NBFCs: An Important Pillar of the Financial Ecosystem

Syllabus: GS3/ Economy

Context

• The Reserve Bank of India (RBI) has been encouraging Non-Banking Financial Corporation (NBFCs) to adopt prudent growth strategies and focus on long-term sustainability. 

Non-Banking Financial Corporation (NBFCs)?

• NBFCs are companies registered under the Companies Act, 1956, engaged in financial activities such as;
  • Offering loans and advances,
  • Acquiring shares, stocks, bonds, debentures, or other marketable securities,
  • Operating deposit schemes in various formats.
• It does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property. 
• The functions of the NBFCs are managed by both the Ministry of Corporate Affairs and the Reserve Bank of India.

What is the difference between banks & NBFCs?

• NBFCs lend and make investments and hence their activities are akin to that of banks; however there are a few differences as given below:
  • Demand Deposits: NBFC cannot accept demand deposits;
  • Payment System: NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself;
  • Deposit Insurance: Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not available to depositors of NBFCs, unlike in case of banks.

Importance of NBFCs

• NBFCs are critical to India’s financial ecosystem, particularly in rural and semi-urban areas where banks have limited reach. Their importance lies in;
  • Financial Inclusion: By providing credit to underserved regions.
  • Faster Services: With simplified processes and doorstep delivery.
  • Priority Sector Lending (PSL): Addressing credit needs in agriculture, microfinance, and other unorganized sectors.
  • Economic Growth: Supporting sectors like housing, infrastructure, and small enterprises through financing.

Challenges faced by NBFCs

• Higher Risk Weights: In 2023, RBI increased risk weights for loans to NBFCs, making bank borrowing more expensive.
  • Bank funding to NBFCs dropped from 22% to 15% year-on-year by April 2024.
• Funding Constraints: Smaller NBFCs with lower credit ratings face a fund crunch due to rising borrowing costs and limited financing options.
• Shallow Bond Market: India’s debt market lacks depth and liquidity, limiting access to diversified domestic funding.
• Regulatory Constraints: SEBI’s cap on the issuance of International Securities Identification Number (ISIN) and absence of active market makers hinder bond market growth.
• Cost Pressures: Rising credit costs, projected to increase from 2.6% in 2024 to 4% by 2025, affect NBFCs’ profitability.
• Overseas Borrowing Challenges: While attractive due to reduced hedging costs, overseas funding is still at a nascent stage for many NBFCs.

Way Ahead

• Strengthening Bond Market: Developing a vibrant and liquid bond market will reduce reliance on bank funding and support NBFCs in raising long-term capital.
• Co-Lending Model: Encouraging co-lending arrangements between banks and NBFCs can lower borrowing costs and ensure better credit distribution.
• Focus on Compliance: NBFCs must adhere to RBI’s guidelines on risk mitigation and grievance redressal to build credibility.
• Diversified Funding Sources: Exploring securitization, commercial papers, and equity markets while balancing domestic and overseas funding options.

Concluding remark

• NBFCs remain a cornerstone of India’s financial system, particularly for promoting financial inclusion and economic growth. 
• However, funding challenges, regulatory pressures, and market inefficiencies must be addressed to ensure their sustainability.

Source: TH