NBFCs: Banking on new areas?

Sanjiv Shankaran

THE LAST couple of years have seen significant developments in the financial sector that have raised competition across-the-board. Non-banking finance companies (NBFCs) have perhaps felt the pressure most.

Consequently, top-rung NBFCs are changing tack, and initiating moves to become financial supermarkets. They are seeking to provide as many services as possible, and their fate will be decided by how successful they are.

Supermarkets in the making

Leading NBFCs have gradually extended their product portfolio to include asset management companies (AMCs), housing finance firms and are now readying to enter insurance.

This trend seems different from that of the early 1990s when most NBFCs rushed to launch a merchant banking subsidiary. But this could not be sustained with the poor business in the primary market and the industrial slowdown. Most such merchant banking subsidiaries have been wound up.

But the NBFCs' latest moves to increase the lines of business may be of a more permanent nature despite the growing competition from the resource-rich banks and financial institutions in core and emerging areas. The last few years saw the traditional boundaries between different categories of financial intermediaries disappear. Thus, the NBFCs had to contend with heavy competition even in areas that were their preserve.

Working capital loans were traditionally the preserve of banks, and term lending that of the financial institutions. Now these sets of institutions move in and out each other's areas freely. And both have also moved into retail financing, the traditional preserve of the NBFCs.

The NBFC pillars...

Traditionally, the NBFCs have dominated the market for retail finance. Their forte has been credit delivery to areas not covered by banks and FIs. Thus, NBFCs are perhaps better acquainted and more sensitive to the latent needs of the retail customer. With such new areas as insurance being opened up, top-rung NBFCs are presented with an opportunity to grow. But these areas fall outside the NBFCs' traditional sphere of competence and raise questions about the sensibility of their move.

A financial intermediary's business is dominated by the attendant risk. Given the banks' ability to access low-cost funds, they are likely to service the relatively top-end clients, leaving others with the riskier customers.

The issue assumes greater significance considering that the average NBFC will be pushed down to relatively untouched or untapped areas where credit information may be scarce. But this perception does not hold water when one considers that the top NBFCs have one of the lowest levels of non-performing assets (NPAs) in the financial sector.

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Implications of new forays

Some areas where the NBFCs are showing interest are insurance -- recently opened up for private participation -- and housing finance. Sundaram Finance has started an associate company that disburses housing loans. This is a good example of the recent trend to diversify because traditionally housing finance has been the domain of HDFC and LIC Housing Finance.

The long duration of housing loans and the necessity to access large quantities of funds has reduced the other finance companies to relatively marginal players. Recently, one such firm, Home Trust Finance, that was not backed by institutional money, merged with HDFC. Now, Sundaram Finance has opted to enter this area.

The positive outcome of such a lateral move into other areas should be a diversification of the company's revenue stream. That is, reduce the risks by not putting all the eggs in one basket. Kotak Mahindra, for instance, benefits from a stream of `other income'. Consequently, its revenues are likely to be among the least volatile because it derives a significant income from its thriving group companies engaged in merchant banking, asset management, etc.

Not all NBFCs are entering new areas of asset-based finance. Ashok Leyland Finance, for instance, plans to launch a finance portal that would be used to sell the products of the other financial intermediaries. Also it plans to use its skill in collection to derive a pure service income.

Critical parameters

In the emerging scene, the market for retail customers is where all action is. Each kind of intermediary brings to the market a unique advantage. Banks, of course, come with the advantage of being able to access resources at the lowest cost.

Financial institutions -- mainly ICICI -- access funds at a slightly higher cost, but unlike banks they are not burdened by higher operating costs. NBFCs have the biggest disadvantage -- highest cost of funds.

The market for financial loans, however, is not determined solely by the cost of finance. Service -- which may be loosely described as the convenience offered to the customer in terms of speed, and product features -- plays a critical role in volume growth. In such a case, the profitability of operations will hinge on the ability to keep costs low as also the adaptability of the players.

NBFCs' strengths

NBFCs that succeed are likely to do so by making the most of their ability to contain risk, adapt to changes and tap demand in markets that are likely to be avoided by the bigger players.

Risk containment is critical in the financial sector. For a category supposed to cater to the relatively riskier areas, top-rung NBFCs have proved the most adept at containing risks. The industrial slowdown of the late 1990s saw the NPAs increasing sharply in the portfolio of banks and financial institutions. Top-rung NBFCs which contained risk better were helped by two factors: Lower proportion of loans to corporates and a more effective recovery mechanism.

The large size of a corporate loan means that a single default has a bigger impact. NBFCs that lent mainly to the commercial vehicle segment were perhaps aided by the low proportion of loan to each customer vis-a-vis the total disbursement. A default would, therefore, have limited impact.

The small size of the loans coupled with a better collection mechanism resulted in effective risk containment by the NBFCs. This was further aided by the greater flexibility of the NBFC structure. The flexibility also enables the NBFCs to act with despatch when they sense an opportunity.

The other area where the NBFCs have an edge is the long experience in accessing fixed deposits which gives them access to a database. Lack of reliable data has often tripped big names in the corporate world.

The churning within

While the breakdown of the traditional barriers has led to every player trying to move into retail finance, there has been a major churning within the NBFC industry over the last few years. Triggered by a combination of quickly changing regulatory guidelines and the industrial slowdown, this has eliminated many weaker players.

One of the most significant regulatory changes for the NBFCs in the mid-to-late-1990s was the level of unsecured public deposits that could be mobilised. After the liberalising deposit mobilisation rules in 1996, the Reserve Bank of India suddenly tightened the norms in 1998.

This move, which came in the backdrop of industrial slowdown, adversely impacted the weaker NBFCs. Most stronger ones curtailed asset creation concurrently in the absence of safe investments. Following that phase, just a handful of NBFCs, with a balance-sheet size exceeding Rs. 1,000 crores, is left.

Recent developments pertaining to expanding business opportunities have come from the handful of the big NBFCs that survived the turbulent late-1990s.

A long haul ahead

The top-rung NBFCs have equipped themselves for the fast-changing environment where all intermediaries are competing for retail finance. An outcome of the increased competition is that profit margins of the NBFCs will decline. Moreover, with a huge resources committed to such areas as insurance, which may take years to attain profitability, profit levels are unlikely to be as high as they were.

Last year, the share price of quite a few NBFCs rose sharply only to fall rapidly. Share prices are unlikely to witness any significant, sustained rise this year in the light of the low premium the stock market attaches to financial services, in general, and especially with the prospect of a decline in returns on investment in the near term.

Investors with exposures in such top-rung NBFCs as Sundaram Finance, Tata Finance or Kotak Mahindra may stay invested as there are possibilities of moderate gains in the medium term. However, fresh exposures may be avoided.

Size, the double-edged sword

WHILE the evolutionary process of the NBFCs has made them nimble, their main handicap is the small size of their balance-sheet. An NBFC's access to resources is limited vis-a-vis other financial intermediaries. Their small size and, thereby, the limited cushion available to them in times of difficulties pose a risk to their very survival. The smaller size also restricts their opportunities to grow.

But size is simply not only about the balance-sheet and access to resources. As ICICI's acquisition of two NBFCs in the past has shown, size is also about the distribution reach of a financial intermediary.

Of the various categories of intermediaries, financial institutions have the smallest reach. Their structure is not suitable for large-scale retail operations. However, by expanding their range of financial operations through commercial banks and also through understanding with other entities, the NBFCs, ICICI in particular, have tried to improve their reach.

Commercial banks, especially the nationalised ones, have a major advantage in terms of reach. The presence of a large number of branches spread across the country gives them a platform to carry on a variety of businesses. However, this advantage is perhaps offset by the culture of the nationalised banks that prevent them from exploiting their advantages.

The NBFCs have the reach, though it may largely be region-specific. But the presence of their reach in the retail market, coupled with the powerful brand name that NBFCs such as Sundaram Finance and Tata Finance have, make for a good platform to launch new products. Size, when looked at in terms of the reach, is something that the top-rung NBFCs have.

Size, looked at from the standpoint of resources, is where NBFCs may face a problem. Already the regulations governing seed capital for the NBFCs wanting to enter insurance may have upset the calculations of even some of the stronger firms. Size, or the lack of it, presents a big threat for the NBFCs.

It is the lack of size that appears to have acted as a catalyst in the recent development where four smaller NBFCs -- Apple Finance, Apple Credit, Srei International and Alpic Finance -- have announced that they will explore the option of a merger. The need to attain size may trigger more such developments in the future.