NBFC Sector

Non-banking financial companies (NBFCs) are financial institutions that offer various banking services but do not
have a banking license. NBFCs are also called shadow banks. As per RBI, “A Non-Banking Financial Company
(NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances,
acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other
marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not
include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale
of any goods (other than securities) or providing any services and sale/purchase/construction of immovable
property. A non-banking institution which is a company and has the principal business of receiving deposits
under any scheme or arrangement in one lump sum or in installments by way of contributions or in any other
manner is also a non-banking financial company.”

NBFCs lend and make investments, and hence, their activities are akin to that of banks; however, there are a
few differences as given below:

• NBFC cannot accept demand deposits;

• NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on
itself;
• the deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to
depositors of NBFCs, unlike in case of banks.

Indian financial system includes banks and non-financial institutions. Though banking system dominates financial
services, NBFCs have grown in importance by carving a niche for themselves in under-penetrated regions and
unbanked segments. All India financial institutions include NABARD, SIDBI, NHB, and Exim bank.

STRUCTURE OF NON-BANKING FINANCIAL INSTITUTIONS IN INDIA

Non-banking
Financial
Institutions

Non-banking All-India
Finance Financial
Companies Institutions

NBFC Deposit- NBFC Non- Housing Finance Insurance

Chit Funds
taking deposit taking Companies companies

Infrastructure
Loan Company Finance
Company

Investment Micro-finance
Company Company

Asset Finance
Factors
Company

Core
Investmenty
company

Infrastructure
Debt Fund
NBFCs have been classified based on the kind of liabilities they access, type of activities they pursue, and their
perceived systemic importance.

Liability based classification:

NBFCs are categorized in terms of the type of liabilities into Deposit and Non-Deposit accepting NBFCs. Non-
deposit taking NBFCs by their size into systemically important and other non-deposit holding companies (NBFC-
NDSI and NBFC-ND). There were 9,659 non-banking financial companies (NBFCs) registered with the Reserve
Bank as on March 31, 2019, of which 88 were deposit accepting (NBFCs-D) and 263 systemically important non-
deposit accepting NBFCs (NBFCs-ND-SI). All NBFC-D and NBFCs-ND-SI are subject to prudential regulations such
as capital adequacy requirements and provisioning norms along with reporting requirements. NBFCs whose
asset size is of ₹ 500 cr or more as per last audited balance sheet are considered as systemically important NBFCs.
The rationale for such classification is that the activities of such NBFCs will have a bearing on the financial stability
of the overall economy.

NBFCs
(9659)

Deposit Taking
Non-Deposit Taking
(NBFC-D)
(9571)
(88)

Systemically Important
NBFC-ND
(NBFC-ND-SI)
(9308)
(263)

Activity-based classification

By the kind of activity NBFCs conduct, they may be broadly classified into the following categories:

I. Asset Finance Company (AFC) : An AFC is a company which is a financial institution carrying on as its principal
business the financing of physical assets supporting productive/economic activity, such as automobiles, tractors,
lathe machines, generator sets, earthmoving and material handling equipment, moving on own power and
general purpose industrial machines. Principal business for this purpose is defined as aggregate of financing
real/physical assets supporting economic activity and income arising therefrom is not less than 60% of its total
assets and total income, respectively.

II. Investment Company (IC): IC means any company which is a financial institution carrying on as its principal
business the acquisition of securities,

III. Loan Company (LC): LC means any company which is a financial institution carrying on as its principal business
the providing of finance whether by making loans or advances or otherwise for any activity other than its own
but does not include an Asset Finance Company.

IV. Infrastructure Finance Company (IFC): IFC is a non-banking finance company a) which deploys at least 75
percent of its total assets in infrastructure loans, b) has a minimum Net Owned Funds of ₹ 300 crores) has a
minimum credit rating of ‘A ‘or equivalent d) and a CRAR of 15%.

V. Systemically Important Core Investment Company (CIC-ND-SI): CIC-ND-SI is an NBFC carrying on the business
of acquisition of shares and securities which satisfies the following conditions:
 • it holds not less than 90% of its Total Assets in the form of investment in equity shares, preference
shares, debt or loans in group companies;
• its investments in the equity shares (including instruments compulsorily convertible into equity shares
within a period not exceeding ten years from the date of issue) in group companies constitutes not less
than 60% of its Total Assets;
• it does not trade in its investments in shares, debt or loans in group companies except through block
sale for dilution or disinvestment;
• it does not carry on any other financial activity referred to in Section 45I(c) and 45I(f) of the RBI act,
1934 except investment in bank deposits, money market instruments, government securities, loans to
and investments in debt issuances of group companies or guarantees issued on behalf of group
companies.
• Its asset size is ₹ 100 crore or above and
• It accepts public funds

VI. Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC): IDF-NBFC is a company registered as
NBFC to facilitate the flow of long term debt into infrastructure projects. IDF-NBFC raise resources through issue
of Rupee or Dollar denominated bonds of minimum five-year maturity. Only Infrastructure Finance Companies
(IFC) can sponsor IDF-NBFCs.

VII. Micro Finance Institution (NBFC-MFI): NBFC-MFI is a non-deposit taking NBFC having not less than 85% of
its assets in the nature of qualifying assets which satisfy the following criteria:

• loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not exceeding ₹
1,00,000 or urban and semi-urban household income not exceeding ₹ 1,60,000;
• Loan amount does not exceed ₹ 50,000 in the first cycle and ₹ 1,00,000 in subsequent cycles;
• Total indebtedness of the borrower does not exceed ₹ 1,00,000;
• Tenure of the loan not to be less than 24 months for loan amount over ₹ 15,000 with prepayment
without penalty;
• loan to be extended without collateral;
• aggregate amount of loans, given for income generation, is not less than 50 percent of the total loans
given by the MFIs;
• loan is repayable on weekly, fortnightly or monthly installments at the choice of the borrower

VIII. Factors (NBFC-Factors): NBFC-Factor is a non-deposit taking NBFC engaged in the principal business of
factoring. The financial assets in the factoring business should constitute at least 50 percent of its total assets
and its income derived from factoring business should not be less than 50 percent of its gross income.

IX. Mortgage Guarantee Companies (MGC) - MGC are financial institutions for which at least 90% of the business
turnover is mortgage guarantee business or at least 90% of the gross income is from mortgage guarantee
business, and the net owned fund is ₹ 100 crore.

X. NBFC- Non-Operative Financial Holding Company (NOFHC) is financial institution through which promoter /
promoter groups will be permitted to set up a new bank .It’s a wholly-owned Non-Operative Financial Holding
Company (NOFHC) which will hold the bank as well as all other financial services companies regulated by RBI or
other financial sector regulators, to the extent permissible under the applicable regulatory prescriptions.

Regulatory environment for NBFCs

NBFCs have been part of the informal loan disbursement setup since several decades in India. However, there
were various complaints from investors relating to NBFCs’ dubious functioning and loss to depositors. This threw
up challenges for policymakers and regulators to integrate NBFCs within the overall prudential regulatory
framework of the financial system.

Amendments to the RBI Act in 1997 bestowed comprehensive powers on the RBI to regulate and supervise
NBFCs. Prominent features of the amendments include:
 • Making it mandatory for NBFCs to obtain certificate of registration from the RBI and maintain a
minimum level of net owned funds (NoF)
• Requiring deposit-taking NBFCs to maintain a certain percentage of assets in unencumbered approved
securities
• Empowering the RBI to determine policy and issue directions with respect to income recognition,
accounting standards, etc
• Empowering the RBI to order special audit of NBFCs

Further, asset liability management guidelines were introduced in 2001 to address credit risk and market risk
faced by NBFCs. Fair practices code for lending was prescribed in 2006, directed towards ensuring transparency
in pricing of loans and ethical behaviour towards borrowers. Corporate governance framework was introduced
in 2007 to ensure professionalism in NBFCs and know your customer norms were also made applicable to them.

In the backdrop of 2008’s global financial crisis, the regulations were further amended in December 2011 with
tighter norms on asset classification, provisioning Tier–I capital adequacy and risk weights on exposure to
sensitive sectors, among others. Further, restrictions have been imposed on certain NBFC segments because of
their business risk and size of assets. For e.g., gold loan NBFCs do not enjoy priority sector tag for assets
securitized by them. There is also a cap on LTV at 75%, besides they have to maintain the Tier–1 capital adequacy
ratio of 12%. Similarly, for NBFC-IFCs (Infra Finance Companies) Tier-1 capital adequacy is mandated at 10%. On
November 10, 2014, the RBI released a revised regulatory framework, centered on the following objectives:

• Harmonizing and simplifying regulations to make compliance easier

• Focusing on activity-based regulations without impeding those segments within the sector that do not
pose any significant risk to the wider financial system
• Addressing risks and regulatory gaps wherever these exist and strengthening governance and disclosure
standards

Some key changes made are:

• Minimum NoF criterion for existing NBFCs (those registered prior to April 1999) has been increased to
Rs 20 million.
• To strike a balance between under-regulation and over-regulation of the sector, the RBI has raised the
threshold asset size for NBFCs that are considered systemically important, from Rs 1 billion and above
to Rs 5 billion and above. Thus, all non-deposit-taking NBFCs with asset size of Rs 5 billion and above
are termed systemically important (NBFC-ND-SI) from July 2015, and focus of regulation and
supervision of these entities has been sharpened. Furthermore, a simplified framework for light-touch
regulation has been put into place for NBFCs that are not systemically important, i.e., NBFCs with total
assets less than Rs 5 billion.
• For NBFCs-ND-SI and all NBFCs-D (deposit taking NBFCs) categories, tighter prudential norms have been
prescribed in line with those of banks: Minimum Tier I capital requirement has been raised to 10% from
earlier 7% and asset classification norms from 180 days to 90 days to be adhered in a phased manner
by end March 2018; also, provisioning requirement for standard assets has been increased to 0.40%,
to be implemented in a phased manner by March 2018. The exemption provided to asset finance
companies (AFCs) from the prescribed credit concentration norms of 5% has been withdrawn with
immediate effect. Additional corporate governance standards and disclosure norms for NBFCs have
been issued for NBFCs-D and NBFCs-ND.
• The revised regulatory framework has introduced a new concept of the leverage ratio as part of the
limited prudential norms, which will be applicable to all NBFCs-ND that are subject to limited prudential
norms. Such NBFCs-ND need to ensure a maximum leverage ratio of 7, i.e., total outside liabilities do
not exceed 7 times their owned funds. This additional requirement would link the asset growth of such
NBFCs to the capital they hold.
• To harmonise and strengthen deposit acceptance regulations across all deposit-taking NBFCs (NBFCs-
D), credit rating was made compulsory for existing unrated AFCs by March 31, 2016. The maximum limit
for acceptance of deposits has been harmonised across the sector to 1.5 times of NoF.
 • Under the revised guidelines, the RBI has tightened corporate governance and disclosure norms for
NBFC-D and NBFC-ND-SI. Certain requirements, such as rotation of audit partners and constitution of
nomination and risk management committees, which under erstwhile regulations were only
recommendatory in nature, have now been made mandatory in the case of NBFC-D and NBFC-ND-SI.
• IND AS implemented for all NBFCs and HFCs since April 2018

Regulatory distinction between Banks and NBFCs

NBFC-ND-SI NBFC-D Banks (Basel-III)

Minimum Net Owned Fund Rs. 20 Million Rs. 20 Million NA
Capital Adequacy 15% 15% 9%
Tier-I Capital 10% 10% 7%
GNPA Recognition 90 days 90 days 90 days
Cash Reserve Ratio (CRR) NA NA 4%
Statutory Liquidity Ratio (SLR) NA 15% 19.5%
Priority Sector NA NA 40% of advances
SARFAESI Eligibility Yes Yes Yes
Exposure Norms Single borrower: 15% Single borrower: Single borrower: 15%
(+10% for IFC) 15% (+5% for Infra projects)
Group borrower: 25% Group borrower: Group borrower: 25%
(+5% for IFC) 25% (+10% for Infra projects)
Standard Asset Provisioning 0.4% 0.4% 0.4%

Sources of Fund of NBFCs

There is a difference between the way of operation of a ‘Bank’ and an ‘NBFC’. Banks accept deposits from its
customers and then it uses this money for lending. It pays interest to its customers on the deposits and it charges
higher interest on the loan amount. However, this is not the case with many NBFCs. NBFCs are companies in
finance business but many of them cannot accept deposits from the general public. Hence, their way of raising
money is a bit different. Bank borrowings, debentures, and commercial papers are the major sources of funding
for NBFCs. NBFCs were the largest net borrowers of funds from the financial system, with gross payables (loans)
of around Rs 717,000 crore and gross receivables of around Rs 419,000 crore in March 2018. A breakup of gross
payables indicates that the highest funds were received from banks (44%), followed by mutual funds (33%) and
insurance companies (19%). HFCs were the second-largest borrowers with gross payables of around Rs 528,400
crore and gross receivables of only Rs 31,200 crore.

Major components of sources of fund of NBFCs (share % to total interest-bearing liabilities)

Before we go into further details, let us discuss these terms first.

1. Bank borrowings: It is nothing, but the money raised from banks and the borrower needs to repay
the money in a specified period along with the interest amount.
2. Debentures: It is nothing, but the money raised not from a single person as in case of loan where
the lender was a bank. Here, the money is raised from a large audience which we call ‘Debenture-
holders’.
3. Commercial Papers: These are the short-term instruments used to raise money for a lesser duration.
These are unsecured and hence, the company issuing the commercial papers has to have a good
credit rating for the lender to put the money in the commercial papers of the company.
Now, loans are taken by NBFCs from Banks. The loans generally bear a higher rate of interest, whereas the
commercial papers and the bonds bear a relatively lower rate of interest. Hence, it is obvious that the NBFCs
would prefer raising money more from such less costly sources. If we compare the year 2014 with 2018, we
find that NBFCs are preferring more Commercial Papers than Banks. The business model of NBFC is simple.
They raise funds as explained above and lend the money and charge interest. The difference is their margin
which is called as ‘Net Interest Margin’ (NIM).

Asset-Liability Mismatch

In finance, an asset-liability mismatch occurs when the financial terms of an institution's assets and liabilities do
not correspond. NBFCs raise money from Short-term finance sources like Commercial Papers, Debentures, and
Bonds but they lend the money for Long term purposes. Once the repayment period is complete and the
Commercial papers are due to mature i.e. expire, the company simply issues a new set of commercial papers
and borrows once again. This way the company can "rollover" funds to meet their short-term obligations. But if
NBFCs are there are no buyers of commercial papers this might create an asset-liability mismatch.

NBFC sector overview

The consolidated balance sheet size of the NBFC sector grew by 20.6 percent to ₹ 28.8 trillion during 2018-19 as
against an increase of 17.9 percent to ₹24.5 trillion during 2017-18 as per June 2019 financial stability report of
RBI. The NBFC sector has been growing robustly in recent years, providing an alternative source of funds to the
commercial sector in the face of slowing bank credit.

Even as their importance in credit intermediation is growing, recent developments in the domestic financial
markets have brought the focus on the NBFC sector (including housing finance companies or HFCs) especially
with regard to their exposures, quality of assets and asset-liability mismatches (ALM). The liquidity stress in
NBFCs reflected in the third quarter of the last financial year (September - December 2018) was due to an
increase in funding costs as also difficulties in market access in some cases. Despite the dip in confidence, better
performing NBFCs with strong fundamentals were able to manage their liquidity even though their funding costs
moved with market sentiments and risk perceptions.
In the CP market, the absolute issuance of CPs by NBFCs have declined sharply relative to its level pre - IL&FS
default. During the stress period, CP spread of all entities had increased, particularly that of NBFCs, highlighting
a reduced risk-appetite for them. Subsequently, the CP spread for NBFCs has reduced and its gap vis-à-vis other
issuers has narrowed. Thus, in a way, the IL&FS stress episode brought the NBFC sector under greater market
discipline as the better-performing companies continued to raise funds while those with ALM and/or asset
quality concerns were subjected to higher borrowing costs. Post-crisis, while banks’ overall exposure to NBFCs
increased, their subscription to CPs of NBFCs continued to decline.

IF&LS Crisis

IL&FS refers to Infrastructure Leasing and Financial Services, a group of companies. They lend money to
infrastructure projects because the size and duration of those loans make them very hard for regular lenders to
be involved. As IL&FS cannot accept deposits from the public for lending purposes, it gets its money by issued
debt instruments, which are essentially a lending contract that says that the lender will be repaid according to a
contract. These contracts usually specify the duration, interest rates, and when interest and capital are paid.
Since 2016, it has been relying mainly on short-term loans for its funding requirements. But, it extended long-
term loans to infrastructure projects. It led to an asset-liability mismatch. Short-term liabilities were used to
finance long-term assets. The company has over Rs.91000 crore in debt. There has also been a slowdown in the
infrastructure sector which has impacted the returns of IL&FS. IL&FS has not been able to make the interest
payments, which is the minimum requirement with most debt instruments, on one kind of instrument it issues,
which indicates that they are out of cash. The IL&FS defaulted on several of its loans since 27th August 2018.
Subsequently, the credit rating agencies ICRA, CARE, and Brickwork abruptly downgraded IL&FS and its
subsidiaries from high investment grade to junk status. These large-scale defaults and credit downgrade led to
a panic in the Financial Markets.

Given that the loans they call in are longer-term, they are unlikely to get cash from those loans being repaid,
which means that all those investors who bought these debt instruments are worried that they will not be
repaid. The chain effect leads to panic and falling share prices of companies that hold these instruments, and
those to the next and so on. Several of the companies here are insurance and mutual fund companies, which
makes the situation even more alarming.

Dewan Housing Finance Corporation Ltd (DHFL)

DHFL is a non-banking financial company, also known as a shadow bank. This means it doesn’t have a banking
license or access to central bank liquidity, but is nevertheless involved in financial services – in this case, primarily
giving loans to home buyers in India’s tier 2 and tier 3 cities. Its stock price has fallen by around 90 percent over
the past year, and there are apprehensions about the viability of the company even as it is in the process of
figuring out how to come out of its financial troubles.

On June 5, DHFL has seen its commercial paper – short-term debt instruments – downgraded to “D”, meaning
default. In other words, rating agencies do not expect DHFL to be able to pay back the short-term debts it owes
in full – including about Rs 850 crore of commercial paper. On July 14, Dewan Housing Finance Corporation
(DHFL), reported a net loss of Rs 2,223 crore for the fourth quarter (Q4) of 2018-19. The result was in stark
contrast to Rs 134 crore of net profit that DHFL reported in the same quarter of the previous fiscal year (2017-
18). Not surprisingly, the full-year results also showed a massive decline. The company posted a net loss of Rs
1,036 crore in FY 19 when it in FY 18, it had announced a net profit of Rs 1,240 crore.

Alongside its latest results, Kapil Wadhawan, Chairman and Managing Director, DHFL, said: “In the backdrop of
a significant slowdown in disbursement and loan growth post-September 2018, the financials of the company
have been quite strained for the quarter impacting the overall performance of the year”. In other words, the
company has struggled to forward any new loans even as their existing loans are turning into non-performing
assets (NPAs). DHFL’s gross NPAs have risen to 2.74 percent in the fourth quarter of the last financial year as
against 0.96 percent during Q4 of FY18.

DHFL’s troubles started after another big non-bank financial company — Infrastructure Leasing & Financial
Services (IL&FS) — defaulted on its debt obligations in September 2018. IL&FS was found to be afflicted with a
serious asset-liability mismatch, and its performance resulted in many investors in the NBFC sector to hit the
pause button for fresh investment. DHFL’s finances, too, suffered as a result of declining investments and rising
demands for meeting its obligations. Essentially, since September last year, DHFL has been playing catch up on
its financial obligations. That too without fresh money to count on and worsening loans portfolio. The latest
disclosure by DHFL has raised doubt on the collection efficiency of NBFCs. This could potentially show down
banks buying loans from NBFCs under priority sector loans. The securitization of loans from NBFC to banks rose
to Rs 1.90 lakh crore in FY19 compared with Rs 0.83 lakh crore in the FY18, according to data compiled by Kotak
Institutional Equities. If banks slow down the securitization portfolio, it will be detrimental to borrowing plans
of NBFCs.

To ease liquidity situation, DHFL and Wadhawan Global Capital have sold stake in many of their subsidiaries. In
February, Wadhawan Global Capital (WGC) had announced that it was selling its entire 70 percent stake in the
affordable housing finance company, Aadhar Housing Finance Ltd (AHFL), to Blackstone. DHFL, which held a 9.15
percent stake in AHFL, had also exited the company. Also, in March, Wadhawan Global Capital had entered into
a definitive agreement with an affiliate of the Warburg Pincus Group to sell its entire 49.04 percent stake in its
education finance subsidiary Avanse Financial Services Ltd.

Here's the timeline on the sequence of events:

Sep 21: DHFL got attention when DSP Mutual Fund sold Rs 300 crore of DHFL papers at 11 percent in the
secondary market, way higher than the traded rates sparking speculation that DHFL could be facing liquidity
issues, which has been strongly denied by the company.

Jan 29: An online investigative portal alleged that DHFL promoters had lent money to ‘shell companies’ allegedly
linked to the promoters who have used this money to buy assets abroad.

March 7: Its share price post the accusation fell further, prompting Care to downgrade the ratings of various
debt instruments of DHFL by a notch.

May 19: CARE Ratings downgraded DHFL's FD program worth Rs 20,000 crore from ‘A’ to ‘BBB-‘. CARE A signifies
“low” credit risk, while CARE BBB- signifies “moderate” credit risk.

May 21: DHFL stopped acceptance and renewal of fixed deposits, also stopped renewals and premature
withdrawals from existing fixed deposits on hold.

May 30: Informed the stock exchanges that it will not be able to furnish the audited standalone and consolidated
financial statements for FY19 within the time stipulated by SEBI norms.

June 4: Delayed interest payment on its bonds and bond repayments worth Rs 960 crore due on June 4.

June 5: ICRA, CRISIL, CARE and Brickwork Ratings (Brickwork) have downgraded credit ratings on commercial
papers of DHFL to 'D' (Default) owing to liquidity concerns.

July 14: Reported a net loss of Rs 2,223 crore for the fourth quarter (Q4) of 2018-19

As of Q4 FY 19, DHFL had almost Rs 1.2 lakh crore of assets under management. DHFL’s financial health is a
matter of concern for even the common man because some of the biggest investors in DHFL are public sector
banks and mutual funds. If DHFL was to struggle in paying back, the loss would be spread across the financial
world. One sector has already been affected: mutual funds, which allow investors to put their money into a
selection of stocks as picked by a fund manager. Indian regulations mean that once payments have missed their
due date, rating agencies have to move immediately to change the rating of the company, in this case, move
DHFL down to “D”. Subsequently, mutual fund companies have to immediately follow suit and markdown all
DHFL debt 75%. That means that, if a mutual fund owns DHFL debt – even if it is not the bonds that the company
was unable to pay in time – it has to be marked down 75%. UTI Mutual Fund, for example, which owns a large
amount of DHFL paper has written down all of that debt completely, meaning it doesn’t expect to get anything
back.