Why few NBFCs want to become banks despite RBI's new recommendations

Cost of doing business, regulatory arbitrage, customer profile key parameters

Last Friday, the P K Mohanty working paper from the Reserve Bank of India (RBI) suggested, among other things, that well-run non-banking financial companies (NBFCs) with assets of Rs 50,000 crore and above, and 10 years of operations could be considered for conversion into banks. Since such a transition could reduce the cost of funds by as much as 1.7 percentage points in a highly competitive business, NBFCs from Shriram Capital to Aditya Birla Capital should have been rushing to the drawing boards with conversion plans.

But so far, there is little excitement from the big boys. “If we wanted to convert ourselves into banks, we would have done so four years ago, why wait?” said T T Srinivasaraghavan, managing director, Sundaram Finance. This, even though banks may have significant irritants removed such as the proposal to raise the promoters’ shareholding to 26 per cent from the current 15 per cent (caveat: these are proposals; actual announcements could be some years away).

Making the transition from bank to NBFC has to be examined through three broad parameters — the cost of doing business, regulatory arbitrage and customer profile.

The carrot that banking operations offer is access to deposits, the blended average cost of which is 5.8 per cent. For NBFCs, funding costs, accessed from banks, money markets or mutual funds, hover at 7.5 per cent. Any signs of instability can cause these costs to shoot up. For instance, for almost a year after September 2018 following the crisis in IL&FS, then one of the country’s largest NBFCs, caused a liquidity crunch, the cost of funds shot up to 9 per cent. This predicament may have prompted the regulator to consider the NBFC-to-bank proposal as a long-standing solution to the fund crunch. As Kuntal Sur, partner & leader, Financial Risk and Regulations, PWC, pointed out, “Dependence on easy money can’t go on and NBFCs may encounter another crisis.”

As the chief operating officer of a diversified NBFC pointed out that in 2011 when the RBI had invited applications for banking licences, there were nearly 25 candidates. But that was because times were different: “Access to deposits would have been a huge advantage as banks were the primary financiers for NBFCs and money market instruments were rather thin,” he explained.

Eventually, with just two applicants making the final cut (IDFC and Bandhan), the rest had to reorient their liabilities. The liquidity flush in the bond market after the “taper tantrum” of 2013 — when the US Fed signalled that it would ease its bond-buying programme under the Quantitative Easing mechanism — and growing private equity interest gave NBFCs confidence that they didn’t have to be a bank to be in the lending business.

Srinivasaraghavan said the biggest learning from the 2018 crisis is that well-run NBFCs have the muscle to survive even if the cost of money rises. Suresh Ganapathy, analyst, Macquarie Capital, agreed that the good names can never go out of business.

Although stable liquidity may be a plus point for banks, steep operating costs could be a deterrent. “The requirement to set aside for statutory liquidity ratio (SLR) and cash reserve ratio (CRR) and other statutory costs makes banking operations fit for few,” said Umesh Revankar, CEO & M D, Shriram Transport Finance.

Another key conversion deterrent is the scope for specialisation. “Once an NBFC becomes a bank, it will have to offer multiple services to customers, whereas as an NBFC we can focus on specialised products,” Revankar pointed out. For NBFCs, critical functions often revolve around credit underwriting, lending, and recovery; for banks, these fold in as one among several functions such as the cost of operating branches, servicing deposits, day-to-day cash management and so on. “Employee cost is at least 50 per cent lower for NBFCs compared to banks,” he said.

In any case, with the 2018 crisis separating the wheat from the chaff, there would be fewer eligible candidates for a banking licence than there were in 2011, since the proposal requires aspirants to have an assets size of at least Rs 50,000 crore. “During the liquidity crunch, some NBFCs had to shed assets for survival and decided not to bulk up balance sheets thereafter. They are adopting a fee-based model and, therefore, can never aspire to have loans of over Rs 50,000 crore,” says a CEO of an NBFC cited above.

Yet, Sur of PwC believes that it is a matter of time before large NBFCs, particularly those with established financial services experience, choose a banking platform. “The regulatory arbitrage may not exist forever, thereby making banking a preferred model,” he said.

The possibility of tightening regulatory requirements for NBFCs, in tandem with the past year’s scaling up of certain key aspects, such as fortnightly reporting of asset-liabilities management position or increasing the capital adequacy threshold to 18-20 per cent from 15 per cent, could shrink the advantage NBFCs have over banks.

Ganapathy, though, thinks more is required than just regulatory arbitrage to make the jump. Given that most listed and large corporate-backed NBFCs seldom falter on regulatory adherences, compliance isn’t an adequate benchmark to judge if an NBFC is a worthy candidate for a banking licence. His fear is that the contagion of bank failure could be far worse than when NBFCs go bust. “Imagine if DHFL had failed as a bank.”

The last aspect that will play a decisive role is the willingness of the existing NBFCs to cater to a wider set of customers. “Most of our customers fall in the unbanked and underserved category who may not pass the credit criteria test for a bank,” Revankar said. Therefore, the model of borrowing at a cost higher than banks and lending at higher rate to price in the credit risk works in NBFCs’ favour. That arbitrage will be lost if they convert to banks.

Srinivasaraghavan also questions the objective of handing out fresh bank licences. Fifty years ago, he pointed out, bank nationalisation was done to serve financial inclusion but this objective is still served mostly by NBFCs. “If banks haven’t helped the cause much in 50 years, what’s the purpose now?”