Explained: Do NBFCs have a better future than large, diversified players?

Non-banking financial companies may have entered a comfort zone years after having been put through the wringer

The impending merger of HDFC Ltd and HDFC Bank has reignited a hoary old debate — is the non-banking financial company (NBFC, or shadow bank) model past its sell-by date? After all, if market leader HDFC Ltd — albeit a mono-line business entity — thought it fit to vacate this space by merging into its offspring, 45 years into its existence, isn’t it possible that others may be unable to hold out much longer? But the reality on the ground points to a brighter dawn.

Reserve Bank of India (RBI) data show that NBFCs have emerged stronger, with reasonable balance-sheet growth, increased credit intermediation, higher capital and lower delinquency ratios. This was driven essentially by growth in credit and investment on the part of non-deposit-taking NBFCs. Deposit-taking NBFCs’ numbers grew modestly: they adopted a more cautious approach.

FY21 (the year for which systemic data is available) saw the share capital and reserves of NBFCs expand in a big way, with some raising additional capital via rights issues. This was to buttress their financials against the likely recognition of impaired assets after the lifting of the Supreme Court’s order on the standstill on asset classification during the pandemic.

The Report on the Trend and Progress of Banking in India (T&P:20-21) notes that NBFCs’ credit also gained traction with the support of regulatory initiatives, including the co-lending model in November 2020. This is a key reason why their credit-intensity — measured by the credit-GDP ratio — has risen consistently, reaching a high in 2021. Significantly, NBFCs’ credit as a proportion of bank credit also went up.

Emerging themes

A few broad themes are also emerging — all indicating that shadow banks may be poised to take meaningful bites of market share.

“We support micro-entrepreneurs in rural and semi-urban India. We have funded over 60,000 entrepreneurs, of whom 45 per cent are first-time borrowers — new to credit or new to category. A co-lending partnership with banks is complimentary, as we provide last-mile access,” says Gaurav Gupta, managing director (MD) and chief executive officer (CEO) of Adani Capital.
 

Adani Capital has a co-lending pact with State Bank of India. Though this is not an exclusive arrangement, the takeaway from it is that even the country’s largest bank finds it meaningful to tango.

It is also possible that NBFCs may prefer to team up with the more aggressive private banks, with fintech firms being the third pole of this scheme. This last aspect will become clear once the central bank unveils its operational circular based on the Report of the Working Group on Digital Lending including Lending through Online Platforms and Mobile Apps. It’s also opened up a debate: do sharply-focussed NBFCs have a better future than large, diversified players?

“The landscape is moving towards a stack architecture where banks will provide the basic plumbing and be responsible for hygiene of risk and security. At the next level, you will have NBFCs and non-NBFC fintechs that provide the customer interface and will collaborate with banks,” explains Saurabh Tripathi, Asia Pacific regional leader at  Boston Consulting Group (financial institutions practice).

And all of this is playing out even as the RBI weighs the issue of fresh banking licences, though this will not to apply to NBFCs promoted by industrial houses. The larger point is that it’s merely off the burner for now; it has not been ruled out.
 

Doubting Thomases

“This talk that NBFCs have no future came about because of the blowouts at a couple of them and the central bank tightening regulations. Plus, the big question mark on the liabilities side, where there are only two sources of funding — bank credit lines and the bond markets. Both these sources were seen to be slowing their exposure to NBFCs,” notes Vimal Bhandari, executive vice-chairman and CEO of Arka Fincap.

Arka and Adani Capital are among a clutch of NBFCs that came into being in the wake of the turmoil at Infrastructure Leasing & Financial Services (IL&FS) and Dewan Housing Finance Corporation. The others are Gunit Chadha’s APAC Financial Services, Bhupinder Singh’s InCred, and Shachindra Nath’s U GRO Capital.

Between them, these NBFCs raised close to Rs 5,000 crore during the post-IL&FS phase — the biggest-ever pool of capital to back professionals in this space, even as some legacy NBFCs were being put through the wringer.

Says Chadha (former Asia-Pacific boss of Deutsche Bank): “NBFCs have a significant opportunity to deliver credit. It’s just that some NBFCs are building assets under management, and chasing an all-things-to-all-borrowers business model which will inevitably run head-on into banks.”

Incidentally, Chadha got Multiples, the private equity firm headed by Renuka Ramnath, to pick up a 37 per cent stake in APAC just a month after the September 2018 blowout at IL&FS.

Advantage niche players?

Again, while it pays to be a niche player, it’s also not quite the case that those with a large, diversified book are facing headwinds.

Rajiv Sabharwal, MD and CEO of Tata Capital, reckons that it’s wrong to say that the NBFC model has no future. “In fact, the scale-based regulations (SBR) would make us stronger, with compliance similar to banks in the upper layer.” The central bank’s four-tiered SBR cuts out areas of arbitrage between banks and NBFCs that were detrimental to orderly growth and systemic stability.

“There are at least eight categories of NBFCs, of varying sizes and vintage. To paint them all with the same brush is wrong. The regulator recognises this and has brought in the SBR,” adds Aseem Dhru, founder and CEO of SBFC Finance.

It’s a view shared by every other NBFC corner-room occupant — contrary to the widely-held belief — and sees the central bank’s move as being pragmatic. The SBR has a base, a middle, an upper and a top layer, with a progressive increase in the intensity of regulation. The base layer consists of non-deposit-taking entities with assets of less than Rs 1,000 crore and certain others engaged in specific activities. The idea behind this architecture is that it enhances transparency and governance while not burdening them with higher-level regulations.

For instance, Dhru (a HDFC Bank veteran) had acquired the Rs 807-crore loan book of Karvy Financial Services. Backed by the Singapore-based Clermont Group and Arpwood Partners, he wants to redefine the play in lending to micro-enterprises: “One of the segments that we think is in the rain shadow of private banks and state-run banks is the small business segment. And we thought there’s space to be a nationwide player here.”

SBFC has plans to go public, and though the timing is not certain, it will yield a definite sense of what the world thinks of this model — it will be the first NBFC float in a long time.
 

Key takeaways

NBFCs’ share as measured by the credit-GDP ratio, which has risen consistently, must be seen in the context of the fact that the past four years have been difficult for them, with the central bank having closed the regulatory arbitrage window and put the top 50 NBFCs through an undeclared asset quality review (AQR), much like it did for banks.

And it is to the credit of the sector that no major variances were found, unlike in the case of a few leading private banks when AQRs were undertaken during the stints of governors Raghuram Rajan and Urijit Patel.

The RBI’s T&P:20-21 also observes “that a fallout of the pandemic and the slowdown in economic activity is that credit growth of commercial banks remained subdued in FY21, but NBFCs  have stepped up to fill this space.”

Can NBFCs do more? Few CEOs of shadow banks will go on record on this. But a tweak of inter-creditor agreements is one suggestion — that they, too, be made part of this scheme when a loan goes bad and a decision to restructure is on the anvil. Another is that the better-governed NBFCs be allowed to diversify their liability profile — for instance, why can’t they be allowed to raise deposits of up to Rs 500,000, in line with the cover granted by the Deposit Insurance and Credit Guarantee Corporation (as a small portion of their liabilities)?

Looked at another way, non-deposit-taking NBFCs are almost the exact opposite of small finance banks (SFBs), when it comes to their business model. The former can’t raise deposits, but can lend to just about any sector; the latter can raise deposits, but can lend no more than Rs 2.5 million to any one borrower. The SFB model may be ripe for a rethink as well, but that’s another story.

So, what is one to make of the chatter that NBFCs should become banks, or be prepared to face extinction? “The desire to seek a banking licence is driven both by the fear that the arbitrage window is almost non-existent vis-a-vis banks, and that the liabilities side has no public deposits,” points out Y S Chakravarti, MD and CEO, Shriram City Union Finance.

What is clear as daylight is that regulatory arbitrage as a model is off the table, but that’s not the same as saying that NBFCs will roll over and die.