By AJIT KUMAR MISHRA
INDIAN INSTITUTE OF MANAGEMENT INDORE
Shares of non-banking financial companies (NBFCs) such as Religare, IFCI, Mahindra & Mahindra Financial, Shriram Transport Finance, and Reliance Capital rallied aggressively after this release only to cool-off by the end of the day.These stocks went up hoping that the profitability of these NBFCs would improve if they were converted into banks. However, the road to bank conversion is more challenging than it appears. The issue of conversion of NBFCs into banks got a fillip after the Reserve Bank of India gave Kotak Mahindra the licence to convert into a bank last year.
Now, other large profitable NBFCs such as Sundaram Finance, Ashok Leyland Finance and Cholamandalam Finance have this option.Not that the RBI will be in a hurry to give these NBFCs a banking licence. But it is certainly an option for them considering that one of their competitors has opted for it.Importantly, with total assets of more than Rs 2,000 crore in the case of Ashok Leyland Finance and Sundaram Finance, they are even larger than some of the old private sector banks.
Uniformly, however, all the three NBFCs mentioned are not enthusiastic about converting into banks. Ashok Leyland Finance is sure that conversion into a bank may not even prove advantageous; that there is already a bank in the group — IndusInd Bank — may also be a reason for its lack of enthusiasm.However, even the other two look at the conversion option as a question that needs to be answered over the long-term.
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.A non-banking institution which is a company and which has its principal business of receiving deposits under any scheme or arrangement or any other manner, or lending in any manner is also a non-banking financial company (residuary non-banking company).
Differences between the NBFCs and Banks:
- (i) a NBFC cannot accept demand deposits (demand deposits are funds deposited at a depository institution that are payable on demand -- immediately or within a very short period -- like your current or savings accounts.)
- (ii) it is not a part of the payment and settlement system and as such cannot issue cheques to its customers; and
- (iii) deposit insurance facility of DICGC is not available for NBFC depositors unlike in case of banks.
However, to obviate dual regulation, certain category of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI viz. venture capital fund/merchant banking companies/stock broking companies registered with Sebi, insurance company holding a valid certificate of registration issued by IRDA, Nidhi companies as notified under Section 620A of the Companies Act, 1956, chit companies as defined in clause (b) of Section 2 of the Chit Funds Act, 1982 or housing finance companies regulated by National Housing Bank.
The NBFCs that are registered with RBI are:
- (i) equipment leasing company;
- (ii) hire-purchase company;
- (iii) loan company;
- (iv) investment company.
With effect from December 6, 2006 the above NBFCs registered with RBI have been reclassified as
- (i) Asset Finance Company (AFC)
- (ii) Investment Company (IC)
- (iii) Loan Company (LC)
AFC would be defined as any 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, earth moving and material handling equipments, 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.The above type of companies may be further classified into those accepting deposits or those not accepting deposits.
Besides the above class of NBFCs the Residuary Non-Banking Companies are also registered as NBFC with the Bank.
The NBFCs that are registered with RBI are:
- (i) equipment leasing company;
- (ii) hire-purchase company;
- (iii) loan company;
- (iv) investment company.
With effect from December 6, 2006 the above NBFCs registered with RBI have been reclassified as
- (i) Asset Finance Company (AFC)
- (ii) Investment Company (IC)
- (iii) Loan Company (LC)
AFC would be defined as any 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, earth moving and material handling equipments, 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.
The above type of companies may be further classified into those accepting deposits or those not accepting deposits.Besides the above class of NBFCs the Residuary Non-Banking Companies are also registered as NBFC with the Bank.
The main reason for NBFCs being so keen on this change is access to low cost funds. Currently NBFCs cost of funds is around 15%, banks due to their float funds, current and savings account have a cost of funds of around 7%-8%. Also banks are part of the payment and settlement system while NBFCs do not have access to this. However this move would require NBFCs to ensure that the interests of the company and the depositors are not hurt in the bargain. Some NBFCs have hired consultants to give them recommendations on this.
In the long term this move will be good for NBFCs as they will have access to cheaper cost of funds. Also as many NBFCs are not very viable this provides an option to merge with stronger banks. For the banks they would benefit from a larger branch network and the strong brand equity of the leading NBFCs in the retail sector. Banks would also benefit from merging with some strong NBFCs who have high localised business presence and the banks will be able to encash on this and build it up further. From the depositors viewpoint they would suffer as they will have to put their deposits into banks which pay lower interest rates. However the stronger regulations for banks will make them safer for depositors.
The costs of conversion appear primarily to be dissuading factor. Though NBFCs can get low-cost savings and current account deposits, as also tax advantages, when they convert into a bank, they would also have to park a higher proportion in government securities.The statutory liquidity ratio is 25 per cent for banks while it is 15 per cent for NBFCs. Conditions such as mandatory priority sector lending are also viewed as imposing additional costs.
Overall, there is the feeling that the advantage of low-cost deposits is neutralised by the conditionalities of a banking licence. This has certainly made the NBFCs wary of conversion.
NBFCs are also not sure of transforming themselves into a bank, which involves more than lending to customers and managing assets.Skills relating to offering of products such as savings bank account, cash management services, forex management and so on need to be learnt. NBFCs are not certain if such skills can be acquired without making large capital investments.
As it is, the capital needs of their business are quite high. Being one among many in the banking industry compared to being among the top of the NBFC industry does not also sound such a great idea.The NBFCs may view the conversion into a bank as an opportunity to grow. Over the long-term, growth opportunities in the retail financing space may get constrained because of spread compression and single-digit volume growth. Conversion into a bank may be seen as an option to grow in size.That, however, seems a long way off. The prospect for growth in the next couple of years appears encouraging and these NBFCs seem to have the wherewithal to succeed in the market place.The experience of Kotak may also be keenly watched before a decision is taken. Kotak has taken the plunge and if it succeeds then the probability of Sundaram Finance or Cholamandalam exploring the conversion option seriously will increase.
However, of the various issues touched upon, the possibility of NBFCs converting into banks appears high, as these institutions are already regulated by the RBI and follow some of the prudential norms such as capital adequacy, provisioning norms applicable to banks.
In addition, historically RBI has given NBFCs with a good track record and low-NPAs an option to enter the banking sector. Only one NBFC, Kotak Mahindra Finance, availed itself of this option.Today NBFCs are also in a position to bring in the capital requirement, which maybe anywhere between Rs 300 crore and Rs 1,000 crore.
The advantages NBFCs would enjoy once they get converted into banks, is access to lower-cost deposits and improved leverage. Currently only a few NBFCs are allowed to access public deposits. As of March 2009, NBFCs had only Rs 21,548 crore as deposits outstanding against Rs 37,00,000 crore with the scheduled commercial banks.
The prudential norms prescribed by RBI for NBFCs and lack of access to low cost funds have suppressed their return on equity (RoE) as compared to banks. Profitability will go up with access to low-cost deposits and lower capital requirements.
However, the transition to a bank will not be easy for a NBFC.
Access to low-cost deposits would depend on the branch network and currently branch licences are scarce in metro and urban areas. Banks, with their first mover advantage, have already charted out huge branch expansion programmes which would increase the competition for low-cost deposits.
Once they convert to banks, NBFCs will also have to comply with Cash Reserve Ratio and Statutory Liquidity Ratio norms as well as the mandatory priority sector lending norms.
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 broadbased.
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. While this move to open up entry into banking sector is positive for NBFCs it is not negative for the existing banks.
Despite the threat of increased competition, the impact will be low.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.In addition, NBFCs will also forego the advantages of operating in an unregulated turf with concentrated exposures. Banks on the other hand, will get to enter the markets serviced by the .NBFCs
References: www.rbi.org.in
www.thehindubusinessline.com
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