Non-banking financial companies (NBFCs) have been stealing the thunder from banks in the past year despite rising costs and more stringent regulations. The profit growth of 24 major NBFCs in 2011-12 was 24 per cent as compared with 16 per cent for banks. This was on the back of loan books expanding 28 per cent for NBFCs while banks managed only 18 per cent.

The sector also managed to put its assets to much better use with a return on average assets of 2.7 per cent while that of the banking sector was 1.1 per cent. The balance sheets of NBFCs have expanded by 27 per cent compounded annually over the period 2008-09 and 2011-12.

How did NBFCs manage to do so well? Diversification of loan book seems to be one key answer.

Even as a falling industrial cycle led to lower industrial credit offtake, consumer loan demand remained intact. NBFCs played this trend by resorting to mergers and acquisitions with a vengeance, at rather modest valuations.

This consolidation may, in fact, arm a few NBFCs with a meaningful size to compete with banks when the new banking licences are issued. Given the regulatory challenges in the near term and strong rally in NBFC stocks, investors need to be selective while betting on the sector.

Challenges abound

There are quite a few near-term hurdles for the sector. The RBI has been increasingly more wary of rising loans to the NBFC sector.

A new set of draft regulations suggest that the central bank may increase the tier-1 capital requirement of NBFCs to 12 per cent from 10 per cent to reduce credit risk. Standard asset provisioning has been implemented. Loans overdue for 90 days, instead of 180, may be treated as non-performing assets (NPAs).

These rules will further impact the profitability of NBFCs, but reduce asset quality problems.

Gold loan companies already have stricter tier-1 capital requirement and loan-to-value has also been reduced by the regulator.

The removal of priority tag for on-lending to the sector (barring microfinance loans) and new securitisation guidelines (which reduce the attractiveness of the direct assignments) have curtailed funding for NBFCs.

Even for housing finance companies, higher provisioning on loans led to some strain last year. But the bigger concern in the near-term is that NHB has abolished pre-payment charges on housing loans, even as home loan rates have already been cut by competition.

NBFCs are facing stiff competition on the assets side as well. Banks, having burnt their fingers in the corporate loan segment, are looking towards retail loans to maintain loan book growth. This has led to aggressive pricing of retail loans products which NBFCs may not be able to match.

While in the past, banks have shifted their focus back and forth retail books whenever corporate cycle is changed, most banks are currently taking the retail segment very seriously and are setting up retail hubs for origination and quicker processing. Even in the gold loan space, banks (especially old private sector banks) are expanding their portfolios at the higher rate given the favourable regulations.

But with intensifying competition in home loans, auto financing and gold loans space, today, NBFCs are also planning to diversify across the retail value chain. Bajaj Finance and M&M Financial no longer stick to captive finance alone. A few NBFCs are looking to under-banked segments as well for growth opportunities. For instance, M&M Finance and Dewan Housing have subsidiaries focusing on rural housing.

SME loans are another area where NBFCs have thrived with low NPAs. Companies such as Shiram City Union, Bajaj Finance and Religare Finvest have increased their presence in the SME loan segment (including secured loans such as loan against property and gold loans) over the last couple of years.

Consolidation for size

Consolidation in the NBFC space has also enabled the emergence of stronger firms. Companies such as Dewan Housing and Shriram Transport Finance through acquisitions in the last three years, got access to newer clientele which helped them further enhance their share in their respective fields. Acquisitions improved their position in the premium housing market and construction equipment portfolio, respectively. For instance, Dewan Housing Finance’s consolidated loan book went up from less than Rs 9,000 crore as of March 2010 to around Rs 27,000 crore as of March 2012.

On the other hand, a few of the other NBFCs have diversified into new areas through buyouts. For instance, Magma Fincorp recently bought a housing finance company from GE Capital while L&T Finance Holdings did so early this year.

L&T Finance Holdings also acquired auto financing arm of Societe Generale Consumer Finance. With these investments, L&T Finance is now present in most of the areas, including micro finance.

Banking licences

With government once again looking to issue new banking licences, there is rising market interest in NBFCs.

NBFCs have a better shot at a banking licence compared with other corporate groups, given their strong lending book and that they are already regulated by the RBI.

Companies that have strong rural presence and diversified lending book are in a better shape to convert into a bank, given the financial inclusion focus of the RBI. NBFCs have a choice to convert into a bank or transfer a part of their asset book to newly set up a bank. The RBI also allows conversion of rural branches of NBFCs into bank branches. This would also reduce the capex required for setting up branches afresh.

Rural presence will help them to adhere to priority norms. Shriram Transport and M&M Financial fit the bill with a strong rural presence. L&T Finance Holdings and Bajaj Finserv with diversified loan book and holding company structure may also be contenders for the new banking licences. Cumulatively these four entities manage more than Rs 1 lakh crore worth of loans.

Valuation

The current valuation, as represented by price-to-book value, varies from 1.1 times book in the case of Dewan Housing to 8.4 times book for Gruh Finance. Companies with strong profitability, such as Gruh Finance, HDFC, Bajaj Finance and Mahindra Finance, enjoy high valuation in comparison with NBFCs with lower profitability. L&T Finance Holdings is one stock which got re-rated inspite of having low return ratios, given its good chances at getting a banking licence. On the other hand, the stock of Manappuram Finance got de-rated by the market due to governance issues and unabated regulatory challenges.

The NBFC sector may enjoy further improvement in valuations once interest rates decline. Not only will their borrowing costs decline, companies can also access debt markets to prop up their loan book growth.

Currently, around 50 per cent of the total borrowing by the deposit taking NBFCs and 40 per cent by systemically important NBFCs is from bank borrowings. A liquid market for less than AA rated securities will also benefit them significantly.

> Santosh.majeti@thehindu.co.in

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