Nbfcs To Banks Bumpy Ride Ahead Finance Essay
Friday 26th February, 2010: The finance minister Pranab Mukherjee announced that the government is looking at issuing higher number of banking licenses in the coming year and that NBFCs that meet the regulatory requirements and criteria as laid down certainly stand a chance to get them. Following this announcement, the positive impact on NBFCs was certainly evident in the immediate upswing of their stock prices.
Thursday 18th November,2010: The only listed Microfinance Company’s shares fell 20% after earnings warning due to the crackdown by Andhra Pradesh on business practices by lenders to the poor threatens to squeeze revenue, profits and asset quality at SKS Microfinance.
Wednesday 24th November, 2010: The CEO of LIC Housing Finance, one of the biggest NBFC, was arrested under bribery charges. This NBFC was touted to get a sure-shot Banking license by the virtue of its size (satisfying the capital asset criterion) and the operational feasibility. Now, a black cloud haunts its conversion into Bank.
There are a few BIG questions to be answered now: How difficult is this "NBFCs to Banks" ride going to be? Is there a need for additional credit auditing of NBFCs before granting them the "Bank" status? Do the RBI criteria for granting Banking license have to be stricter?
A peep into the history presents a bleak picture. The last bank license in the domestic sector was given to YES Bank way back in 2003. Kotak Mahindra is the only example of a NBFC successfully converted to a bank even when there are 310 ‘deposit taking’ NBFCs registered with RBI as of April 30, 2010.
RBI has laid down a set of criteria which needs to be fulfilled; such as minimum capital requirement, foreign ownership percentage, allowing Business houses to set up a bank from NBFC, extent of Promoter shareholding. These are just one set of criteria laid down by RBI. With more and more financial scams coming into the limelight, e.g. the LIC housing Finance scan, in spite of the strong regulatory system in place, there is a need of some operational parameters to be looked upon to sustain in the industry once the banking license is granted.
The minimum capital requirement for giving licenses of new private banks as per 1993 guidelines was ` 100 Cr which was further raised to ` 200 Cr in 2001 guidelines. The new RBI proposal is to increase the limit further beyond ` 300 Cr up to ` 1000 Cr. This will ensure more financial security and invite only serious parties with sufficient financial backing. The proposal is not a major concern as many big NBFCs like Religare Enterprises, Reliance Capital, IFCI, Mahindra & Mahindra Financial services etc. are already in a position to bring in the stated required capital, which maybe anywhere between ` 300 Cr and ` 1,000 Cr.
The issue of promoter shareholding has been raised by RBI to make sure that only promoters who have no interest in exercising control over the banks would seek banking license. The Japanese experience with Keiretsu, the Korean experience with Chaebols and the Indian experience prior to nationalization1 have exemplified the fact that whenever few parties controlled the power over the banks, they made huge fortunes by utilizing the available funds for themselves or their favored groups. As a result, large and medium-scale industries and big and established business houses prospered while the vital sectors of economy like small-scale industry, agriculture and exports choked due to the paucity of funds. To address this concern, RBI has proposed that the promoters can bring in a minimum of 40 percent of capital with either a lock in clause of 5 years or without one and then dilute their holding stake over a period of time and that the threshold for other significant shareholders can be kept around 10 percent. RBI also stated that business houses might get an opportunity to promote banks and also help revitalize Rural Regional Banks (RRBs) in under banked areas. 2
However the RBI proposal has not garnered support of National Bank of Agriculture and Rural Development (NABARD). "RRBs are playing a major role in rural finance. They have been recently recapitalized and are functioning well in their respective domains. To sustain this movement, retaining them in their current form will be desirable", says U.C. Sarangi (NABARD Chairman). Research Analysts believe that "Once RRBs are acquired and converted into commercial banks; they will come under the conservative regulatory structure of the Reserve Bank. There is also a chance that their primary operational objective will be affected." 3
This condition might pose a challenge to the NBFCs promoted by business houses like Mahindra & Mahindra, Reliance, Aditya Birla, Tatas etc. However, the bright side for business houses is the support they have received from certain industry experts. For example, Confederation of Indian Industries(CII) has proposed that the industrial and business houses that have predominant presence and experience in the financial sector could be allowed to set up banks subject to the due diligence process. This would help in recreating the success demonstrated by the business houses in Telecom, Power, Automobiles, Defense, Asset Management Companies and NBFCs in the financial sector.
In contrast to this, Industrial and business houses that have prior experience in financial sector have been the favorites for getting the new banking licenses. Mahesh Thakkar, director general of Finance Industry Development Council (FIDC) pointed out "NBFCs who are asset financing with good track record are better placed to run a bank than a corporate house. Secondly, NBFCs are competent because unlike corporate, they are familiar with RBI regulations". This certainly raised the hopes of NBFCs as was evident from the sudden upsurge in the shares of IFCI and IDBI just after the release of discussion paper by RBI.
Foreign shareholding in the new banks is another point of contention. The advantages of foreign investments are huge – Domestic banks can utilize foreign capital for the promotion and foreign technical expertise for raising the service levels. However, keeping in mind the objective of creating strong domestic banking entities, RBI has proposed to cap aggregate non-resident investment including FDI, NRI and FII at a suitable level below 50 percent and locked at that level for the initial 10 years 1, even though foreign investment up to 74 percent is allowed in banking sector. The aim is to bring in more diversification in banking sector by allowing public sector banks, private sector banks and foreign owned banks to coexist in the banking space.
Religare Enterprise Ltd.
LIC Housing Finance
Aditya Birla Financial Services
(Between 300 to 1000 Cr)
No promoter holding
Industrial/ Business House
Above are few NBFCs with the criteria laid down by RBI. It can be seen that many of the criteria are not easily satisfied.
All said and done, there are many advantages that NBFCs will enjoy once they get converted into banks, as is evident from Kotak Mahindra’s example. The biggest advantage is that the NBFCs will have access to lower-cost deposits and improved leverage. Currently only 310 NBFCs are allowed to access public deposits and thus Banks continue to be largest source of finance for NBFCs. This explains why the loans provided by the NBFCs are at higher rates than those offered by the banks. This also exerts pressure on their margins, thus leading to lesser profitability. So, conversion to banks is certainly a lucrative option for once converted into a bank, these institutions will definitely enjoy more profits.
But these low-cost deposits would depend on the branch network and currently branch licenses are scarce in metro and urban areas. Also the banks have already set up large expansion plans posing a tough competition for low-cost deposits (CASA) in urban and semi-urban areas.
Currently, many NBFCs focus on lucrative niches and earn exceptional spreads. For example, infrastructure NBFCs like Srei Infrastructure lend money between 10 per cent and 14 per cent to the infrastructure. Once converted into Banks, this focus on niche sectors won’t be possible and lending money will have to be broad-based i.e. across the sectors and at competitive market rates. Thus, the government wants to ensure that after conversion into Banks, the institutions should be able to sustain themselves in the already competitive banking sector.
As far as penetration of the NBFCs is concerned, many new branches will have to be opened up, especially in the tier II and tier III towns. Also, many existing branches may not be operational in the sense that they would face tough competition from the existing banks and this might lead to their close-down. Thus, this conversion in to banks will necessitate re-jig of the branch networks of NBFCs. In this case, some NBFCs like Religare Enterprises Limited will have an operational advantage because of their existing widespread network in tier II and tier III cities.
But as has been rightly said that "Good things come at a price", NBFCs will also have to get used to working in the highly regulated Banking sector as against enjoying the advantages of operating in an unregulated turf and that too in specific sectors. This includes compliance with Cash Reserve Ratio and Statutory Liquidity Ratio norms as well as the mandatory priority sector lending norms. Thus, even after the bumpy ride of conversion from NBFC to bank, sustenance is going to be a challenge.
The big question still stays - Will the government be successful in achieving the twin goals of efficiency and financial inclusion through the conversion of NBFCs to banks? The finance minister is convinced that there is a huge need for low-cost financing at the semi-urban and rural areas in India and issuing more licenses is the way to go. Allowing NBFCs to operate in this area would help achieve financial inclusion at a faster pace, given their large network and understanding of local needs. And allowing industrial houses, some of them already owners of large NBFCs, would bring these large and important institutions into the ambit of bank regulations. Thus, converting financially sound NBFCs, which concentrate on Tier 2 and Tier 3 cities, into banks will help the cause of financial inclusion.
In short, it’s important that NBFCs are given a smoother route to get converted into Banks; though the necessary background checks should be done thoroughly. Following points should be considered:
The initial promoter holding can be more than 40% thus ensuring the minimum capital requirements are met; later over a period of 5 years, these banks can dilute the promoter holding through the way public offerings.
Association with the Business houses does obviously help. So, a partnership with a business house can be looked; for example, in Kotak Mahindra bank, Mahindra & Mahindra business house holds a stake, thus providing the necessary support.
NBFCs like IFCI and Religare Enterprise, which satisfy most of the criteria must be granted the banking license first and only after their initial success, the business houses can be allowed to foray in the banking sector.
For the special purpose of total financial inclusion, the government should specifically lay down a criterion of minimum number of centers in Tier II and Tier III cities.
Thus, even though the ride of conversion of NBFCs to Banks is going to be bumpy, their conversion will ensure that they get an opportunity to play the glittering role in the banking sector specifically and in Indian economy the broad sense.
RBI Discussion paper (11th August, 2010): rbidocs.rbi.org.in/rdocs/content/PDFs/FIDIS110810.pdf