It is generally accepted that greater financial system depth, stability and soundness contribute to economic growth. But beyond that, for growth to be truly inclusive requires broadening and deepening the reach of banking that helps both consumers and producers raise their welfare and productivity and build savings, make investments, avail credit, and more important, insure themselves against income shocks and emergencies.Though the Indian financial system has made impressive strides in resource mobilization, geographical and functional reach, financial viability, profitability and competitiveness, vast segments of the population, especially the underprivileged sections of the society, have still no access to formal banking services. If one takes a look at the number of bank accounts vis-à-vis the entire population, 92-94% of the population in the UK has either current or savings accounts, whereas in India the figure comes down to mere 31% .In rural areas the coverage among adult population is 39% against 60% in urban India2. The financially excluded sections largely comprise marginal farmers, landless labourers, self employed and unorganizedA sector enterprises, ethnic minorities, socially excluded groups, senior citizens and women3. Hence, there is need for making sure that the footprint of the banking sector is much more accessible to all the citizens.Although NBFCs cater to the rural and semi-urban space,yet their scale is capped to particular segments and regions.Hence it is imperative to increase the banking licences. A larger number of banks would foster greater competition, and thereby reduce costs, and improve the quality of service. More importantly, it would promote financial inclusion, and ultimately support inclusive economic growth, which is a key focus of public policy.
What are NBFCs
As per RBI, a Non-Banking Financial Company(NBFC) is a company registered under the Companies Act, 1956 and is engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/ securities issued by Government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, sale/purchase/construction of immovable property.
NBFCs are financial institutions that provide banking services without meeting the legal definition of a bank, i.e. one that does not hold a banking license. Operations are, regardless of this, still exercised under bank regulation. NBFCs provide financial services that are partly fee based and partly fund based. Their fee based services include portfolio management, issue management, loan syndication, merger and acquisition, credit rating etc. and their asset based activities include venture capital financing, housing finance, equipment leasing, hire purchase financing factoring etc. NBFCs are doing functions similar to that of banks; however there are a few differences: An NBFC cannot accept demand deposits; An NBFC is not a part of the payment and settlement system and as such an NBFC cannot issue cheques drawn on itself; Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available for NBFC depositors unlike in case of banks. They are not subject to certain regulatory prescriptions applicable to banks like CRR. NBFCs can be classified into two broad categories, viz., NBFCs accepting public deposit (NBFCs-D) & NBFCs not accepting/holding public deposit (NBFCs-ND) Residuary Non-Banking Companies(RNBCs) are another category of NBFCs whose principal business is acceptance of deposits and investing in approved securities1.
Why should NBFCs be converted into Banks
NBFC model particularly those in lending activities has been successful in expanding the reach of financial system and thus by converting to banks, this model could be scaled up to better leverage the benefits and achieve the objective of financial inclusion.As at the end of financial year 2009-10, the total assets of NBFCs were at Rs.1,09,324 crore and Public deposits were at Rs.17,247 crore4.
(In Rs Crores)
Profile of NBFCs
Some of the sectoral credit issues, such as infrastructure and microfinance, could be better addressed if NBFCs specializing in the specified sectors can better leverage their competence by converting to banks and having access to low-cost funds. Most of the NBFCs are regulated by either RBI,NHB or SEBI and have traceable track record in terms of management and financial performance, risk management and statutory guidelines.Thus, additional requirements of statutory ratios, priority sector lending etc can be met with ease as compared to a private player who doesnot have exposure to the financial sector4.
Capital Adequacy Ratio of NBFCs-D (No. of companies)
The expertise of the NBFC in the financial sector could flow into the bank if NBFCs are allowed to promote banks.The NBFCs could retain their niche space and yet contribute to the financial sector through the bank they would set up.Below graph shows that NBFCs have been producing better returns on assets as compared to banks. C:UsersAnkitDesktopArticlesROA.png Currently NBFCs loose out on the front of efficient fund raising which can only be done by entities that have institutional backing like Banks, Once they are converted into banks it will help in making them all the more competitive4.
NBFC to Banks : A Bumpy ride Ahead
Banking Regulation Act expressly bars any business other than that permitted by the Act [Sec 6 (1)]. But for domestic NBFCs,there is no bar on non-financial business, except that on crossing of a certain barrier (50% of income or assets).Activities like “Lease and Hire Purchase” and “Operating Lease” are highly regulated or not permitted to banks, conversion of NBFCs into bank would require withdrawal from many segments of such businesses, folding up of large number of branches as well as disinvestment from subsidiaries/affiliates not engaged in businesses permitted to banks. The initial capital requirement for NBFCs is a miniscule Rs. 2 crore but if it wants to turn into a bank it has to maintain at least Rs 300 crores.Even if it raises this capital, it may not have the financial strength or parentage to support bank’s capital needs particularly in periods of stress.The main source of funding for Banks is low cost Retail deposits(at around 55%) but for NBFCs it is wholesale funds which get repriced at a much faster rate. Thus, In situations of tight liquidity NBFCs are likely to face greater crunch in funds as compared to banks5. RBI places restrictions on commercial banks in their lending operations. Out of Rs 100 taken in as deposits, approximately Rs 30 has to be set apart as statutory requirements towards CRR and SLR. This leaves the banks with Rs 70 to lend. Out of this, 40% has to be statutorily lent towards the priority sector as defined by RBI. This leaves banks with approximately Rs 42 to lend at their own discretion .Whereas for an NBFC there is only 15% requirement for CRR and no requirement of SLR and no restrictions on priority sector lending which leaves it with Rs 85 as compared to Rs 42 for a bank. Many NBFCs would definitely find these regulations very restrictive on conversion into a bank6. Due to the maturity differences of the assets and liabilities of the NBFCs and banks, there may be possibilities of the bank funds being utilized to meet the NBFC liabilities and also of indulgence in regulatory arbitrage5.
Asset Quality is a major concern in banking and restricting NPAs a pain. NBFCs have been efficient enough to maintain NPAs at 1.1% close to average for banks at 1.12%.But there is a large divergence in the way NPAs are calculated for banks and for NBFCs. For Banks any due past 90 days is characterised as an NPA and calls for provisioning.But for NBFCs as much as 12 months’ overdue is permitted in case of lease and hire purchase transactions and 6 months in case of loans and other exposures which means on conversion into a bank there may be a huge rise in the NPAs of NBFC and hence the need for provisioning which will again drive down the profitability. NPA data of NBFCs (Source : Reserve Bank of India) The NBFCs generally operates on the model of lending to riskier projects with interest rates higher than offered by the banking institutions. The concentrated loan-books which now allow some NBFCs to focus on lucrative niches and earn exceptional spreads may no longer be possible. Lending would need to become broad based.The maturity mix of the asset portfolio is also skewed towards long term and the asset mix may not be compatible to the banking liabilities. If NBFCs are converted into banks they may take a long time to align themselves to banking5. Promoter holding maintains capital stability which is important especially in intial years of operation for a financial services company. However, for a bank this could risk concentration of business decisions in the hands of a few, tilting them towards sponsor interests rather than financial inclusion.Current guidelines require promoters to bring in intial capital of 40% with a lock in period of 5 years.The possible caps after lock in period under discussion are 5-10% or 20% or retaining current approach.This means that there could be significant dilution of promoter holding in the event of NBFCs being awarded banking licence. C:UsersAnkitDesktopArticlesshareholding.png The NBFC model and the bank model are entirely different as NBFC model provides financial access to excluded categories without the same regulation as applicable to banks. On the other hand, the banking license gives the institution full scope to carry out full-fledged banking activities, with stricter regulatory requirements. Therefore the NBFCs may not fulfill the ‘well established and well regulated’ criteria and hence the ‘track record’ of an NBFC cannot be taken as an automatic eligibility criterion for conversion into banks. In addition, the conversion may entail a rejig in the branch networks of NBFCs and not all their existing branches may continue to be operational. Access to low-cost deposits would depend on the branch network and currently branch licences are scarce in metro and urban areas and expansion very expensive. Banks, with their first mover advantage, have already charted out huge branch expansion programmes which would increase the competition for low-cost deposits. In 2008-09, NBFCs accounted for 9 per cent of the total financial system assets, while commercial banks held a dominant 70 per cent of the assets. Therefore NBFCs are currently not of a scale to threaten existing banks.
C Cost of Funds – Banks Vs NBFCs
NBFCs play an important role in broadening of financial services to unbanked segment, enhancing competition and bringing diversification in the financial sector. With their experienced management, knowledge of buyer behaviour, risk and NPA management and adherence to regulatory requirements and traceable track record in terms of management and financial performance, risk management and statutory guidelines,their bagging banking licences could be helpful in better leveraging the benefits and achieving the objective of financial inclusion. But there are some hindrances in their way like: adhering to stringent regulatory requirements of maintaining CRR, SLR etc, shutting down of their non-financial businesses, jump in intial capital requirement to a minimum of Rs 300 crores, Asset-Liability mismatch will need to be balanced and Lending will be required to be more broad based. Additionally restrictions like priority sector lending along with competition from existing banks for low cost deposits would severely dampen the enthusiasm of NBFCs eyeing banking licences. In nutshell, NBFCs have experience, reach, resources and expertise due to which it should enjoy preference over new private entrants at the time of allocation of banking licences but the way from an NBFC to a full-fledged bank is definitely going to be a very bumpy road.