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What Is NBFC And What Does It Mean To Indian Economy?

The Non Banking Financial Companies aka NBFCs have emerged as a crucial source of credit for small and medium-sized enterprises (SMEs), micro-enterprises and the informal sector in India as they have filled the gap left by traditional banks, which have been reluctant to lend to these segments due to their perceived risk

What Is NBFC And What Does It Mean To Indian Economy?
POSTED ON March 20, 2023 4:27 PM

Last week, the Reserve Bank of India cancelled the Certificate of Registration (CoR) of 17 Non-Banking Financial Companies (NBFCs). The central bank said in a media statement that “…in the exercise of powers conferred on it under Section 45-IA (6) of the Reserve Bank of India Act, 1934, (it) has therefore cancelled their (NBFCs) CoR". 

The RBI listed ten Non Banking Financial Institutions (NBFI), two companies that were prescribed for unregistered Core Investment Company (CIC) and five NBFCs which were ceased to be a legal entities due to amalgamation/ merger/dissolution/ voluntary strike-off, etc. 

With such news making a buzz around the city, here is a quick explainer of what is NBFCs and how they impact our overall economy.

A Non-Banking Financial Company acronym NBFC is a company registered under the Companies Act of 1956. According to the Reserve Bank of India, NBFC is 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 the immovable property. 

Further, a Residuary Non Banking Company is also a class of NBFCs whose principal business (when a company’s financial assets constitute more than 50 per cent of the total assets and income from financial assets constitute more than 50 per cent of the gross income) is to receive deposits under any scheme or arrangement in one lump sum or in installments.

NBFCs are an integral cornerstone in the Indian economy, particularly in providing credit to the unbanked and underbanked segments of the population.

A Credit Source

NBFCs have emerged as a crucial source of credit for micro, small and medium-sized enterprises (MSMEs) and rural, small-scale, unbanked and informal sectors in India. They have filled the gap left by traditional banks, which have been reluctant to lend to these segments due to their perceived risk. According to a report by the Reserve Bank of India (RBI), the share of NBFCs in the total credit extended to the economy increased from 16.4 per cent in December 2022 to 29.1 per cent in February 2023.

NBFCs have also played a vital role in promoting financial inclusion in India. They have extended credit to segments of the population that have been excluded from the formal banking sector, such as low-income households, small traders and farmers. According to Digital Financial Report published by World Bank in April 2022, the share of Indian adults with an account surged from 53 per cent in 2014 to 80 per cent in 2017. On the back of the increased access, India’s UPI, the country’s real-time payment system which instantly transfers funds between two bank accounts using mobile apps of banks and other third parties (e.g., Google Pay), rose from processing 17.9 million digital transactions per month in 2016 to 1.3 billion per month in 2020. NBFCs too leveraged digital technology to reach out to the underserved segments and provide them with financial services. 

Facilitating Growth

The growth of NBFCs has been facilitated by several factors. One of the main reasons is the regulatory framework that governs them. Unlike banks subject to strict regulations and capital requirements, NBFCs enjoy more regulatory flexibility. They are not required to maintain a minimum level of statutory liquidity ratio (SLR) and cash reserve ratio (CRR), which frees up their capital for lending. This regulatory flexibility has allowed NBFCs to innovate and offer new financial products and services that cater to the specific needs of their customers.

Another factor that has contributed to the growth of NBFCs is the availability of funding. NBFCs rely heavily on wholesale funding, which they obtain through a variety of sources, such as commercial paper, bonds and bank loans. Moreover, the availability of funding has increased in recent years, driven by the growth of the corporate bond market and the increasing participation of foreign investors.

NBFCs have also been instrumental in supporting the growth of the Indian economy. They have provided credit to key sectors such as real estate, infrastructure and MSMEs, which have been critical drivers of economic growth in the last few years. It has also been critical in providing credit to the SME sector, which accounts for a significant share of employment and output in the Indian economy.  

The Economic Survey 2022-23 stated that the total credit extended by NBFCs is picking up momentum, with the aggregate outstanding amount at Rs 31.5 lakh crore as of September 2022 as compared to Rs 28.03 lakh crore in September 2021. NBFCs continued to deploy the most significant quantum of credit from their balance sheets to the industrial sector, followed by retail, services, and agriculture. 

Calculating The Risk

The growth of NBFCs has also posed challenges for the Indian economy. One of the main challenges is the issue of asset quality. NBFCs are exposed to risks such as credit risk, liquidity risk and interest rate risk, which can impact their asset quality. The Infrastructure Leasing and Financial Services (IL&FS) crisis in 2018 highlighted the risks associated with the sector and led to increased scrutiny by regulators.

The sudden deterioration in the financial condition of the IL&FS had led to a domino effect, such as a severe funding drought that led to a liquidity crisis in the NBFC,  investors losing confidence in the stocks of some housing finance companies which then further ended up in a flash crash as Sensex lost over 1000 points in a matter of minutes and the corporate sector that saw the unravelling of several companies such as DHFL and Reliance Anil Ambani groups.

The issue of regulatory oversight is another challenge that needs to be addressed. While NBFCs are subject to regulations, the regulatory framework is not as stringent as that for banks. The RBI has taken several steps to strengthen the regulatory oversight of NBFCs, such as increasing the minimum capital requirements and introducing stricter asset classification norms. However, there is still a need for greater regulation and supervision of the sector to ensure its stability and resilience. 

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