NBFCs Face The Cost-And-Compliance Squeeze

Last November, the Reserve Bank of India (RBI) dealt a body blow to non-banking finance companies (NBFCs) when it asked banks to steeply raise the risk weight for loans given to NBFCs by 25 percentage points.

The impact was immediate as it partially turned off NBFCs’ primary capital spout. The rate of bank lending to them almost halved to 15.3% in March 2024 from 29.9% in March 2023, RBI data showed. Lenders have to set aside more capital when risk weights increase, reducing their ability to lend more. For instance, Ashwani Kumar, CEO and managing director of UCO Bank said the bank would likely reduce credit exposure to NBFCs in the coming quarters by Rs 1,000 crore.

Announcing the bank’s quarterly earnings at a press conference in April, Kumar said the bank has to achieve a minimum benchmark it has set for itself. It will not lend to NBFCs that are unwilling to accept rates that will help achieve the benchmark.

Although the latest RBI diktat, which came in response to a sharp rise in unsecured loans and risky practices, added to their woes, regulatory restrictions, high cost of funds and increasing competition from banks were already putting the squeeze on the shadow banking business. As of September 2023, there were 9,327 (down from 9,642 four years before) registered NBFCs in the country, which have collectively advanced Rs 36.9 lakh crore, largely home loans and credit to micro, small and medium enterprises (MSMEs). While a handful of them have grown to the size of mini banks and are able to raise money from the markets, others are struggling to stay in business. Yet others are selling off high-cost, low-margin businesses and expanding asset-light, fee-generating businesses. Those with a credit rating of AA and below are finding it particularly challenging to raise money at a reasonable cost.

NBFCs’ profitability will moderate somewhat in the next 12-18 months as funding costs for them will increase according to ratings firm Moody’s. Funding costs for large NBFCs increased about 50 basis points on average in fiscal 2024 from the prior year.

Depending on tenure, AAA-rated NBFCs raise money at anywhere between 9% and 10.5% in the domestic bond market. The rate rises to nearly 17% for the lowest BBB-rated shadow banks. Add another 7-8% operational expenditure and 2-3% margin and it is clear there will be few takers for loans that expensive. And the willing ones will come with very high risk.

“There is a crisis every decade (in the NBFC sector),” an industry veteran and chief of a large non-banking financial institution told The Core on condition of anonymity. “We need a co-existing model for banks and NBFCs as they have to play a complementary role.”

He said banks alone cannot meet the financing needs of a large, fast-growing economy such as India’s. It needs NBFCs to reach credit to unbanked and low-banked segments.

The Changing Landscape

In a March report, credit rating agency S&P Global said RBI regulations would drive up NBFCs’ capital costs, blunting the ability of smaller ones to compete.

“There are several factors impacting the cost of funds. First, it depends on rates set by the regulator, followed by the liquidity condition in the market. The size and the rating of the NBFC to a certain extent can help to reduce the cost of funds,” YS Chakravarti, MD and CEO, Shriram Finance Limited told The Core.

While some companies are selling off businesses to focus resources and capital on segments they are strong in, others are tapping the capital markets for cheap funds. Some are diversifying and yet others are merging arms to strengthen balance sheets.

On May 13, Chennai-based Shriram Finance's board of directors approved a plan to sell the company's entire stake in Shriram Housing Finance Limited (SHFL) to the global private equity firm Warburg Pincus. Warburg Pincus will acquire the stake through its affiliate Mango Crest Investment for Rs 4,630 crore. Shriram Finance will use the capital to bolster its businesses of vehicle financing and lending to small businesses.

R Thyagarajan, the 86-year-old founder of the Shriram Group, built his reputation and the financial conglomerate by lending to sub-par borrowers when they were seen as uncreditworthy and shunned by banks. Thyagarajan now believes shadow banks will have to cede territory as banks look for newer areas to lend. He has earlier described Indian regulations as strangulating and leading to progressive atrophy of active enterprises.

An RBI crackdown on gold-loan providers has them scurrying to diversify operations. Muthoot FinCorp, for instance, is planning to enter MSME lending and loans against property. It hopes to bring down gold-loans business from the current 98% to 80% in three years.

Belstar Microfinance Ltd, the microfinance subsidiary of Muthoot Finance, another leading shadow bank, is planning to raise Rs 1,300 crore through an initial public offering. Tata Motors plans to consolidate its vehicle financing subsidiaries under Tata Motors Finance Ltd, an NBFC owned by the Tata Group, by merging them with Tata Capital.

“Top tier NBFCs have reached a stage where the RBI wants to regulate them in the same way as banks,” said the earlier quoted industry veteran. Because of their size, banks would anyway exhaust sectoral limits quickly. That means their options are largely limited to pass-through certificates (PTCs), loan assignments, and co-lending. PTCs are bond-like instruments usually with mortgage-backed securities as underlying assets.

“A proper realignment has to happen. Until then NBFCs will continue to take only tactical decisions to navigate the market,” the industry veteran said. According to him, one way to ease the pressure could be to allow more NBFCs to accept deposits and introduce a deposit guarantee scheme.

Individuals end up having exposure to NBFCs anyway through mutual funds as they are big subscribers to PTCs issued by NBFCs.

Exploring Alternatives

The higher cost and unavailability of funds locally is pushing NBFCs into offshore markets in search of capital.

"Everyone is increasingly turning to the bond market. They've ramped up their borrowing because it's now much cheaper than taking out bank loans especially for high rated corporates. Another option they're exploring is offshore borrowing," said Venkatakrishnan Srinivasan, founder of Rockfort Fincap LLP, a financial advisory firm that focuses on rupee debt - structured finance, bond placements, working capital funding etc.

Manappuram Finance, Muthoot Finance, and state-run REC are planning to issue bonds, each amounting to approximately $500 million. A total of eight NBFCs, including a government-owned infrastructure finance firm, intend to raise over $2 billion through external commercial borrowings (ECBs). According to RBI data, the NBFCs that applied for ECBs in January include REC (over US $500 million), Tata Motors Finance (US $200 million), L&T Finance Holdings (US $125 million), and Shriram Finance ( US $750 million).

Muthoot Finance already raised $650 million in the overseas market through dollar-denominated bonds. “While the average cost might be slightly elevated, a 10-15% diversification through foreign funding as a start is unlikely to significantly impact the overall borrowing costs,” said Sumit Sharma, Founder-Radian Finserv, an NBFC. However, tapping the domestic bond market will be the preferred choice provided the NBFCs are comfortable with the taxes on capital gains.

Rockfort’s Srinivasan says banks prefer to buy commercial papers issued by NBFCs than lending to them because gains up to Rs 1 lakh per year are exempted from capital gains tax. "For the bond market, any instrument held for more than one year qualifies for long-term capital gains. However, the interest payments on bonds are still subject to tax laws," he added.

As NBFCs explore asset-light models, co-lending with banks could emerge as a viable alternative. For example, the business model adopted by UGRO Capital, an NBFC, in terms of becoming a co-lender along with banks to micro and small enterprises could be replicated by the other NBFCs. As per RBI's regulations, in a co-lending arrangement, loans are disbursed in an 80:20 capital deployment ratio between the bank and the NBFC, respectively. Most of the capital comes from banks, and NBFCs take care of the sourcing and the corresponding customer experience. Banks feature a lower cost of capital and NBFCs have a comparatively higher price. Thus, the final rate of interest provided to the customers is usually a combination-weighted average capital cost.

“Collaboration with banks and other financial institutions presents a promising strategy for NBFCs. They can engage in co-lending arrangements and strategic partnerships, leveraging bank technologies for lead-based models, FLDG models (First Loss Default Guarantee) , and other collaborative frameworks,” said Gaurav Jalan, Founder & CEO, mPokket, an NBFC.

However, the situation will continue to remain challenging for the NBFCs with ratings below AA as investors will increasingly shun risk. In yet another blow to NBFCs, the RBI has reportedly written to at least four banks this month asking them to be cautious about their co-lending partnerships. The regulator is concerned about the poor underwriting standards of loans in some cases and potential asset quality issues

“To minimise challenges in accessing loans from banks, NBFCs should focus on enhancing their credit ratings through strong financial performance and governance practices. Building a reputation for responsible lending and timely repayment can improve their credibility and attractiveness to banks,” said PE Mathai, CEO, Muthoottu Mini Financiers, a NBFC focused on microfinance loans.