The road ahead for NBFCs

The Reserve Bank of India (RBI) recently issued a slew of regulatory changes to tighten rules and bring about a level playing field between non-banking finance companies (NBFCs) and banks. In a nutshell, NBFCs will now have to maintain higher capital, recognise bad loans earlier and increase their provision on bad loans.

But despite the more stringent norms, this space continues to offer good opportunities for investors. For one, the new regulations have ended the uncertainty over how the RBI will address the iniquity arising from the regulatory advantage that NBFCs have been enjoying over banks. Two, over the long run, a better regulatory framework to mitigate risk, improve disclosures and strengthen governance standards will also reduce the perceived risks of NBFCs.

Lastly, and more importantly, while most of the changes have been in line with earlier recommendations, the additional time given by the RBI to comply with these norms comes as a relief for the sector. NBFCs can implement these norms in a phased manner up to March 2018.

Hence the impact on the profitability of NBFCs will be lower than what was expected earlier.

However, some companies, given the nature of their customer segment, may find it more challenging to comply with these norms.

So, which NBFC stock should you bet on?

Amongst significant changes is the tightening of the non-performing asset (NPA) recognition norms. Currently, loans where borrowers have defaulted in their payments for 180 days or more are classified as NPAs. Now, according to the new regulation, this has been brought down to 90 days, on par with banks.

However, since the RBI has allowed NBFCs to implement these norms in a phased manner — 150 days by the end of March 2016, 120 days by the end of March 2017 and 90 days by the end of March 2018 — the impact on earnings gets staggered over time and will therefore be lower than earlier expected. A quick changeover to the new norms would have affected the profitability of NBFCs immediately.

The RBI has also increased the provision requirement on standard assets (ones that are servicing the loans on time) from 0.25 per cent of total outstanding to 0.4 per cent.

Impact : This will impact NBFCs in two ways. One, it will lead to an increase in NPAs as companies will need to re-classify their assets based on the 90-day norm. This will mean additional provisions for bad loans. Two, NBFCs will not be able to recognise income on assets which turn bad following the new norms. This will impact margins for these companies as well.

Companies will report an increase in NPAs in the beginning, as they migrate to the new norms.

However, it is difficult to assess the actual impact, as it will depend on each company’s business model, strategy to implement these norms, as well as the provision cover they wish to maintain. This will, in turn, determine the impact on profitability. Moreover, the RBI has also allowed a one-time adjustment of the repayment schedule of all existing loans, which would not amount to restructuring. This will help in reducing NPAs. Given all these, it will be difficult to quantify the increase in NPAs for each company.

However, some players are better placed than others, since they were already following stringent asset quality norms and higher provision cover. Bajaj Finance, for instance, has already moved 95 per cent of its loan portfolio to a 90-day cut-off. Sundaram Finance already follows a 120-day norm for asset classification and M&M Finance follows a 150-day norm.

While Shriram City Union Finance still follows a 180-day norm, it has a high provision cover which should provide cushion to earnings.

Hence, most players, given the three-year time frame, will be able to manage the increase in provisions on account of bad loans by reducing their provision cover if need be, without impacting their profitability. As far as the standard provisioning goes, the impact will be gradual and minimal. Some companies such as Bajaj Finance, Sundaram Finance and Muthoot Finance already have 0.4 per cent provision on standard assets.

Some companies, however, are likely to face structural challenges, given the nature of their business.

Companies such as M&M Finance and Shriram Transport Finance, for instance, cater to customers who have irregular cash flows. It may be difficult for these players to tweak their business models. M&M Finance is focussed on the rural and semi-urban areas while most of Shriram Transport Finance’s customers are small truck operators who do not have regular incomes and cash flows.

While these regulations do not apply to housing finance companies (HFCs) such as HDFC and LIC Housing Finance, the governing body for these companies, the National Housing Bank (NHB), is most likely to bring norms on par with the RBI’s regulations. Both HDFC and LIC Housing Finance already follow a 90-day norm and provide 0.4 per cent on standard assets. Hence, they will not be impacted.

The RBI has also increased the capital to risk weighted assets (CRAR) for NBFCs. Now these companies will have to maintain a Tier I CRAR of 10 per cent as against 7.5 per cent earlier. For gold loan companies, the Tier I has been maintained at 12 per cent, but the RBI has indicated that it may review it later to bring in uniformity in norms.

Impact : RBI regulations on capital adequacy are to ensure that companies’ own capital is pegged to the risk profile of their borrowers. An increase in the capital adequacy ratio means that NBFCs will have to set aside higher capital to grow their assets by the same proportion. But most NBFCs already have Tier I well above the required 10 per cent and hence there will not be any significant impact on their growth prospects.

Gold loan companies, on the other hand, could gain if the RBI lowers the capital requirement from the current 12 per cent to 10 per cent on par with other NBFCs.

The RBI has also lowered the amount of deposits an NBFC can raise. From four times its ‘net owned funds’, NBFCs can now raise only deposits worth 1.5 times their ‘net owned funds’.

Impact : Currently, NBFCs have deposits well within the stipulated limits and hence will not be impacted by this move in the near term. Most NBFCs have public deposits that are less than one time that of their net worth.

However, in the long run, it does cap a potential source of funds for NBFCs, which will have to depend on bank borrowings that could be more expensive and hence impact cost of funds and margins.

If NHB lowers the limit for HFCs too, HDFC, which currently has deposits of two times its net worth, will have to unwind some of its deposits to meet the norm.

Aside from the above mentioned prudential norms, NBFCs will have to increase their disclosures and also lay down a ‘fit-and-proper’ policy for appointment of directors. NBFCs will have to disclose data on ratings, penalties and movement of NPAs, among other things, from March 2015. Over the long run, better disclosure and strong governance standards will reduce the perceived risks of NBFCs.

Sundaram Finance is a key player in the commercial vehicles space. Despite the slowdown, the company has been able to mitigate risk by focussing on less risky segments, lending primarily to the new vehicles segment. Sundaram Finance has adopted the NPA norms ahead of the regulatory requirement, bringing it down to 120 days in 2012-13 itself. The company’s GNPA stood at 2.25 per cent as of September 2014.

Shriram City Union Finance has created a niche in the small enterprises segment. Given the nature of the target customer, adapting to the new NPA norms may pose some challenges. However, the company has been able to assess the risk in this segment in the past. About 90 per cent of the customers are chit fund customers, who have long track records. It also has a high provision cover of about 80 per cent, which should give enough headroom to migrate to the new NPA norms.

Bajaj Finance is a diversified NBFC, with the business spanning consumer finance, SMEs and commercial lending. Traction in the consumer finance space has helped it deliver strong loan growth. The company’s GNPA stood at 1.41 per cent as of September 2014, with 95 per cent of the portfolio already conforming to the 90-day norm.

L&T Finance Holdings has businesses spanning corporate, retail and infrastructure lending. Diversity in lending has helped it offset the sluggishness in sectors such as infrastructure. The company has provided ₹160 crore of provisions in addition to regulatory requirements. The company follows a 180-day NPA norm at the company level, and 90 days for housing portfolio.

HDFC continues to be on a strong footing in the housing finance space. While the recent new norms do not apply to HFCs, NHB is likely to implement these at a later date. HDFC will have to unwind some of its deposits, as they are two times its net worth currently. However, HDFC’s diversified funding mix across bank borrowings, deposits and bonds has helped it maintain margins in the past.