NBFC: Non-Banking Financial Corporations

Once upon a time, in a busy city, a gentleman named Shyam was very determined for his business idea. One day, he went to his nearest bank to ask for a loan for his business. But the bank rejected his application due to strict rules and risk aversion. Shyam felt disappointed as he lacked any other solution.

One day he learned about non-banking financial corporations (NBFCs), which offered services akin to a bank with more flexibility and more innovative financial solutions.

With his discovery, Shyam started learning more about it. In this blog, we will take you through Shyam's research and help you understand more about NBFCs and the functions of NBFCs.

What is the Meaning of NBFC?

A non-banking financial corporation is a company established under the Companies Act, 2013. Any company that carries out the business of a financial institution is an NBFC, according to Section 45-1 (c) of the RBI Act.

NBFCs are primarily engaged in loans and advances, acquisition of stocks, equities, debt, etc., issued by the government or any other local authority.

The Reserve Bank of India regulates non-banking financial companies in India, and they play a crucial role in shaping the country's economy as they fill the financial gap between individuals and businesses.

Different Types of Non-Banking Financial Companies

NBFCs can be of various types, depending on their specialisation. They are:

• Asset Finance Company
• Investment Company
• Loan Company
• Core Investment Company
• Micro Finance Company
• Mortgage Guarantee Company
• Housing Finance Company
• Infrastructure Finance Company

Overview of Non-Banking Financial Companies and Their Services

Non-banking financial companies provide various financial services to cater to the diverse needs of every individual and business. We can categorise them into the following services:

Asset Financing

NBFCs provide loans to businesses to purchase assets like machinery, equipment or vehicles. Typically, borrowers secure this kind of loan against the loan amount.

Infrastructure Financing

Non-banking financial companies also finance infrastructure like constructing roads, ports, power plants and airports. This kind of loan is typically for a longer duration and has a higher level of risk.

Personal Finance

These financial institutions provide loans to individuals in the form of personal loans, credit cards etc. Borrowers generally use personal loans for multiple purposes, such as weddings, education, medical expenses, home renovations, etc., and they are typically unsecured.

Commercial Finance

NBFCs also provide loans to businesses as capital loans for various needs such as inventory financing, invoice discounting or trade finance.

House Finance

Non-banking financial companies provide loans for the purchase, construction or renovation of homes. Lenders provide these loans secured against the financed property.

Microfinance

Lenders typically provide these loans to small businesses or low-income individuals. This loan could be for starting a new business or buying inventories.

Difference Between a Non- Banking Financial Company and Bank

Banks and non-banking financial corporations provide lending services to customers. However, they have some differences, such as:

• A Bank is a government-authorised intermediary that provides banking services to customers. On the other hand, an NBFC is a company that offers banking services without a bank licence.
• Non-banking financial companies are incorporated under the Companies Act of 1956, whereas banks are incorporated under the Banking Regulation Act of 1949.
• NBFCs cannot accept deposits not repayable on demand, while banks can accept demand deposits.
• Banks avail transaction services to customers like overdraft facilities, issuing traveller's cheques, and transferring funds, while NBFCs do not offer these services.
• As per RBI rules, banks must maintain reserve ratios such as CRR or SLR, while NBFCs do not have to keep such ratios.
• Non-banking financial companies allow foreign investments of up to 100%, whereas private sector banks permit only 74%.
• Banks play a crucial role in the payment and settlement cycle. On the other hand, NBFC is not a part of the system.
• Banks provide deposit insurance through Deposit Insurance and Credit Guarantee Corporation (DICGC) which NBFCs do not offer.

Role of NBFCs in the Growth of the Indian Economy

India is seeing a hike in small businesses and entrepreneurship, but everyone is not eligible for bank loans, and that's why non-banking financial companies are crucial for the economy's growth. Tailored products are available for every sector because different individuals and businesses have different needs. Non-banking financial companies also offer digital disbursement of loans, which has led to increased consumption. It provides lending services to sectors where traditional banks do not lend.

Non-banking financial companies understand and study their customers and their credit scores well, which gives them clear information about the customer and an edge over their competitors in the banking sector. The distribution range of these companies is also extensive compared to the banks which function in that area.

Thanks to the rapid rise in NBFCs, the Indian economy has received many benefits such as:

• They create an increase in employment opportunities
• They cater to semi-urban and rural areas and first-time buyers or users.
• They provide financial assistance to weaker sections of the society.
• They help in wealth creation
• They supplement bank credit to the rural part of the economy.

Challenges Faced by Non-Banking Finance Companies

No Refinance Option

Banks provide multiple refinancing options in India. But, NBFCs do not provide refinance options because they depend on the banks or the capital markets to raise funds, which is a major challenge for them.

Challenges in Obtaining NBFC Licence

Obtaining a licence for an NBFC can be a complicated process involving lengthy documentation and approval from the Reserve Bank of India (RBI). The RBI regulates non-banking financial companies and oversees the registration processes they need to follow.

Lack of a Statutory Recovery Tool

A statutory recovery is a kind of written warning from the lender. If they fail to repay the dues on time, an intimation is sent to the borrower. However, the lack of a statutory recovery tool with non-banking financial institutions is a massive challenge in payment collections.

Disparate Tax Treatment

There is an inequality in the tax system for banks and non-banking financial institutions, such as tax deduction at source, dual taxation on lease/hire purchase etc.

Lack of Defaulter Database

Credit risk is one of the significant challenges faced by these companies, and one of the main reasons for this is the lack of a defaulters' database, which is essential for lenders in the credit assessment process.

Several Representative Bodies

These financial institutions are still in the development phase in India, and there are various representative bodies for them. Having a single representative could be much more helpful for non-banking financial companies and makes them more systematic.

Removing the Priority Sector Status To Bank Lending To NBFCs

This is a big challenge for non-banking financial companies. Restoring the collaboration model between banks and NBFCs will ensure that the underserved sections of society have access to credit flow. This will enable non-banking financial companies to create wealth in the country's rural areas.

Minimum Mandatory Credit Rating

NBFCs (the deposit-taking ones) must have investment-based credit, which will help them accept deposits without any legal issues. However, if the rating of the NBFC falls to a minimum level, it will not be able to obtain deposits under any circumstances. Moreover, the NBFC must pass on the same information about their position to the Reserve Bank of India (RBI).

Operational Challenges

NBFCs are developing in India and have a limited size and scale. Hence, they do not have the same level of operational efficiency as banks, which may result in increased operating costs, which in turn impact their profitability and make it more challenging to compete with banks.

NBFC Compliances in India

After incorporation, non-banking financial companies still need to comply with various regulations as NBFC compliance requirements differ from one company to another. It is challenging for these companies to consider all the aspects and ensure compliance.

Facts About Non-Banking Financial Companies

Lower Fees

These companies charge lower fees than banks, making borrowing more affordable to customers. This feature also adds up to their profitability as it may provide more loans to different sections of society.

Less Time Consuming

NBFCs require less paperwork than banks. The loan process is also less time-consuming because of their efficient procedures, and you can expect quicker loan approvals and disbursements.

Flexible Regulations

Typically, NBFCs have less stringent rules than banks. They have more flexibility in innovating and customising their products based on the financial needs of their customers.

Provide Loans to both Public and Private Sectors

Both public and private sectors can take loans from NBFCs. This allows borrowers more flexibility and enables many individuals and businesses to get financial help.

Easy Registration than Banks

The process of NBFC registration may be hard, but it is more straightforward than obtaining a bank license. This allows more organisations to penetrate the financial sector and compete with other players and banks, thereby providing more options to borrowers.

Focuses on Small Borrowers

Banks typically focus on fulfilling the financial needs of large businesses, while NBFCs concentrate more on small businesses. Individuals with limited or no credit history can also get a loan through these institutions.

Credit Assessment

Banks focus more on an individual's credit score, which may lead to borrowers getting rejected in some cases due to poor credit history. This is not the case with NBFCs, as they promote loans even for individuals with low or no credit scores.

Penalty Clause

NBFCs do not have any penalty clause, which allows you to repay the loans in a much more accessible manner than banks. It also allows you to have a convenient option in managing your repayment schedules without worrying about hefty penalties.

Statutory Charges

NBFCs do not include statutory charges such as stamp duty and other costs, which allows you to assess the loan value more carefully.

Scope of Non-Banking Financial Companies

In today's world, digital lending has become one of India's most important financial services. There is a high demand for smaller amounts of loans with an easy and digital process. This demand from individuals and small and medium-sized businesses has boosted the role of NBFCs.

NBFCs have the potential to provide financial services to many small and medium-sized businesses much faster than traditional banks. They also offer flexible payment plans, low-cost EMIs, and attractive interest rates.

There is also a hike in artificial intelligence (AI) and blockchain-based financial services, which may enhance the product portfolio of NBFCs. Moreover, rural areas and villages are getting internet access more easily, thereby strengthening the role NBFCs in India.

The scope of NBFCs in the future will see many changes, such as:

Technology Driven Innovation

Today, NBFCs focus more on digital lending and disbursement of loans online, and as technology continues to advance, it enhances the customer experience and attracts more people towards it. The NBFC industry may adopt artificial intelligence (AI) and machine learning (ML) to optimise their process, providing you with personalised financial solutions.

Collaboration with FinTech

NBFCs can expect future growth in collaboration with FinTech companies as Fintechs have a variety of products and new customer segments. NBFCs can unlock new potentials and cater to more customers with the aid of Fintechs.

Regulatory Changes

As mentioned above, NBFCs in India face regulatory challenges, and RBI is likely to continue updating the regulations for NBFCs to encourage an easy way to get loans for individuals and businesses.

Better Risk Management

In the finance industry, there is always a risk of default present. Hence, NBFCs are likely to improve their risk management techniques which will allow them to reduce credit risk. Using data, credit scoring models and other sources will enable these companies to implement better risk management.

Credit Needs

As NBFCs focus on providing customised financial solutions to individuals and businesses, they will continue to expand their size in the country. Moreover, they offer financial services to underserved segments such as micro, small and medium enterprises (MSME), low-income individuals and rural areas. With the help of technology, these companies can potentially reach new locations and offer their products based on customers' needs.

Contribution to Economic Growth

NBFCs will continue to fund infrastructure projects and support the economic growth of the country. With the development of the Indian economy, these companies will continue to fund infrastructure projects and promote sectors including transportation, renewable energy, digital infrastructure and affordable housing.

Better Customer Experience

With improved technology, NBFCs will continue offering an easy loan process, quick approval, and better transparency to help build customer trust and secure easy financing options.

How does an NBFC Raise Money?

An NBFC cannot accept deposits from current or savings accounts for fundraising, so they have alternatives to raise money, such as:

Low- Interest Long Term Loans

The RBI allows NBFCs to take long-term loans from banks. These loans can be availed as either secured or unsecured loans, offering non-banking financial companies easy access to funds.

Foreign Direct Investment (FDI)

After the liberalisation era in 1991, the amount of FDI in India has seen a boost, and an NBFC can receive up to 100% foreign investment for their working capital needs.

Issuing Commercial Papers for Small Term Loans

An NBFC can also raise funds by issuing commercial papers. They act as short-term unsecured promissory notes issued by financial companies, and the tenure can range from 3-12 months. An NBFC having a net worth of Rs. 100 Crores is eligible to issue commercial papers.

Issue Bonds

Another option to raise money easily is through bonds. The rating of the NBFC helps in deciding the interest rates of the bond they offer. Some NBFCs also issue bonds for retail investors.

Securitisation of Loans

An NBFC also depends upon the securitisation of loans as a valuable tool for managing liquidity, raising funds and correcting ALM mismatches.

The Bottom Line

Non-banking finance companies have emerged as vital players in the growth of the Indian economy. Their offerings fulfil the gap in the banking system as they are a proven funding source for individuals and small and medium-sized businesses, which are the pillars for boosting the economy.

They create healthy competition with banks as they provide loans even to the rural population or people with low credit scores, making the financial system more dynamic and efficient. With the development of technology, the role of NBFCs will be more critical in the future and will provide more innovative products.

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