The rise and rise of NBFCs

The Reserve Bank of India recently announced the names of 15 large non-banking financial companies (NBFCs), including LIC Housing Finance, Bajaj Finance, Shriram Finance, and Tata Sons, under the scale-based regulations (SBR) for 2023–24. These NBFCs from the upper layer were considered systemically important and would be subject to enhanced supervisory regulations. The RBI introduced SBR for NBFCs in 2021 based on the perceived risk to the financial system and its implications for financial stability. The SBR is based on the principle of proportionality, which is a function of their size and activity. The regulations were in response to the 2018 collapses of DHFL and IL&FS, which had inflicted collateral damage on the financial system.

NBFCs, often referred to as “shadow banks,” have played a crucial role in the Indian economy by complementing banks in deploying funds to various sectors. In fact, many of them have engaged in co-lending partnerships with major banks, offering a variety of loans, such as personal loans, vehicle loans, home loans in affordable housing, loans to MSMEs, and microfinance loans. Notably, they serve underserved and unbanked segments, along with individuals with poor credit histories ignored by the banking sector, thus contributing significantly to financial inclusion. The financial inclusion index improved from 56.4 in March 2022 to 60.1 in March 2023, primarily due to their efforts.

Of the total Rs 3.50 lakh-crore micro-credit loans given by the banking industry, microfinance institutions, or MFIs, surpassed banks as the leading microcredit providers with a 40 per cent share in the gross micro-credit portfolio at the end of December 2022. Incidentally, the average disbursement per account in micro-credit increased by 8 per cent to Rs 44,000 during the first quarter of the current financial year.

Though the SBR framework was introduced in 2021, it became effective in October 2022. Under the SBR framework, NBFCs are placed in four layers: top, upper, middle, and base. The top layer remains vacant to be filled if the central bank perceives a substantial increase in systemic risk. As of March 2022, 94 per cent of NBFCs were in the base layer, representing only 5 per cent of the total asset size. The remaining 6 per cent of NBFCs had a whopping share of 95 per cent of assets, reflecting their market dominance. Because of the interconnectedness of NBFCs with other players, mainly banks, in the financial landscape and the risks they pose, the central bank has issued prudential guidelines for NBFCs in the upper and middle layers.

The crucial role played by NBFCs can be gauged by the fact that loans and advances given by NBFCs were Rs 29.24 lakh crore as of December 2022, surpassing 20 per cent of the total advances of commercial banks. Leveraging technology, they have been offering innovative and customised financial products and services and helping with last-mile connectivity. When compared to banks that sanctioned 5.6 per cent of loans through digital channels, NBFCs sanctioned 60 per cent of loans digitally in 2019–20. Even in other metrics, their performance has been remarkable. The net interest margin, or NIM, was an impressive 8.90 per cent for the NBFCs in the upper layer since they lend predominantly to the retail sector, while the NIM for the middle layer was a mere 2.4 per cent as they lend mainly to industry. The return on equity, or ROE, was 11.3 and 7.1 for the upper- and middle-layer NBFCs, respectively.

NBFCs face challenges in getting cheaper funds since, unlike a bank, they do not have access to savings or current accounts. Only a few of the NBFCs can accept term deposits from the public. NBFCs fund their operations mainly through borrowings from the market and banks, which account for around 75 per cent of their total borrowings. The upper-layer NBFCs increasingly depend on bank borrowings, constituting nearly half of their total borrowings as of December 2022. NBFCs in the middle layer rely more on market borrowings through commercial paper and debenture issuances, though their bank borrowings have also gone up in recent quarters. While the debenture issues of NBFCs have been subscribed to by banks, insurance companies, and pension funds, CPs have been funded mainly by mutual funds.

NBFCs have been facing many challenges of late. For example, microcredit institutions are facing challenges from business correspondents. VC funding is another challenge for them. Despite the challenges faced by them regarding asset quality, competition from banks, and increased regulations, the NBFC sector in India is expected to continue to have robust growth in the coming years and play a key role in India’s economic growth.

(The writer is a former banker and currently teaches at Manipal Academy of Global Education, Bengaluru)