A company registered under the Companies Act of 1956, which performs the primary function of accepting deposits (except demand deposits) along with acquisition of shares, stocks, debentures and securities from the government, apart from providing lending services is called a Non Banking Financial Company. Although NBFCs play similar roles like banks, they don't form a part of the payment and settlement system and hence cannot issue cheques. NBFCs also don't accept demand deposits and depositors can't avail the deposit insurance facility of DICGC in case of NBFCs. According to the section 45 IA of the RBI Act, 1934, NBFCs need to be registered with the RBI for carrying out operations in India. However, they can also be registered with other regulatory authorities. For example, stock broking companies could be registered with SEBI; insurance firms with IRDA, Nidhi companies can be registered under the Company's Act and housing companies under the National Housing Bank.
NBFCs have been ushered into limelight recently following Finance Minister Pranab Mukerjee's hint on the conversion of NBFCs into the banks. The day saw a sharp rise in the price of NBFC stocks such as Mahindra and Mahindra Financial services, Religare Enterprises, IFCI, Shriram Transport Finance and Reliance Capital in anticipation of their conversion into banks. However, considering the reluctance and restrictions that RBI has observed in giving banking licences, the feasibility and smoothness of conversion still remains a question mark.
In continuation to the Government's proposal of encouraging penetration in the banking industry, RBI has released a set of norms to ensure stability and growth in the sector. It had observed that non-banking finance companies (NBFCs) who wished to convert into banks should have a minimum net worth of Rs. 200 crores. However, RBI has decided to provide some relief to NBFCs if their net owned funds fall below the below the stipulated Rs 200 crores. They will not face any immediate deregistration and instead will discontinue their NBFC business and try to restore the net owned fund limit within a time frame. The ones desiring conversion should have a minimum capital adequacy of 12 per cent and its net non-performing assets should not be more than five per cent. These NBFCs would have to increase the net worth to Rs. 300 crores within three years from the date of conversion. Also, NBFCs promoted by large industrial houses or own/controlled by public authorities, including local, State and Central governments have been barred from converting themselves into a bank. Apart from all this, the NBFC must be a triple A rated or its equivalent in the year before they approach RBI for converting themselves into banks. The guidelines on issues such as priority sector lending; promoters' contributions, NRI and foreign equity participation applicable to banks would also govern NBFCs converting themselves into banks. In the past, the only NBFC to have got a banking licence includes Kotak Mahindra Bank. This proves the fact that RBI would consider the possibility of issuing license to NBFCs provided they have a good track record and low NPAs.
NBFCs are looking forward to obtain banking licences and commence operations as they want to capitalise the advantage that would come in the form of accessibility to lower-cost deposits and improved leverage. Currently only a few NBFCs are allowed to access public deposits. As of March 2009, NBFCs had only Rs 21,548 crores as deposits outstanding against Rs 37,00,000 crores with the scheduled commercial banks. The prudential norms prescribed by RBI for NBFCs and lack of access to low cost funds have suppressed their return on equity (RoE) as compared to commercial banks. Profitability will go up once they get to access low-cost deposits and lower capital requirements. Currently NBFCs cost of funds is around 15%, banks due to their float funds, current and savings account have a cost of funds of around 7%-8%. Also banks are part of the payment and settlement system while NBFCs do not have access to this. However this move would require NBFCs to ensure that the interests of the company and the depositors are not hurt in the bargain. Some NBFCs have hired consultants to give them recommendations on this. NBFCs which have concentrated loan-books allowing them to focus on lucrative niche segments and earn exceptional spreads may no longer be possible. Lending would indeed become more broad based. The net interest margins in the banking sector in India today is by far amongst the highest in the world and in boom time economy like this, the NPA is always under control making the conversion even more favourable. So these are perfect situation for banking industry to flourish. By and large India still is an under-banked country and we have seen the past track record of the banking industry which has been fantastic. So these NBFCs believe that by getting a banking licence, they will be able to trade at significantly higher PE multiples because presently the NBFCs are trading in that typical 10-15 times PE multiple whereas private sector banks are trailing at 30-40% higher PE multiples. This will make investors take advantage of this difference in the valuation ratios which is justifiable as a lot of the NBFCs are performing very well. If they are able to get banking licences, then it will be very positive for a sentiment in the stock and then truly these stocks can be held for a period of 2-3 years when they will actually move from NBFCs to banks and the banking profits will start rolling in. The rise of these stocks on the proposal announcement of the conversion on the day of the budget bears testimony to this. Experts also believe that the expertise that NBFCs have achieved in lending and recovering loans in the rural and semi urban areas strengthens their case for the conversion process. Also as many NBFCs are not very viable this provides an option to merge with stronger banks. For the banks they would benefit from a larger branch network and the strong brand equity of the leading NBFCs in the retail sector. Banks would also benefit from merging with some strong NBFCs who have high localised business presence and the banks will be able to encash on this and build it up further. From the depositors viewpoint they would suffer as they will have to put their deposits into banks which pay lower interest rates. However the stronger regulations for banks will make them safer for depositors. In addition, the conversion may entail a reduction in the branch networks of NBFCs and not all their existing branches may continue to be operational. While this move to open up entry into banking sector is positive for NBFCs it is not negative for the existing banks. In 2008-09, NBFCs accounted for 9 per cent of the total financial system assets, while commercial banks held a dominant 70 per cent of the assets which is way above the total assets of NBFCs. This signifies that NBFCs are currently not of a scale to threaten existing banks. In addition, NBFCs will also forego the advantages of operating in an unregulated turf with concentrated exposures. Banks on the other hand, will get to enter the markets serviced by NBFCs.
However, there are a few analysts who are against the conversion process. There are two kinds of non-banking companies, one deposit taking and the other non-deposit taking, which include the NBFCs. NBFC and bank models are entirely different as NBFC model provides financial access to excluded categories without the same RBI regulations as applicable to the banks. In addition, NBFCs' continued dependence on wholesale deposits and short-term borrowings to sustain even their existing business operations would raise financial stability issues. Thus converting these non-deposit systematically important NBFCs into banks is an extremely challenging task because their model is fundamentally different that a bank's model.
Due to differences in the maturity of assets and liabilities of NBFCs and banks, there exists the possibility of the bank's funds being utilized to meet the NBFC liabilities and also of indulgence in regulatory arbitrage. Moreover, the experience of NBFCs in the financial sector might not be enough to be a competitive advantage and help them strengthen their banks. Hence, it is better if NBFCs float separate banking entities rather than they themselves converting into banks. This is due to two reasons: firstly there would be significant profitability pressure given the Cash Reserve Ratio and Statutory Liquidity Ratio requirement; and secondly the ability to run successful operations given the experience in running only niche businesses is questionable in itself.
The CII is not in favour of automatic conversion of the NBFCs into banks due to various reasons. Due emphasis is on the fact that in order to fund India's growth story and to drive the inclusion agenda, the minimum capital for these new bank-turned-NBFCs should be at least Rs 1,000 crore. Several NBFCs have more than Rs 1000 crore capital today so that is not really a very solid criterion. This lower capital would lead to relatively smaller banks which could lead to higher risk taking and more volatile earnings. This could result in lack of focus to financial inclusion and defeat the purpose of this licensing decision of RBI.
Hence it is better if banks are standalone entities. The experience of NBFCs in running niche businesses might be probably helpful for the regulators to evaluate whether the NBFC should qualify or it has in place the requisite risk management measures within the firm or not, but it doesn't imply that the conversion of an NBFC into bank is easy. If the NBFC applies for a bank license it will have to do a lot of work around it in the initial days. However if a standalone bank is created instead of converting a NBFC into one it'll bring about broader participation. RBI postulates that bring knowledge, capital and governance separately into the organisation. Hence we can bring about this level of sophistication by bringing in retail distribution already built into the market place. The banks should preferably be standalone wherein the liquidity is sufficiently maintained and more entities are brought forward to partner with them.
Like every coin having two sides, NBFCs getting license to operate as banks has its own advantages and disadvantages. The Central bank here has to play a very important role in factoring into account the dual goals of achieving banking penetration and maintaining stability in the system in the long run. In case of giving licences to the NBFCs, it has to be cautious and must ensure that the whole economy has sustainable growth.
