Tech Adoption Can Improve Credit Delivery, Borrower Convenience For NBFCs.

High portfolio growth and rising share of non-traditional products leading to increased regulatory oversight

Karthik Srinivasan Senior Vice President and Group Head, Financial Sector Ratings, ICRA

The Assocham-ICRA joint report titled "NBFCs - Regulators as Enablers to Financial Lending Companies" was unveiled today at the Assocham 10th Annual Summit of Non-Banking Finance Companies and Infrastructure Financing held in Mumbai today.

Commentary from Assocham

"Non-banking financial companies (NBFCs) and infrastructure financing have emerged as growth catalysts in India’s dynamic financial landscape, spurring economic empowerment for small businesses and infrastructure finance. As the country aspires to be ‘Viksit Bharat’, the role of the NBFC sector will be more critical because it is playing an important part and becoming an integral member of the financial ecosystem, contributing to the stability, innovation, reach and profitability of the financial system. Thus, the challenges hindering the growth of NBFCs need a reassessment," says Deepak Sood, Secretary General, Assocham in his foreword "The Government’s focus on providing relief and enhanced credit flow to the industry, particularly to small businesses, has resulted in a more positive macroeconomic outlook across industries including financial services. This focus is also supplementing national policies that target poverty reduction, women empowerment, assistance to vulnerable groups, and community development. These efforts are being supported and financed by NBFCs, microfinance institutions and infrastructure financing."

Commentary from ICRA

Commenting on the same, Karthik Srinivasan Senior Vice President and Group Head, Financial Sector Ratings, ICRA Limited said, " The NBFCs registered a robust expansion in the last two financial years, boosting their position in the overall financial ecosystem. However, their improved systemic importance and higher interconnectedness, especially with the banking sector, have led to increased regulatory oversight and actions in the recent past."

"Sizeable pent-up credit demand, after the pandemic, resulted in a sharp credit expansion, especially in the retail segments. During 2010-2020, NBFCs largely focussed on asset-backed lending and steadily built their franchises. Constant improvement in credit bureau data and better understanding of borrower cash flows helped them fine-tune their underwriting processes. This was further boosted by the digitalisation of their credit process, which started gathering pace from 2018-2019, and access to alternate borrower data that helped them widen their target borrower base and expand their credit offerings. As a result, personal and consumption loans increased sharply, especially after the pandemic, but this segment has emerged as another monitorable, attracting regulatory tightening. Losses in this segment would be higher than the conventional asset-backed lending of NBFCs. Thus, various internal control measures and early warning signals are key." Shri Srinivasan emphasised.

Some Key Highlights from the report:

High portfolio growth and rising share of non-traditional products leading to increased regulatory oversight

• NBFCs have steadily improved their market position by expanding at a healthy compound annual growth rate (CAGR) of ~15% during FY2017-FY20242 , while the loan book of banks recorded a CAGR of ~11% during this period. Overall, NBFC credit has tripled in the last eight years. Excluding NBFC-Infra, the sector’s AUM increased at a CAGR of ~17% during the above-mentioned period.
• Considerable growth in the AUM also warranted adequate regulatory evolution in view of the new products and services and the increased interlinkages between NBFCs and various financial sector entities. The sector also witnessed the emergence of new players operating in the non-traditional segments and the advent of technology, which revolutionised credit and product delivery and, led to a steep expansion in the borrower base. 
• Retail loans increased at a CAGR of 18% during FY2017-FY2024, driving the overall sectoral growth and leading to an increase in retail loan share in the overall NBFC credit. Retail loan growth was driven by unsecured loans (microfinance, personal and consumption loans and unsecured small and medium enterprise [SME] loans), which expanded at a higher pace
• The share of unsecured retail loans is estimated to have increased to 14% of the overall NBFC credit (23%, excluding NBFC-Infra) in March 2024, up from 5% in March 2016. Unsecured loans expanded at a CAGR of about 32% during FY2017-FY2024, but on a lower base; this is double the growth rate of retail secured loans (vehicle, home loans (HLs), loan against property, gold, etc) during the same period.
• Microfinance loans expanded at a CAGR of 35% during FY2017-FY2024. As a credit product, microfinance focusses on underserved borrowers, facilitating financial inclusion. The regulatory framework for this segment has also evolved proportionately in the past decade.
• Personal and consumption loans, within the unsecured loans segment, expanded at a sharp pace in the last 2-3 years, rising at a CAGR of about 42% during FY2022-FY2024.
• This was driven by two factors – cross-selling and digital lending. The cross-sell strategy is being adopted to strengthen the hold on the franchise by improving borrower engagement. This involves offering credit and other financial services to meet a borrower’s various lifestyle and business requirements. For example, a borrower with an HL may require a personal loan or a consumer durable loan, etc, and may also need other financial services like insurance, investment, etc. NBFCs were increasingly offering pre-approved loans to meet such requirements of their credit-tested borrowers.
• For product segments in which they have a limited track record or for diversifying their borrower base, NBFCs are relying on digital lending via co-lending/partnership arrangements. These arrangements are synergistic as fintechs/smaller NBFCs are able to improve their operating leverage, while larger partners are able to diversify their borrower and product segments.
• Regulators have kept pace with the evolving nature of these loans and are considering the target borrower segment – new-to-credit and borrowers with modest credit profiles. The increase in the risk weights for consumption credit in November 2023 shall raise the capital requirements of NBFCs and would require them to recalibrate their growth plans. The Reserve Bank of India’s (RBI) digital lending guidelines on increased disclosures and the focus on borrower protection and transparency are also targeted at driving responsible growth in this segment.
• Technology adoption can improve credit delivery as well as borrower convenience. Taking this into consideration, the RBI has set up a regulatory sandbox to pilot programmes in a controlled environment to keep pace with the evolving technological landscape. The Reserve Bank Innovation Hub (RBIH) was set up to foster innovation in the fintech space.

Enhanced systemic importance and interconnectedness to financial ecosystem

• NBFCs are the net borrowers of funds in the financial sector ecosystem. This, along with their high interconnectedness, could pose systemic challenges if their asset and/or liability-side risks are not addressed commensurately. NBFCs’ funding profile is characterised by long-term borrowings in the form of debentures and term loans, which account for the bulk of their total debt. The share of short-term borrowings, like commercial paper, has remained range bound in the last 3-4 years. 
• Banks are the largest lenders to the sector. Bank credit to NBFCs rose at a CAGR of 17% during FY2020-FY2024 vis-à-vis the overall bank credit growth of 13% during this period. As a result, bank credit to NBFCs increased to 9.5% by March 2024 from 8.0% in March 2019.
• Banks also invest in various market debt instruments, especially long-term capital market debt, along with participating in securitisation and loan sell-down transactions. 
• As per ICRA’s estimates, banks account for 2/3rd of the overall NBFC (excluding NBFC-Infra) liabilities. For NBFC-Infra entities, banking exposure (direct credit and via investments in various debt instruments) is about 30%.
• The RBI has taken note of the interlinkages with the banking sector and the increased dependence of NBFCs on banks in the recent past. Thus, the risk weights for bank credit to the sector was increased by 25 percentage points across the rating categories (AAA to A) in November 2023. The scale-based regulations and prompt corrective action (PCA) framework were also aimed at strengthening the regulatory structure in view of the increased systemic importance of the sector. The RBI has also harmonised some of the NBFC regulations vis-à-vis banks, in line with its approach towards regulations as per the nature of the risk rather than the nature of the entity. 

Strengthened risk profiles fortify resilience against impact of regulatory actions

• The asset quality has been on an improving trend over the last two fiscals. The unwinding of the provisions created during the pandemic and better risk profiles supported the headline asset quality numbers in FY2023 and FY2024. ICRA expects asset quality headwinds to crop up in the near term due to the seasoning impact of the sharp credit growth in the recent past, the increase in the share of riskier asset segments and concerns regarding borrower-level overleveraging.
• Base estimates suggest an increase of 30 basis points (bps) in the NBFC-Others category. As this segment would be most impacted if the growth slows and the funding tightens, the jump could be marginally higher than the above levels in a stressed case scenario. The asset quality of HFCs and NBFC-Infra is expected to improve as recoveries would continue and fresh slippages are expected to be limited. 
• Profitability shall remain healthy in the current fiscal, notwithstanding the funding cost pressure and the impact of the moderation in the growth trends, especially for NBFC-Others. The return on managed assets (RoMA) shall largely remain stable for HFCs and NBFC-Infra.
• The capital profile is the key mitigating against the risks of weakening loan quality and moderating earnings, especially for NBFC-Others. NBFC-Infra, however, faces the risk of credit concentration, considering the high loan ticket sizes in the infrastructure space. The capital profile of all the key NBFC segments has improved over the past five years as internal generation remained good in relation to capital consumption, especially during the pandemic-hit years when growth had slowed down. Further, some entities raised capital to mitigate the risks visible on account of the pandemic. Currently, the capital profile of the sector is quite adequate in relation to the risks.

NBFCs channel credit flow to traditionally un­derserved segments

• The NBFC space is quite concentrated, with large entities accounting for the lion’s share. These players have longer vintage or are a part of a corporate group, which provides them with access to commensurate funding for meeting their growth requirements
• Large NBFCs3 are generally focussed on the traditional asset segments, namely vehicle loans, HLs and small business loans, which together account for 2/3rd of the overall NBFC AUM (excluding infra loans). Unsecured loans (including microfinance) constituted about ~20% of the AUM of these entities vis-à-vis ~43% for mid and small (M&S) NBFCs.
• M&S NBFCs are expected to expand at a faster pace with a CAGR of 26-28% during FY2024-FY2025 vis-à-vis the large NBFC (excluding NBFC-Infra) CAGR of 18-20%. Large NBFCs would continue to constitute about 80% of the total NBFC AUM (excluding NBFC-Infra) in March 2025.
• Large NBFCs compete with banks in some traditional lending businesses. These NBFCs, especially in the vehicle finance and mortgage businesses, have carved out a space for themselves. However, increasing competition from banks, especially in the retail segments, has affected their market position.
• NBFC-Infra however continued to increase their share in infrastructure loans as banks slowed down.
• NBFCs have carved out a space for themselves through their differentiated and customised credit offerings and by targeting borrower segments, which have generally been overlooked or are underserved by banks. Be it microfinance, used vehicle financing, affordable housing finance, small business loans or consumer finance, NBFCs have been on the forefront and have been early movers, thereby creating a unique franchise. Further, with their feet-on-street approach, NBFCs have been a key contributor to the financial inclusion drive in the country.
• As they have created a franchise and managed their credit quality performance in challenging operating environments in the recent past, namely demonetisation, NBFC crisis and the pandemic, NBFCs are in a relatively better position to address the evolving credit requirements, powered by digitalisation, access to better borrower-level data, and innovative underwriting models. NBFCs are moving towards a borrower-focussed approach of credit delivery instead of the earlier product-focussed approach. This is also evidenced by the increase in unsecured credit observed in the recent past with NBFCs extending additional loans to its existing borrowers to meet their various credit requirements.
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Used vehicle, affordable housing and business loans are focus segments

• Vehicle loans and HLs constitute the bulk of the NBFC AUM (excluding NBFC-Infra), accounting for about 45-48%. Higher interest rates and competitive pressure from banks in the new vehicle loans segment and for credit to the salaried/prime borrowers in the HL space have resulted in the entities focussing on used vehicles and lower-ticket HLs in the affordable housing segment.
• Within the vehicle assets space, commercial equipment (CV)/construction equipment (CE) and passenger vehicle (PV) together accounted for the bulk of the NBFC vehicle AUM at ~80% as of March 2024. CV/CE AUM is projected to expand by 12-14% in FY2025, while PV is estimated to grow by 21-23%. Overall NBFC vehicle loans are projected to grow by 15-17% in FY2025.
• Banks have essentially taken up share in the new vehicle financing segment in the recent past, while NBFCs continue to dominate in the used vehicle segment. Financial penetration in used asset financing, which is a large market, is low. The share of used assets in the overall NBFC vehicle book is, therefore, projected to expand to 40% by March 2025 from about 35% in March 2020. Used vehicle loans are expected to rise at a CAGR of 19-21% during FY2024-FY2025 while new vehicle assets AUM growth is projected at 15-17%.
• The increasing share of used vehicles augurs well for financial inclusion as it facilitates credit to the last mile borrowers, who are usually not catered by the banks.
• HLs are highly interest rate sensitive products, leading to more competition. HFCs, over a period, have steadily increased their share of loans to the self-employed category of borrowers, whereas banks have a limited presence. Further, they are largely focussing on smaller-ticket HLs, i.e. affordable housing loans.
• Affordable housing loans expanded at a CAGR of ~20% during FY2018-FY2024 vis-à-vis the traditional housing loans growth of ~8% during this period. Affordable housing loans crossed the Rs. 1-trillion mark in December 2023.
• NBFCs have emerged as the key lenders in the micro, small and medium enterprise (MSME) space. The classification of retail and wholesale trade as MSME from June 2021 further expanded the NBFC base in this segment. This segment has seen a sharp revival post the pandemic with the waning of the asset quality related concerns, which had impacted growth till FY2020. The NBFC credit to MSME segment expanded at a CAGR of 22% during FY2022-FY2024.

Overall, the report highlights the significant growth of NBFCs in India and their contribution to financial inclusion. However, NBFCs face challenges related to funding costs and regulations. Adapting to the regulatory environment and focusing on responsible growth will be crucial for their future success.