less than 15% of its aggregate risk-weighted assets. However, the aggregate CRAR of the ND-SI NBFC sector have risen to 28.1% in quarter ended March 31, 2014 as compared to 27.2 % in similar quarter of the previous year. However, higher capital adequacy of most NBFCs is unlikely to constrain business growth and offers assurance against further delinquencies

Asset Quality:Owing to the prevailing economic downturn, the NBFC sector is also showing signs of stress as evidenced from rise in NPAs. Non-deposit taking- systematically important- Non Banking Financial Companies’ gross NPA as a percentage of total credit exposure (aggregate level) though stood stable at 2.8% from December quarter, but have risen from 2.2% in quarter concluded March 30, 2013. (Y-o-Y basis).

Profitability:The Returns on Assets (RoA), which is one of key measures of profitability, of NBFCs-ND-SI stood at 2.3% in March 2014, higher against 2% witnessed in corresponding quarter of previous year i.e. March, 2013.

The proposed norms on prudential regulatory framework of non-banking finance companies

(NBFCs) by Reserve Bank of India (RBI), however could impact the overall profitability of NBFCs due to higher provisioning requirements for standard assets and revision in non-performing assets (NPA) norms.The RBI panel had proposed that the asset classification and provisioning norms (including standard assets provisioning norms) to be made similar to banks for all registered NBFCs, be implemented in a phased manner. Like, the period for classifying loans into NPAs in case of NBFCs was higher at 180/360 days compared to 90 days for banks, RBI had proposed NBFCs to comply with the requirement of a 120 day norm from April 1, 2014 to March 31, 2015 and a 90 day norm thereafter.The guideline, based on the Usha Thorat Committee Report on Issues and Concerns in NBFC Sector, released on Dec 2012, also proposed to raise the provisioning for standard assets to 0.25% to 0.40% of the outstanding amount with effect from March 31, 2014 for all NBFCs.Challenges faced by the sector:Difficulty in raising funds: Policy and regulatory changes relating to, removal of the priority sector lending status on bank-loans to NBFCs from April 1, 2011, restrictions placed on providing credit enhancement in bilateral assignment transactions under the revised securitization guidelines of August 2012, and the sectoral cap of 30% on mutual funds’ debt investments by SEBI in October 2012 has put lot of hardship for NBFCs in raising funds at competitive rates resulting in higher cost to the end borrowers.Additionally, bank lending to NBFC sector also has come down substantially. As per the latest data available, NBFC borrowings from the banking sector, which is one of the major sources of funding for the sector increased manifold from Rs 54200 crore as on March 31, 2006 to Rs 250800 crore in March 31, 2013 (an increase of more than 4 times). However, growth of bank credit to NBFCs decelerated in March 2013 to 13.6% from 32.5% and 42.8% recorded in September 2012 and March 2012. This deceleration is attributed to lower demand for auto and consumer loans, stricter norms on lending against gold, withdrawal of priority sector status for some loans given by banks to NBFCs for on-lending for specific purposes, etc. Further, bank credit to NBFCs decelerated on account of revised DBOD guidelines.Disparity in tax rules for NBFC: At present, NBFCs are taxed on deferment of income in the year of accrual, while banks, PFIs, state finance corporations, housing finance companies and state industrial investment corporations are taxed only when it is received or credited to the profit and loss account, whichever is earlier.Like other lenders, NBFCs too follow the Reserve Bank of India's (RBI's) prudential norms and defer income regarding their NPAs and make provisions for the same. However, income tax authorities do not recognize these norms and tax NBFCs on such deferment of income on accrual basis resulting in tax on unrealized income.Slowing credit demand: Non-banking finance companies (NBFCs) are witnessing a slow growth in retail credit due to a significant slowdown in the key segments, like construction equipment, commercial vehicle and gold, which constitute around 56% of NBFCs' total retail credit. This slowdown is expected to have some pressure on asset quality and margins.Macro-economic uncertainty: The cross-sectional distribution pattern of the industry depends much on the performance of the economy as a whole. As slowdown in the economy increases the risk of default and restructuring of loans can increase, which could further lead to a deterioration of asset quality.Though inflation, both CPI and WPI have shown signs of easing, along with pick up in manufacturing sector, a few important concerns remain. The fiscal-deficit has remained

stubbornly high for the past few years and while the Government hopes to contain it at 4.1%, for the year, the task might yet prove to be very formidable.International crude oil prices have been volatile in the wake of the unrest in Iraq and could have a significant impact on domestic inflation. Finally, downside risks to growth have been further aggravated with predictions of a below normal monsoon, in the wake of the El Nino phenomenon. The progress of the Southwest monsoon, which set in late, has been rather tardy and could have a significant bearing on agricultural output this year.Remedial Measures for the Industry:Greater Innovation: Although NBFCs have been designing innovative products to suit the client and market conditions, the sophistication of financial services has been gradually increasing in the recent past. There is an imperative need for NBFCs to aggressively evolve in designing innovative products to become real game changers in the economy.White Label ATMs: With NBFCs already having significant business presence in semi-urban and rural centres, they should explore business potential by establishing white-label ATMs in such areas. These ATMs can be used by any domestic debit card holder to withdraw cash, make a balance inquiry, change the personal identification number or ask for mini statements.Recently, Reserve Bank of India (RBI) authorized three more non-banking finance companies (NBFCs) to open and operate so-called white-label automated tellers machines (ATMs) in addition to the four companies allowed earlier. Bangalore based BTI, Kolkata-based Srei Infrastructure Finance and Mumbai-based Riddhi-Siddhi Bullions have been given authorization to set up ATMs.Need for a single representative body for the Industry:In the case of NBFCs, there are multiple representative bodies such as ‘Finance Industry Development Council (FIDC) for Assets Finance Companies’, ‘Association of Gold Loan Companies (AGLOC) for Gold Loan NBFCs’, etc. In addition, RBI has recently issued guidelines for ‘Self-Regulatory Organization for Micro Finance Institutions’.At this stage of development of the NBFC sector, in the interests of harmonious development of all its segments, establishing one representative body for the entire sector would be an idea worth exploring by subsuming the existing bodies. However, care should be taken to ensure that all segments are adequately represented in such an apex body, to promote harmonious and balanced growth of the sector and avoid internecine conflicts.Proper grievance redressal mechanism: Prot

Industry Analysis

Industry

: Finance - NBFC

NBFC’s brace for tougher norms from RBIThursday,November 13,2014

Non-Banking Financial Companies (NBFC) have evolved as an important segment of the Indian financial system, which operate across a variety of segments, including car and commercial vehicle finance, loans against property, gold loans and unsecured retail loans. The sector, which accounts for around 12% of the assets of the total financial system, has emerged as a vital intermediary for financing and has provided strong competition to banks and financial institutions. They are undoubtedly complementary to the banking system, capable of absorbing shocks and spreading risks at times of financial distress.However, the privileges that NBFC had enjoyed over banking system have almost vanished as Reserve Bank of India, in order to create a level playing field and for eliminating arbitrage opportunities between banks and non-banking finance companies (NBFCs) have tightened the rules for shadow banks, by raising minimum capital requirement funds limit, while capping deposit acceptance and aligning bad loan norms with banks. These recommendations by India’s apex bank are in line with those suggested by suggested by the Usha Thorat committee and suggestions made by member of Central Board of the RBI, Nachiket Mor.Nevertheless, across the world, shadow banking activities have come under the scanner following the global financial crisis of 2008, particularly in developed nations where these entities played a more active role than in India. Shadow banks are entities that undertake credit intermediation very similar to banks, but escape the stringent regulation that the latter are subjected to. The modus operandi of such entities lacks transparency with respect to business model, leverage, and ownership which makes it difficult to regulate them.Performance of the SectorNBFC witnessing consolidation:The NBFC sector has been witnessing a consolidation process in the last few years, wherein the weaker NBFCs are gradually exiting, paving the way for a stronger sector. This trend can be understood by the number of NBFCs registered with RBI going down to 12,029 in 2014 from 12630 witnessed in 2010.However, the current decline in the number of registered NBFC is mainly due to cancellation of certificates of registration and migration of non-banking finance companies that accept public deposits (NBFC-D) to the non-deposit-taking category.

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A total of 12,029 NBFCs have been registered with RBI as on March 31, 2014, out of which 421 firms have been registered as deposit taking NBFCs; while 465 stand as non-deposit taking NBFCs with asset size of Rs 100 crore and above, additionally, non-deposit taking NBFCs with asset size between Rs 50 crore and Rs 100 crore stand at 314 and those with asset size less than Rs 50 crore stand at 11009.As on March 31, 2014, the average leverage ratio (outside liabilities to owned fund) of the NBFCs-ND-SI stood at 2.94, Return On Assets (net profit as a percentage of total assets) stood at 2.3%, Return on equity (net profit as a percentage of equity) stood at 9.22 % and the gross NPA as a percentage of total credit exposure (aggregate level) stood at 2.8%.Asset Liability compositionUnlike commercial banks, finance companies do not have access to the call market or RBI refinance facility in the event of liquidity crisis. In the recent past, several NBFCs faced a liquidity crunch as a result of asset quality problems. Systematic liquidity and negative shifts in sentiment towards companies and sector also tend to suck out liquidity. Hence, it is essential to assess the assets and liabilities composition of the sector to understand sector’s liquidity and funding resources.Liabilities of the NBFC Sector:Debentures form majority composition of NBFC’s liability, this is followed by Owned funds, which stands at 23% of sector’s total liabilities, bank borrowings (21%) and other borrowings (12%). Besides, deposit account for just 1% of total liabilities, borrowings from Financial Institutions (1%), Inter-corporate borrowings (2%), Commercial Paper (3%), other borrowings (12%), and current liabilities & provisions (5%).

Assets of the NBFC sector:Loan and assets at 73% form the majority of NBFC’s asset composition, which is followed by investments (16%) cash and bank balances (3%), other current assets (7%) and other assets (1%).

 * The data is only of reported deposit taking NBFCs and those of non-deposit taking NBFCs with asset size of Rs 100 crore and abovePositive Factors for the SectorDeclining cost of funds: The decline in wholesale rates in the past few months augurs well for midsized non-banking financial companies (NBFCs) such as LIC Housing Finance, L&T Finance Holdings, Muthoot Finance, Bajaj Finance and Canfin Homes that may see a drop in cost of funds and consequent improvement in earnings in the next few quarters.NBFCs rely primarily on wholesale deposits for funding their loan book. Wholesale deposits are funds raised from institutions such as mutual funds, insurance companies and corporate bodies. Wholesale rates had shot up a year ago due to the tight liquidity situation. LIC Housing Finance, for instance, raised three-year bonds at 10.57% in August 2013. Over the past three months, though, rates have come down as liquidity has eased and inflows have improved in tandem with the growth in confidence in the economy. LIC Housing Finance was recently able to raise three year bonds at 9.18%.Reducing dependence on bank’s funding: With banks holding on to their lending rates even as market rates have fallen sharply, non-banking finance companies or NBFCs such as Shriram Transport, Finance and LIC Housing Finance, their biggest customers, have turned their  backs on the banking system and resorted to borrowing more by selling commercial  paper and short-term bonds.This was evident after bank’s lending to NBFCs turned negative at the end of September, for the first time in more than four years, by falling by 4.4% compared to the year ago period to Rs 2.93 lakh crore, according to latest Reserve Bank of India data.In 2013, bank lending had risen 26% in the corresponding period over the previous year. Bank

loans have traditionally been a major source of funding for NBFCs. However, with the base rate, the benchmark over which banks lend to NBFCs has remained high as RBI has not signaled lower rates due to persistent concerns over high inflation. NBFCs have, therefore, found it cheaper to raise funds directly from the market. Indian firms, including NBFCs, raised almost Rs 1 lakh crore between September 15 and October 15 through commercial paper.Product Innovation and superior delivery: Given NBFCs deeper understanding of customer needs, NBFCs continue to focus on product innovation and customizing product offering, which help these companies to maintain their niche position in the market and give them edge over banks. A classic example of product innovation is building of an organized market in used vehicle financing, a segment largely untouched by banks. Similarly, NBFCs have built a scalable business model in gold financing, despite bank’s longstanding presence in this segment. An example of this customization would be the structuring of monthly installments while accounting for seasonality of cash flow, in case of construction equipment loans.Major Concerns for NBFCSMacro-economic uncertainty: The cross-sectional distribution pattern of the industry depends much on the performance of the economy as a whole. As slowdown in the economy increases the risk of default and restructuring of loans can increase, which could further lead to a deterioration of asset quality.Though inflation, both CPI and WPI have shown signs of easing, along with pick up in manufacturing sector, a few important concerns remain. The fiscal-deficit has remained stubbornly high for the past few years and while the Government hopes to contain it at 4.1%, for the year, the task might yet prove to be very difficult to achieve task. India's fiscal deficit reached nearly 83% of its full-year target in the first half of the year, giving the government a tough job meeting its budget target even with help from a fall in global crude prices that will reduce the oil subsidy bill. The fiscal deficit stood at Rs 4.39 trillion ($71.5 billion) during April-September, or 82.6 percent of the full-year target.Managing Asset quality: Maintaining asset quality in the face of growing NPAs and restructuring of advances is a major challenge for the industry, which has clear link with the overall state of the economy. The gross NPA ratio of Non-deposit taking- systematically important- Non Banking Financial Companies’ stood at 2.8% as on March, 2014 against 2.2% in the same quarter of the previous year. It is only in this context that growing number of NBFCs utilize routes such as selling bad loans to asset reconstruction companies (ARCs), corporate debt restructuring (CDR) mechanism and one-time settlement (OTS) window to improve its asset quality.Disparity in tax rules for NBFC: At present, NBFCs are taxed on deferment of income in the year of accrual, while banks, PFIs, state finance corporations, housing finance companies and state industrial investment corporations are taxed only when it is received or credited to the profit and loss account, whichever is earlier.Like other lenders, NBFCs too follow the Reserve Bank of India's (RBI's) prudential norms and defer income regarding their NPAs and make provisions for the same. However, income tax authorities do not recognize these norms and tax NBFCs on such deferment of income on accrual basis resulting in tax on unrealized income.Recent DevelopmentsRBI tighten rules for shadow banks:The Reserve Bank of India (RBI) has tightened rules for NBFCs, also known 'shadow banks', by raising capital adequacy requirement and net owned fund limit, among others. India’s Apex Bank also has restricted deposits with a set of changes that it hopes will protect consumers and

the market without stifling growth.As per the latest directives, the RBI has raised the limit for NBFCs to maintain the Net Owned Fund (NOF) requirement to four times by 2017 to Rs 2 crore. Prior to this, the NOF requirement stood at Rs 25 lakh. NBFCs, in a phased manner, would be required to raise it to Rs 1 crore by March 2016 and further double it to Rs 2 crore by 2017.Also, it directed NBFCs, primarily engaged in lending against gold jewellery, to maintain a minimum tier I capital (or equity capital) of 12% with effect from April 1, 2014 as against existing requirement of 10%. For deposit and non-deposit taking NBFCs, Capital to Risk (Weighted) Assets Ratio or CRAR, which includes tier I capital of 7.5%, stands at 15% at present. But as per new rules, NBFCs have to raise the tier I capital to 8.5% by end of March 2016 and 10% by March 31, 2017.On provisioning front, RBI has ordered NBFCs to raise provisioning of standard assets to 0.3% by end of March 2016; 0.35% by March 2017 and to 0.4% by end of March 2018. At present, every NBFC is required to make a provision for standard assets at 0.25% of the outstanding.Importantly, to create a level playing field, RBI has mandated similar asset classification norms for NBFCs-ND-SI and NBFCs-D as that for banks. An asset is classified as non-performing if it has remained overdue for 90 days in banks. Uptill now, NBFCs enjoyed a lighter rule with their assets turning NPAs, when it has remained overdue for a period of six months or more for loans; and overdue for twelve months or more in case of lease rental and hire purchase installments.Further, tightening the loop, RBI has mandated that NBFCs failing to achieve the prescribed ceiling within the stipulated time period would not be eligible to hold the CoR (Certificate of Registration) as NBFCs. With the revised guidelines in place, the regulator has revoked its temporary suspension of licenses for the sector which was in force since April 1, 2014. RBI has also revised the threshold to Rs 500 crore from Rs 100 crore for defining systemic significance for NBFCs given the overall growth of the sector over the years. New companies will have to bring Rs 2 crore to the table to get a licence and the old ones with smaller capital will get two-and-a-half years for raise up to this level.Moreover, NBFC accepting funds from public will have to get themselves rated by March 31, 2016. Those entities that do not get an investment grade rating by March 31, 2016, will not be allowed to renew existing or accept fresh deposits thereafter. In the intervening period, i.e. till March 31, 2016, unrated companies or those with a sub-investment grade rating can only renew existing deposits on maturity, and not accept fresh deposits, till they obtain an investment grade rating.NHAI in talks with NBFCs to set up asset recast firm: With banks showing no interest in the National Highways Authority of India (NHAI)'s proposed asset reconstruction company (ARC), the authority has initiated talks with a clutch of non-banking financial companies (NBFCs) to revive unfinished road projects. Road projects worth Rs 1.8-lakh crore have been stuck owing to various issues ranging from land acquisition, environmental clearance and other issues.The NHAI, back in August gave an in-principle approval for the setting up of an ARC, in which it would have a 25% stake with the remaining holding picked up by banks. NHAI's initial investment in the ARC is estimated to be around Rs 1,000 crore. The ARC will buy loans extended to the road projects in case of a default or funds crunch and sell the completed projects to investors.  In total, there are around 20-25 projects, which can be funded through

this route in the first phase.RBI places curbs on NBFC loans against shares: In an attempt to curb potential volatility in the stock markets after a surge in equity prices and to forestall lending risks amid a pile-up of bad loans, the Reserve Bank of India (RBI) placed restrictions on the amount that non-banking financial companies (NBFCs) can lend against shares pledged as collateral. As per the rule, NBFCs with assets in excess of Rs 100 crore will be required to maintain a loan-to-value ratio of 50%, which means that the financiers will be allowed to lend an amount equivalent to only 50% of the value of shares pledged as security.RBI, also underscored that these lenders will be allowed to accept only so-called ‘Group 1’ shares as collateral, while giving loans amounting to Rs 5 lakh and above. Group 1 shares have the feature of being more liquid and less volatile than the other shares trading in the markets as these could be bought and sold on at least 80% of the trading days in the previous 18 months on the stock exchanges, and the average cost incurred due to a price decline is less than 1%. Bad loans, meanwhile, have been rising as the economic downturn and project delays crimped the ability of borrowers’ loans to repay on time. By applying these restrictions, RBI wants to track lending against shares more strictly.Interestingly, norms for lending against shares for banks are much stricter. Banks are not allowed to lend more than Rs 10 lakh, if the shares are held in physical form and not more than Rs.20 lakh if shares are held in demat form. Banks are also required to maintain a minimum margin of 50% of the market value of shares in case they are held in a physical form and 25% if they are held in the demat form.RBI allows banks to appoint NBFCS as biz correspondents:To hasten financial inclusion, the Reserve Bank of India, late in June 2014, allowed commercial banks to appoint non-banking financial companies (NBFCs) as business correspondents (BCs). So far, NBFCs could not be appointed as BCs, which provide limited services on behalf of banks in unbanked areas. However, only non-deposit-taking NBFCs after this would be eligible to act as banks’ BCs.Earlier, banks had to assign BC outlets to a branch within 30 km in case of semi-urban and rural areas and five km for metropolitan regions. This was aimed at ensuring adequate supervision.for BCs. RBI, however, decided to remove the stipulation to provide operational flexibility to banks, as technological developments had made oversight easy. Meanwhile, the apex body mandates the banks must ensure that the NBFC-ND does not adopt restrictive practices such as offering savings or remittance functions only to its own customers or bundling of their services and should continue to take measures to address possible reputational risks arising out of the appointment and functioning of BCs.The review of norms to appoint BCs follows recommendations of a committee headed by RBI board member Nachiket Mor. The committee had suggested steps to accelerate flow of credit to those at the bottom of the pyramid and enlarge catchment areas of BCs.Outlook:The overall outlook for NBFC sector remains to be stable even as Reserve Bank of India has announced regulations stricter for non-banking finance companies with systemic importance to create a level playing field between them and the banks.Although, the revised regulatory framework for non-banking financial companies will slice down companies’ profitability and increase their non-performing assets of the industry, the impact would be lower in the short term because of the long transition period. Since, these tighter regulations will give 3-year transition period that would allow NBFCs to cushion impact

on their financial profiles.Moreover, overall, higher capital requirements, regulatory alignment with banks, enhanced disclosure requirements and tighter corporate governance norms will strengthen the NBFC sector structurally in the medium term. The enhanced regulations would increase transparency and improve investor confidence and its access to capital markets for large NBFCs (which are subject to most of these stricter requirements).Notably,  also non banking companies’ dependence on bank’s fund is coming down, which is evident after bank’s lending to NBFCs turned negative at the end of September, for the first time in more than four years, by falling by 4.4% compared to the year ago period to Rs 2.93 lakh crore, according to latest Reserve Bank of India (RBI) data. This is positive since banks charge a higher rate of interest to these companies, which in turn increases their cost of borrowing.Besides, expected uptick in economic growth augurs well for the industry, whose cross-section distribution pattern depends on the performance of the economy as a whole.

Industry Analysis

Industry

: Finance - NBFC

NBFC sector witnessing consolidation; medium terms outlook remains cautiousMonday,January 13,2014

Non Banking Finance Corporations (NBFC’s) play a crucial role in broadening access to financial service, enhancing competition and diversification of the financial sector. The sector, which accounts for around 12% of the assets of the total financial system, has emerged as an important intermediary for financing and has provided strong competition to banks and financial institutions. They are undoubtedly complementary to the banking system, capable of absorbing shocks and spreading risks at times of financial distress.Based on liability, they can be classified into two categories (i) NBFCs-Deposit taking (NBFCs-D) and (ii) NBFCs-Non-Deposit taking (NBFCs-ND), on nature of business, they can be categorized as loan companies (LC), investment companies (IC), infrastructure finance companies (IFC), asset finance companies (AFC), core investment companies (CIC), infrastructure debt funds (IDF), micro finance institutions (MFI), and factors.The ability of NBFCs to produce innovative products in consonance with needs of their clients is well recognized. This, in addition to the proximity to the clients, makes them different from banking sector. Thus, in short period of time, NBFCs have become market leaders in most of the retail finance segments like commercial vehicles, car financing and personal loans.The entire sector has been in limelight ever since RBI issued guidelines allowing any business sector to apply for banking licenses and indicating that by January it would finalize the preliminary list of candidates selected for the banking license.  It had stated that Entities / groups in the private sector, public sector and Non-Banking Financial Companies (NBFCs) shall be eligible to set up a bank through a wholly-owned Non-Operative Financial Holding Company (NOFHC). Several NBFC such as IDFC, LIC Housing Finance, Reliance Capital, L&T Finance, Edelweiss Financial Services and Bajaj Finserve are in fray in the fray to obtain bank licenses, which the RBI proposes to hand out in the first quarter of 2014.Performance of the Sector:NBFC witnessing consolidationNon-banking finance companies (NBFCs) are witnessing a period of consolidation, with the number of firms registered with the Reserve Bank of India (RBI) declining to 12,225 at end of June 2013, as per RBI’s data.  It may be pointed out that the NBFC sector has been witnessing a consolidation process in the last few years, wherein the weaker NBFCs are gradually exiting, paving the way for a stronger sector.However, according to the RBI’s annual report on ‘Trend and Progress of Banking in India’, the current decline in the number of registered NBFC is mainly due to cancellation of certificates of registration and migration of non-banking finance companies that accept public deposits (NBFC-D) to the non-deposit-taking category.

Change Ind

Although the number of NBFCs in business declined, these companies increased their total assets and net owned funds marginally. During 2012-13, the consolidated balance sheet of NBFCs-D expanded marginally by 2.2% to Rs 1, 24,900 crore. On the liability side, borrowings from banks although declined, were still the biggest source of funding for NBFCs-D followed by debentures and public deposits, which were the next important sources of finance. Deposit-taking NBFCs' borrowings from financial institutions were relatively minimal in the previous fiscal but this picked up dramatically by 170%. However, their borrowings from government and inter-corporate borrowings declined substantially.On asset side, loans and advances of NBFCs-D constituted close to three-fourths of their assets. NBFCs-D total investments declined to Rs 7,200 crore during FY13 from Rs 7,400 crore the previous year on account of fall in their investments in equity shares which dipped to Rs 1,790 crore from Rs 1,840 crore a year ago. During the year, NBFCs-D provisionally mobilized Rs 7,085 crore deposits as of end-March against Rs 5,704 crore mobilized previous year. Six larger companies, constituting about 2.8% of total number of NBFCs-D, mobilized about 95% of total deposits as of end-March 2013.NBFCs-ND-SI witness sharper expansion - Further, while deposit-taking NBFCs saw muted growth, the subset of systemically important non-deposit-taking NBFCs (NBFC-NDs) saw an expansion of 19.5% in their consolidated balance sheets during 2012-13. Borrowings increased significantly by 22.5% mainly via debentures, bank loans, commercial papers and inter-corporate borrowings.On the asset side, the position of NBFCs-ND strengthened further during the year with loans and advances increasing 22%. The rise in hire-purchase assets and investment also propped up the asset position of NBFCs-ND-SI. The leverage ratio of the NBFCs- ND-SI sector had increased marginally to 3.20. Exposure of this segment to capital market as a per cent of total assets declined from 8.9% to 8.1% during the year. Net profit for these companies grew 29.82% compared to the previous year to Rs 22,200 crore at the end of March 2013. Despite the rapid growth, asset quality held steady with gross NPAs increasing marginally to 2.2% of total advances from 2.12% from last year.Financial Performance:

NBFCs - D: Profitability of  NBFCs improved during the year with net profit of NBFCs-D showing marginal improvement. However, asset quality deteriorated with gross non-performing assets (NPAs) increasing to 2.4% of total advances from 2.2% last year.For the last couple of years, the asset quality of the NBFCs-D has been deteriorating. Continuing with last year’s higher level of NPA, it further deteriorated during 2012-13. This time around also, weakening of the asset quality of NBFCs-D broadly followed the prevailing trend of rising NPAs in the banking sector and may, inter alia, be attributed to slackened economic activity.NPA Ratios of NBFCs-D 

 end-March Gross NPAs to Total Advances (%) Net NPAs to Net Advances (%)

2012 2.2 0.5

2013P 2.4 0.8NBFCs-ND-SI: Profitability of NBFC ND improved modestly by 29.82% at Rs 22200 crore as compared to Rs 17100 crore in the previous year. Further, on the asset front, while the ratio of gross NPAs of NBFCs-NDSI to their total assets had increased marginally, the net NPAs to total assets declined during the year.NPA Ratios of NPA Ratios of NBFCs-ND-SI

Gross NPAs to Gross Advances (%) Net NPAs to Total Assets (%)

2.12 0.93

2.2 0.8Key Issues for NBFC:Higher Borrowing from banks: Borrowing cost of funds for NBFCs continues to remain high as the proportion of bank funding in the overall borrowings of NBFCs remains high coupled with high levels of bank base rates during FY2013. Credit to Non Banking Financial Companies (NBFCs) increased by 26.6% in September 2013 as compared with the increase of 28.4% in September 2012.Uncertainty about retail NCDs: The cost of funding of NBFCs also has been impacted by the RBI guidelines on funds raised by NBFCs through private placements of debentures, which capped the maximum number of investors to 49 for private placement issuances. Additionally, RBI has set the minimum subscription amount for a single investor to be Rs 25 lakh and in multiple of Rs 10 lakh thereafter. Further, the guidelines highlighted that the money raised by NBFCs through debentures should be used by themselves and not be used as resource for other group or parent firms.These guidelines have impacted NBFCs, as they substitute their retail fund mobilization from the private placement route to the more costly bank borrowing/ public issue route (where costs are estimated to be higher by 50-100 bps) depending upon the individual NBFC’s proportion of retail private placements and the proportion of outstanding retail private placement debentures falling due for repayment over the next 12 months.Dull CP market: The Commercial Paper market is going through a dull phase, in line with the current downturn in the economy. This has increased the funding challenges for NBFCs. Ideally, an NBFC should be able to raise 1/3rd of its liabilities from retail, 1/3rd from banks and 1/3rd from CPs and institutional placements. In the present scenario, given the move to put the squeeze on NCDs and given the dull CP market, NBFCs have ended up increasing their dependence on banks, which definitely not a positive sign as the Reserve Bank of India (RBI) has excluded loans given  by banks to non-Banking finance companies from the priority list.

Dip in ROE: The return on equity for non-bank finance companies (NBFCs) could dip to single digits, if no transition period is offered to these entities by the Reserve Bank of India (RBI) for new banks to comply with the priority sector lending requirement of 40%. However, if newly converted NBFC is exempted from the priority sector norms, ROE may drop to only 13% from the present original ROE of 16-17% (current average).In the draft guidelines for licensing of new banks in the private sector, RBI has outlined that the new banks should comply with the priority sector lending targets and sub-targets as applicable to the existing domestic banks. Currently, domestic banks are required to lend 40% of their advances to certain segments such as agriculture, small business, retail traders, professionals and self-employed individuals.Slowing credit demand: Non-banking finance companies (NBFCs) are witnessing a slow growth in retail credit due to a significant slowdown in the key segments, like construction equipment, commercial vehicle and gold, which constitute around 56% of NBFC's total retail credit. This slowdown is expected to have some pressure on asset quality and margins.Prevailing macro-economic uncertainty: The macroeconomic uncertainty affects the cross-sectional distribution patterns of NBFCs. As slowdown in the economy increases the risk of default and restructuring of loans can increase, which could further lead to a deterioration of asset quality. Currently, the economy is in doldrums with a little more than four year low Gross Domestic Production (GDP) growth of 4.8% in July-September quarter and contracting Index of industrial production (IIP) growth for October. Thus, with this significant slow down in Indian economy, NBFCs are encountering structural challenges such as increased refinancing risk, short-term asset-liability mismatch leading to decelerating growth and declining margins, which is expected to have a bearing on the profitability of NBFCs in the medium term.Tighter regulatory norms for Indian NBFC: Official policies relating to NBFCs in general and gold loan NBFCs in particular, have been prone to knee-jerk reactions for Indian NBFC sector, thereby affecting the stability of the sector and denting investors’ confidence.Regulatory Changes by RBI:RBI eases group limit for NBFCs in insurance JVs: Reserve Bank of India (RBI) has relaxed norms for non-banking finance companies (NBFCs) in insurance joint ventures by allowing them to hold more than 50% in such companies, if the insurance regulator requires them to do so to meet capital infusion requirements, but on case to case basis. Further, the relaxation, if permitted, will be subjected to compliance by the NBFC with all regulatory conditions. Meanwhile, NBFCs that wishes to apply for such relaxation have to apply to the regional office of RBI under whose jurisdiction its registered office is situated, along with supporting documents.According to the existing rules, in case if more than one company (irrespective of doing financial activity or not) from the same group of an NBFC wants to buy stake in an insurance company, the contribution by all companies in the same group should not surpass 50% in the insurance joint venture (JV) company. Further, RBI observed that in the operation of the insurance company, IRDA very often mandated them to expand its capital taking into account the stipulations of the Insurance Act and the solvency requirements of the insurance company and that the restriction of a group limit of the NBFC to 50% of the equity of the insurance JV company was acting as a constraint for the insurance company. In view of this, RBI decided to consider a case-to-case basis relaxation of the 50% group limit norm for NBFCs (non-banking finance companies) in the equity of insurance joint venture.RBI to recognize self-regulatory bodies for NBFC-MFIs:The Reserve Bank of India (RBI)

has decided to recognize industry associations of non-banking financial companies engaged in microfinance (NBFC-MFIs) as Self-Regulatory Organizations (SRO), which will ensure effective monitoring of NBFC-MFIs, their compliance with regulations and the code of conduct and aid the customers of NBFC-MFIs. This decision was based on the recommendations made by a sub-committee under the chairmanship of Y. H. Malegam which was formed to study the issues and concerns in the micro-finance sector. A self-regulatory organization recognized will have to adhere to a set of functions and responsibilities such as formulating and administering a code of conduct recognized by the bank, a grievance and dispute redressal mechanism for clients, ensuring borrower protection and education, monitoring compliance by NBFC-MFIs with the regulatory framework put in place by RBI, surveillance of the microfinance sector, training and awareness programmes for members, self-help groups, etc, and submission of financial data, including annual report, to RBI.The recognition to the SRO for the sector assumes significance in the wake of SKS Microfinance crisis in Andhra Pradesh in 2010 that had resulted in spate of suicides by borrowers due to coercive recovery practices by the lender.RBI puts stricter norms for gold loan NBFCs:In the light of the spike in gold imports in the recent years and the potential threat this could pose to external stability of the country, the Working Group to Study the Issues Related to Gold Imports and Gold Loans NBFCs in India (WG) was set up by the Reserve Bank, under the Chairmanship of Shri K.U.B.Rao. The group’s recommendation although were submitted in its report in January 2013, the same were outlined as guidelines by India’s central bank on September 16, 2013.Safety of gold: The first guideline is about the safety standard of the branches being operated by these NBFCs, as the working group observed that branches of some NBFCs which are predominantly into lending (50% or more of the total financial assets) against gold jewellery, lack adequate safety mechanism and thus need to transfer gold jewelry physically to bigger branches which had vault facility, thus putting the gold at risk. RBI has mandated that a minimum level of physical infrastructure and facilities should be available in each of the branches engaged in financing against gold jewellery, including a safe deposit vault and appropriate security measures for operating the vault to ensure safety of the gold and borrower convenience.Prior approval of RBI for Opening Branches in Excess of 1000 in Number: In another move, now NBFCs with more than 1,000 branches already, will have to take permission from RBI to open any new branches. No new branches will be permitted to open without the facilities for storage of gold jewellery and minimum security facilities for the pledged gold jewellery.Standardization, transparency and KYC verification: The RBI has asked the NBFCs to put in place a process of assessing the quality and value of gold which is uniform. The central bank has decided that gold jewellery accepted as collateral will have to be valued at the average of the closing price of 22 carat gold for the preceding 30 days, as quoted by The Bombay Bullion Association (BBA). Apart from this, where the borrowers are pledging more than 20 grams of gold, the NBFCs are required to get the gold ownership proof from the borrower, apart from the due diligence, to establish KYC (know your customer) of the customer. It reiterated that the LTV Ratio for loans against jewellery continues to be at 60%. Further, the central bank has asked these NBFCs to keep the auction process of jewelry of defaulted account by giving due notice to the defaulter and organising the auction in same Town or Taluka where the branch is

located. NBFCs would also need to disclose in their annual reports the details of the auctions conducted during the financial year.Recently, however Reserve Bank of India (RBI) revised upwards loan-to-value (LTV) norm for NBFCs engaged in gold loans from 60% to 75%. This means, a borrower can obtain a loan of Rs 75 instead of Rs 60 earlier by pledging gold jewellery worth Rs 100. However, the Reserve Bank did not change its earlier mandate that stipulates NBFCs to disburse loans of Rs 1 lakh or above by cheque.Further, it also allowed NBFCs to include suitable caveats to protect themselves against disputes on redemption. Earlier, NBFCs had raised concerns over certification of the purity of gold jewellery accepted as collateral and underscored that under the current practices it was possible only to arrive at the proximate purity of the gold and such a certification could lead to dispute with the borrowers.Outlook:Indian NBFC sector, despite witnessing consolidation, continue to showcase healthy performance, as reflected by their growing share in the finance market, improving profitability, healthier asset quality, diversified resource profile and adequate capitalization. These entities have also strengthened their internal processes, enhanced their origination and collection practices and improved operating efficiencies.However, the medium term outlook for this sector remains cautious as the road to profitability is expected to be bumpy as the entities who gets the banking licences would have to sacrifice near term profits since becoming a bank would erode ROA and ROE substantially over the next five years on account of regulatory requirements and higher costs. Nevertheless, benefits of banking license are likely to unfold over the longer term.Further, there are certain regulatory challenges that the sector is still facing. Moreover, prevailing macro-economic uncertainty are also expected to impact the business cycle of NBFC as this would lead to structural challenges such as increased refinancing risk, short-term asset-liability mismatch leading to decelerating growth and declining margins for the sector.