After a tumultuous period post IL&FS’s collapse followed by setbacks from Covid-19, India’s Non-Banking Financial Company (NBFC) sector is regaining its strength, complementing banks in easing credit flow across the country. In recent weeks, rating agencies like ICRA have upgraded their outlook on the sector, backed by improved regulatory oversight, expansion in bank credit, healthy market issuance, declining NPAs and higher provisions. However, there are still mixed signals, with agencies like Ind-Ra and its parent company Fitch raising concerns about the bulging unsecured personal credit exposures of some NBFCs. In this article, I explore the relevance of NBFCs in a capital-starved country like India and the emerging trend of consolidation, which will further strengthen the well-managed NBFCs to better withstand liquidity stresses in future.
Classroom economics explains human capital and investments as the two factors of production that need to be in equilibrium. This can optimise productivity, generate employment, and foster overall well-being. India, with its demographic dividend, remains well-endowed in human capital, but investments have been inadequate due to restricted credit flow, a key catalyst for sustainable investments. Addressing this credit inadequacy is necessary to achieve India’s full growth potential for us to become a developed nation by 2047.
The Indian financial system enables two vital sources of credit supply: (i) credit flows through balance sheets of financial intermediaries like banks and non-banking financial corporations (NBFCs), and (ii) market credit flowing through bond markets where key participants are mutual funds, insurance companies and banks (Rajeswari Sengupta, et al, 2021). Historically, the former source has dominated credit flow, with corporate bond markets remaining shallow. Within that, banks hold the lion’s share of total credit outstanding (80 per cent), aided by their access to household savings (deposits), the cheapest source of capital.
The rise in bank credit has been fraught with periods of volatility, impeding investor sentiment. Between 1991, when the fabled economic reforms were introduced to tide over India’s balance of payment crisis, and till the early 2000s, bank credit expanded by an average of 15 per cent annually. Between 2003-2008, its CAGR ballooned to 28 per cent, backed by large and at times, indiscriminate disbursals to the commercial sector, swayed by heavy optimism around India’s growth outlook. Unfortunately, this exuberance did not bode well for bank balance sheets as non-performing assets started to rise during the early 2010s.
Looking at the magnitude of the problem, RBI introduced Asset Quality Reviews for banks in 2016. From 2013 to 2017, banking GNPAs rose from 3.4 per cent to 10 per cent. The sharp rise in bad assets hampered bank appetite towards the commercial sector, a sentiment which still prevails. Since then, bank exposure to retail loans has been displacing wholesale credit. From 2016 to pre-Covid, bank credit grew at a mere 10 per cent annually, which further declined to seven per cent during the two years of COVID.
This credit slowdown paved the way for the other type of financial intermediary, NBFCs. Since 2014, NBFCs had been trying to compensate for the shortfall in credit flow, especially across niche areas of MSME and real estate financing. By 2018, NBFCs accounted for 60 per cent of the incremental credit flows to MSMEs and real estate developers, helped by interest rates coming down, credit demand rising, and bank credit supply contracting. This period also saw easy access to funds, as banks were preferring to lend to NBFCs (at the cost of industries) and the emergence of mutual funds as an alternate credit source. A lot of Indian savings were being channelised into mutual funds, with assets under management growing at a CAGR of 20 per cent between 2010-2015. Additionally, debt mutual funds got a boost from demonetisation. This sudden rise in liquidity, coupled with declining interest rates, aided NBFCs to access cheap funds for onward lending.
However, this trend was disrupted after the collapse of a major NBFC, specialising in infrastructural lending, in 2018, creating a contagion within the sector.
Consequently, there was a sharp decline in incremental credit from both commercial banks and NBFCs, lasting from late 2018 till early 2022. The NBFC success story was pegged on their ability to raise cheap funds from banks, bond markets and commercial papers. This contagion led to an immediate drying up of all such sources of wholesale funding. Unlike banks, a majority of the NBFCs had no access to household savings, leaving them high and dry on liquidity. The Indian government and RBI demonstrated remarkable agility in supporting the sector during the crisis, however dwindling investor appetite blocked funding for new credit disbursements.
In India, where financial inclusion and access to bank credit continue to remain a challenge for vast segments of business and retail borrowers, it is necessary to develop an NBFC ecosystem. These customer segments may never be viable for banks, owing to the risks they entail, or the level of expertise required to underwrite such loans. NBFCs, with nimble, tech-enabled approaches and specialised teams, offer the only practical alternative to reach out to such segments, including MSMEs and real estate developers, who are critical for India’s economic growth. Hence, it is necessary to learn from the financial crisis prevailing from 2018 to 2021.
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A key reason for the funding setback witnessed by NBFCs was concentrated liability books. Hence, it is crucial to diversify funding sources to reduce their sensitivity to liquidity shocks in the future. Regulators and stakeholders should work towards enabling access of NBFCs to a wider pool of debt, both domestic and international.
Secondly, unlike banks, most NBFCs do not have deposit-taking licenses (the last such license issued to any NBFCs was in 1997). As a result, NBFCs by design, are always dependent on the Indian wholesale debt market, which itself is illiquid. This exposes them directly to every liquidity shock. It would be useful to devise short-term liquidity buffers, akin to the repo operations by RBI available for banks.
Despite these challenges, well-managed large NBFCs have been able to successfully establish themselves, backed by a good mix of skills and sectoral expertise. There is a wave of consolidation already underway. Financially strong NBFCs with differentiated business strategies will acquire a larger market share, displacing the platitude of smaller and weaker players. These well-established NBFCs will have better access to cheap capital and continue to complement the banking system in extending financial inclusion within the remotest corners of the country.
The writer is Chief Economist, Piramal Group
