India’s ‘Quiet Revolution’: How NBFCs are reshaping the nation’s financial landscape

NBFCs, pivotal to India’s financial landscape, have evolved, focusing on niche areas and strategic risk management, writes Sachinn.

Non-Banking Financial Companies (NBFCs) have been integral to India’s financial landscape for decades. Their role has evolved significantly, transforming from a mere alternative financing option to specialised entities that support the nation’s economy in ways banks cannot.

Over time, NBFCs have grown substantially, complementing banks by focusing on niche areas where they have deeper penetration. They cater to specific regions and businesses that banks may not prioritise, such as two-wheeler financing, housing loans, tractor financing, and micro-lending. While these areas are part of a bank’s portfolio, they are not the primary focus.

NBFCs have effectively filled this gap by addressing localised funding requirements. Their specialised presence has made them valuable partners to banks in reaching underserved areas.

In this article, Sachinn Joshi, CFO, L&T Finance Ltd.,(LTF) reflects on how this sector has evolved to ensure financial access across a huge and diverse country like India.

Risk management and regulatory evolution
NBFCs’ risk management practices have evolved significantly in response to recent challenges. The IL&FS crisis was a systemic shock to the financial system, prompting a re-evaluation of risk management strategies. The lessons learned from this event better prepared the sector for the COVID-19 pandemic.

The Reserve Bank of India (RBI) introduced new regulations and compliance requirements, particularly in asset-liability management (ALM). Even before these changes, many NBFCs had proactively implemented long-term strategies, with liability management as a core component.

A two-tier structure was established at LTF, recognising the importance of liquidity. A Markets Committee, comprising of key stakeholders like the Head of Treasury, CFO, Chief Risk Officer, and Chief Economist, meets regularly to monitor the external environment and provide early warning signals. This Committee reports to the ALCO (Asset Liability Committee), which typically meets monthly but increases its frequency during challenging times.

The ALM strategy prioritised maintaining positive balances across all buckets, even before regulatory requirements mandated it. While this approach incurred negative carry costs, it proved invaluable during crisis by ensuring ample liquidity.

Strategic borrowing amidst rate hikes
Starting in May 2022, the RBI increased repo rates by a total of 250 basis points over nearly a year. Despite this, the weighted average borrowing cost for LTF only increased by 30 basis points over two years. This was achieved through several strategies:

1. Strategic borrowing: When interest rates were low, long-term borrowing was
prioritised, even though short-term options were available and cheaper. This
approach reduced reliance on commercial paper from 12-15% to 5% of total
borrowings and focused on NCDs and bank term loans, insulating LTF from subsequent rate hikes.

2. Leveraging Priority Sector Lending (PSL): By strategically borrowing from banks for PSL assets like tractors and microloans, LTF benefited from lower borrowing costs,
with 20% of total borrowings as on March 31, 2024 coming from PSL sources at rates
over 1% lower than normal term loans.

3. Diversification through External Commercial Borrowings (ECB): Actively seeking
funding from international institutions like International Finance Corporation (IFC),
Asian Development Bank (ADB), and Japan International Corporation Agency (JICA),
LTF secured social loans at competitive rates focusing on financing in less developed
states.

By combining these strategies, LTF maintained a competitive weighted average cost of borrowing despite significant rate increases.

Global influences and domestic stability
The Federal Reserve actions have a global impact including the Indian Financial Sector.

While the Fed had previously indicated potential rate cuts, recent economic data has led to mixed signals, creating uncertainty about future rate movements.

This global uncertainty impacts the interest rate scenario, also influenced by domestic inflation and crude oil prices. Despite these external factors, the Indian economy is performing well, and inflation remains under control.

Initially, the financial sector expected RBI to cut rates in August / September, but this timeline seems to have been pushed back. There is even a possibility that rates might not change at all during the calendar year. However, the RBI’s effective liquidity management has kept short-term rates low, benefiting the NBFC industry.

Capital utilisation and growth potential
Over-leveraged companies often face challenges with capital utilisation, but LTF has avoided this issue by strategically shifting its focus towards building a retail asset book and simultaneously reducing its wholesale book. This has freed up significant capital, resulting in a current debt-to-equity ratio of 3.3-3.4. With the ability to increase this ratio to 5:1, LTF has ample room for growth before needing any incremental capital.

To ensure optimal capital usage, retail assets are categorised into high, medium, and low-risk categories. Each category occupies a specific percentage of the balance sheet, with a target of 55-60% secured assets and the remainder unsecured. This diversified approach would help achieve a targeted return on assets (ROA) of 2.8% to 3% at a manageable credit cost in the near term.

By balancing different asset classes and risk profiles, LTF would be able to maintain a healthy portfolio while maximising returns. Regular evaluation and adjustment of this mix would ensure alignment with overall strategic objectives.

NBFCs continue to be indispensable pillars of the Indian banking sector, demonstrating resilience, strategic foresight, and adaptability in an ever-evolving financial landscape.