When Infrastructure Development and Finance Co (IDFC) was granted universal banking licence in 2014 from among 26 applicants, it was the envy of those who missed out on the coveted prize. Three and a half years later, both investors and the managements that were not lucky enough, are smiling.
A surge in liquidity, regulatory arbitrage, and the crippled state of banks converged to make the non-banking finance company (NBFC) business model a success with equity investors latching on to any business that would reflect the Indian financial services growth without its baggage of bad loans. Life has come a full circle with premium attached to banks shrinking while NBFCs gaining traction.
IDFC Bank which came into being in 2015 has lost 15.91 per cent since, while its parent IDFC gained 16.33 per cent. In the same period, Bajaj Finance, which failed to get a bank licence, rose 265.48 per cent and Warburg Pincus-backed Capital First has doubled. “NBFCs are currently trading at the same price to book and price to earnings valuations as well-run private sector banks,” said Rashesh Shah, chairman, Edelweiss group, which lost out on the banking licence. “They were earlier undervalued and there has been a catch-up now.”
IDFC Bank is planning to merge with non-banking finance companies of the Shriram Group, including Shriram City Union Finance which lends to consumers as that is the ideal way for quick expansion for IDFC Bank. The two are reworking a merger plan after announcing one in July.
Bajaj Finance, which was trading at 2.23 times the book in March 2014, has moved up to 7.91 now; India Infoline is trading at 4.61 and PNB Housing Finance at 4.49. This is in contrast to SBI’s 1.12 price to book, and Punjab National Bank’s 0.75. The Kumar Mangalam Birla -led Aditya Birla Group decided to end its decades-old strategy of owning financial services in a conglomerate and spin it off into a separate company which has a market capitalisation of Rs 39,649.39 crore. NBFCs are quasi banks which lend funds, but do not take deposits in general. They lend to retail borrowers without strong credit history and mid-level corporates which are not usually favoured by big banks.
“There is huge opportunity in the NBFC space given that the credit-to-GDP ratio is low,” said Ajay Srinivasan, chief executive at Aditya Birla Capital, which also missed out on a universal bank licence. “From a macro perspective or industry perspective, there is headroom to grow.” Nearly half of the population did not have access to formal economy. After the launch of Jan Dhan accounts, the number of people having access to formal economy has gone up significantly, said SK Ghosh, chief economic advisor, SBI.
The tide turns
Historically, NBFCs were a neglected lot in the financial services industry because of past scandals like the collapse of CRB Financial in 1997 that led to investors and depositors losing money.
Once the regulations tightened, they found it difficult to access funds. Only the top rated with specialisation like Shriram Transport that exploited securitisation and the priority sector tag for its truck lending, managed to grow. There are some advantages vis-à-vis banks with exemptions from statutory liquidity ratio, the amount of deposits banks have to keep in government bonds, and cash reserve ratio, the amount of deposits to be kept with the Reserve Bank of India without interest.
NBFCs were dependent on banks with 70 per cent of their total funds coming from banks. After the global financial crisis caught them on the wrong foot, they began to tap the market for funds. The surge in liquidity at mutual funds and insurers’ investments in bonds have made funding a better proposition.
“NBFCs are by definition far more cyclical part of the market than banks, because they do not have retail deposit base,” said Sunil Garg, head of international equity research, at JPMorgan. “They are wholesale funded, which means in time of cheap funding they are the biggest beneficiaries and typically not all of them are high margin and higher credit losses. So, amplitude in the upcycle is higher and the amplitude in downcycle is that much deeper.”
Today, most large NBFCs like Bajaj Finance have more than 50 per cent of funds as market borrowings with the remaining from banks. This has enabled them to get funds cheaper. Recently, Bajaj Finance borrowed Rs 12,000 crore through non-convertible debentures, commercial papers and public deposits over the last one year, at 50 basis points lower rate on an average compared with 8.60 per cent that banks charge for lending it.
The emergence of an aspiring middle class led to a surge in demand for smartphones, washing machines, motor cycles and highend television sets which banks did not fund. Strengthening of data analytics and information from credit bureaus helped NBFCs take a quick call on lending to self-employed and those working in informal sector.
“Large NBFCs have developed a business model that allows them the flexibility to grow their retail book and deliver credit to retail customers at competitive and reasonable cost,” said R Venkataraman, co-founder, IIFL Holdings. “For us, we are retail focused, we have distribution reach and defined credit models to understand risks better. We have invested a lot in technology that brings down the operating cost.”
Apart from credit bureau score, NBFCs are using credit underwriting processes such as profiling a customer based on mobile usage, social activities and information available on the social media. They are investing in faster turnaround time of loan applications.
The balance sheet of the NBFC sector expanded by 14.5 per cent during 2016-17. Loans and advances increased by 16.4 per cent and investments increased by 11.9 per cent in March 2017. Despite the growth they managed their asset quality better than banks. Gross bad loans of the industry is down to 4.4 per cent in March 2017, from 4.9 per cent in September 2016 when banks in general witnessed a rise. Net NPAs as a percentage of total advances also declined from 2.7 per cent to 2.3 per cent.
Can the party last?
These may be the best times for NBFCs with subsidiaries outsmarting the parent companies. PNB Housing is valued at Rs 25,069.30 crore, compared with its parent Punjab National Bank at Rs 29,152.92 crore. HDB Financial Services, a unit of HDFC Bank, may head to stock exchanges with an equity value of as much as Rs 50,000 crore. While specific lines of business like mortgage lending may be lucrative during a benign interest rate regime, when interest rate cycle turns, it squeezes them and many a times puts their very survival under question. That is a primary reason many want to convert into a bank which gives them the cushion of retail deposits which stays irrespective of market conditions.
“The reason NBFCs wanted to convert into a bank is because there are built-in limits to growth,” says TT Ram Mohan, professor, Indian Institute of Management, Ahmedabad.
“Operating as an NBFC, there are limited segments that one can cater to. Those segments also go through cycles. At the moment it is doing well, but in the past many of them have burnt their fingers.” Interest rate cycle in India may not have turned yet, but the lure of universal bank is fading thanks to developments in technology and the ability of institutions to reach customers without physical infrastructure. The funding may be abundant, regulations light, and getting customers easy, but the risk have not gone away.
“You will see a deeper cyclicality till the time you are in an environment where the rate cycle is favorable and you do not have adverse economic cycle, these institutions will trade at a premium,” says JPMorgan’s Garg.
“But, they are inherently more volatile globally and this is not an India issue.”