NBFCs are now a dominant supplier of credit to several segments. Given the current liquidity crisis, a structural reforms agenda that would enable sustainable growth of the NBFC sector is crucial
By Saurabh Tripathi & Deep Mukherjee
It is evident, and acknowledged that the importance of NBFCs in the Indian financial system is rising. To the extent that India has to enhance access of credit to a diverse set of borrowers with unique requirements, NBFC’s centrality is likely to increase. NBFCs have graduated from being a significant class of lender to being a dominant supplier of credit to several segments. In FY19, NBFCs contributed 40% of new loan accounts in retail, consumer, housing, and small business segments.
This contribution is broad-based across geographies—49% in tier one and two centres, and 32% in tier five and six centres. This is much more than that of other lenders, such as public sector banks, private sector banks or others, including MNC banks, all of whom play in these segments. In terms of providing credit to first time borrowers, or “new-to-credit (NTC) customers”, NBFCs have done an outstanding job—57% of NTC borrowers in tier one and two, and 55% in tier five and six get their first loan from an NBFC.
It is reassuring to note that both, the government and RBI have worked in concert to support the NBFC industry during the liquidity crisis. The government’s budget announcement to provide first loss guarantee for portfolio purchases from NBFCs, and a slew of measures from RBI to ease flow of credit to NBFCs are strong signals that the state is backing this pillar of Indian lending. Further, changes in the RBI Act, giving it more powers to better supervise and regulate NBFCs, clearly signal the intent for a more hands-on role of the regulator towards developing the NBFC sector.
The system should promote more NBFCs with unique capabilities in data, analytics, and technology to set shop. Given the increasing complexity of assessing credit quality in small business, SMEs and NTC customers, there is a need for constant entry of innovative, quick-footed lenders, with the mandate to experiment. Depending on the existing banking set-up, to take up the entire mantle of financial innovation and experimentation, given the stringent regulatory asks, is a tad optimistic. However, there is a need to re-look the entire framework of regulatory consideration to ensure that NBFCs achieve their full potential in terms of enabling financial inclusion.
The crisis provides an opportunity to reflect on structural reforms agenda, to enable sustainable growth of the NBFC sector. Such measures fall under five categories relating to regulation, innovation in funding instruments, bank finance reforms, strengthening market discipline, and reinforcing systemic support for NBFCs.
n Regulatory cognisance of heterogeneity: NBFCs are a heterogeneous space, given their focus on specific assets class and borrower segment. The risk-return profiles, and overall financial profiles of these players in terms of return on equity, risk-adjusted return on capital, application lifestyle management, and liquidity gaps are quite diverse. The regulatory requirement for liquidity and capital should, ideally, be cognisant of this structural diversity, and avoid one-size-fits-all regulations, particularly with respect to liquidity and capital requirement. Else, it may potentially distort market structure, affecting credit availability in certain segments.
n Diversifying source and instrument of funding: Apart from banks and mutual funds, we need to enhance funding from insurance and pension funds. Such long-term investors are risk-averse by design. Since many NBFCs are unlikely to be rated at, or above AA levels, such investors will not be able to invest in NCD of NBFCs. To address this, it is critical to encourage financial market innovations like covered bonds. Covered bonds are safer than both, standalone corporate bonds, as well as securitised papers, and would be favoured by conservative investors.
nBanks need to treat NBFC as partner, not borrower. Banks’ lending model of treating NBFCs as any other institution borrower needs to change. Co-lending may be the preferred model of the future. The co-lending scheme, introduced by RBI, allows NBFCs to lend to customers jointly with banks. NBFCs acquire the customer, lend a part of the loan to them, and provide first loss guarantee to the banks to lend the remaining part. Banks lend to the same customer at a lower rate, in line with their lower cost of funds and lower consequent risk costs. Banks and NBFCs can operate more closely. Technology integration of their systems will ensure much faster decision-making, and seamless customer experience while controlling the risk.
n Enhance market disclosure: NBFCs may be subject to enhanced market disclosures. Specifically, granular and in-depth disclosures on asset portfolio quality, funding sources, and liquidity profile may be required. As such, increasing liquidity or capital requirement may not solve for ill-considered lending strategy for some NBFCs. However, disclosures, and consequent market scrutiny will force a certain discipline in maintenance of prudential limits on both, the asset and the liability side of the business.
n Backstopping NBFCs: Create a refinance and liquidity support institution for NBFCs engaged in SME finance. As the present crisis has shown, liquidity, more often than insolvency, takes an NBFC down. NBFCs require a lender of last resort. We need one institution that has the capability to undertake repo of securities, backed by NBFC loan portfolio, that can be resorted to at a time of need, to raise funds for short periods.
(Saurabh Tripathi is Senior Partner & Deep Mukherjee is Associate Director, BCG. Views are personal)