What are NBFCs & How it works?

NBFCs supplement banks in meeting the funding needs of the economy by providing the necessary infrastructure to allocate surplus resources to individuals and companies with the deficit.

Like banks, NBFCs are also key financial intermediaries that offer different financial services to customers but do not have a banking license. They are incorporated under the companies act 2013 or companies act 1956.

The major difference between Banks and NBFCs

1. NBFCs do not form part of the payment and settlement system and cannot issue cheques drawn on itself. Similarly, NBFCs are also not allowed to issue a demand draft to their customers.
2. Unlike banks, NBFC is not allowed to accept demand deposits (Savings account and Current Account). 
3. Certain kinds of NBFCs can accept Time Deposit (Fixed deposit), However, the deposit insurance facility by DICGC (which offers insurance to the depositors)  is unavailable in the case of NBFC. Another difference between NBFC  and bank fixed deposit is NBFC fixed deposits are generally rated by the rating agencies in the country. On the other hand, the fixed deposit of banks is not rated by the rating agencies.
4. Banks must maintain reserve ratios like CRR or SLR. As opposed to NBFC, which does not require to maintain reserve ratios. So, NBFCs can lend 100% of their deposits and thus have a lean cost structure.

Before understanding the financial parameters of NBFCs, Let’s understand the types of NBFCs. There is various kind of NBFCs, it can be an asset financing company or a specialized NBFCs providing housing loans. Within these broad classifications, there are further differentiations based on the borrower segment of the NBFCs target. So, first of all, you need to understand the categories in order to examine the business model.

Asset-liability mismatch (ALM) is considered to be a complete and dynamical framework for measurement, managing, and monitoring the market risk of the Banks. 

The Primary source of funds for the bank's deposits and most deposits have a short- to medium-term maturities, thus need to be paid back to the investor in 3-5 years. In comparison, the banks usually provide loans for a longer period to borrowers. Out of them, the home loans and Infrastructure projects loans are of the longest maturity. So when a bank provides the long term loans from much shorter maturity funds, the situation is called an asset-liability mismatch.

ALM creates Risk, and it has to be managed by a process named Asset Liability Management.

Sources of fund for bank

Bank loans: - 

Bankers are the major source of financers for NBFC’s. NBFC’s can use banks as a lender of the resort where NBFC’s can borrow money from banks for various working capital requirements.

Further banks may formulate suitable loan policy with the approval of their respective Boards within the prudential guidelines and exposure norms prescribed by the RBI to extend various kinds of credit facilities to NBFCs for permitted activities.

NBFCs are Better than Banks:  Here’s why?

NBFCs can make an investment or lend; they don’t accept demand deposits. But when it comes to borrowing loan most prefer NBFCs over banks and the reason for this is banks have hard rules and requires more time to approve or sanction a loan. On the other hand, NBFCs ensure the processing is quicker, and the necessary loan amount is disbursed within days. Though the rate of interest is high at NBFCs most of the time as compared to banks, borrowers still prefer to take loans from NBFC considering the ease of getting a loan and less complication.  

The main three reasons why NBFCs are preferred over banks for loans are:

Competitive Interest Rates:

Rate of interest is one of the main aspects of all types of loans. Non-Banking Financial Sectors have started to concentrate on this area in recent decades and have brought down the interest rates to either equally to bank lending rates or at times even lower to bank rates., This has also resulted in lower EMI (Equated Monthly Installment) for borrowers. However, borrowers find it a competitive rate when compared to banks.

 You can get high returns out of your investments by taking the help of Portfolio Management service providers. One of the prominent & renound PMS providers are Moat Financials.

 Quick Processing:

At banks, it is very important that the applicant should fulfill the eligibility criteria, but NBFC is lenient in this aspect. This makes loan approval easier, smoother process, and quicker. Most of the time, people apply for a loan when they are in immediate need of money. NBFCs have taken this as an opportunity to meet the demand by quickly processing the loans at a competitive rate of interest. At times, borrowers are even ready to compromise on the interest rates if the loan amount is huge, and if they could get it approved quickly.

Fewer Rules and Regulations:

As NBFC is under the Companies Act, the rules and regulations for lending are not as stringent as banks. This helps borrowers to get loans easily. And the less complicated loan processing is borrowers are highly satisfied. Of course, the risk of default is high with NBFC, and thus interest rates and other charges will be according priced by the NBFC. Even the loan amount approved will be quite lesser than the collateral value. This is due to the high risk of default. 

Some other important factors to be considered in favor of NBFC’s are: -

• A bank cannot operate any business other than the banking business, but an NBFC can operate such business.
• No maintenance of reserve requirements: No CRR and SLR like banks. So that money can be used for lending at a good interest rate. 
• Foreign Investments up to 100% is allowed in NBFC. On the other hand, only banks of the private sector are eligible for foreign investment, and that would be no more than 74%.

1. Capital Market – commercial paper, Non-convertible debenture
2. Term Deposits
3. Funds from Foreign investors

What all financial parameters need to be analyzed

GROWTH 

• AUM 
• Profit After Tax (PAT) 
• Total Assets 

PROFITABILITY 

• Interest income / Avg. interest-earning assets (%) 
• Interest expenses / Avg. borrowed funds (%) 
• Interest spread (%) 
• Net Interest margin (%) 
• Cost to income ratio (%) 
• Operating Expenses to Average Total Assets (%) 
• RONW 
•  ROTA 

GEARING 

• Capital adequacy Ratios (%) 
• Tier I Capital Adequacy (%) 
• Overall debt-equity (times) 

ASSET QUALITY 

• Gross Non-Performing Assets % (Gross NPA %) 
• Net NPAs (%) 
• Net NPAs/Networth (%)

      CAPITAL ADEQUACY 

Capital Adequacy is a measure of the NBFC’s ability to meet its obligations relative to its exposure to risk and also relates to the degree to which the NBFC's capital is available to absorb possible losses. A higher proportion of Tier I (core capital) in the overall capital is viewed favorably. The expected growth in the asset base and ability of the NBFC to generate capital through profits or by accessing capital markets is also evaluated. 

CAR indicates the % of owners' capital as a percentage of risk-weighted assets.

Capital Adequacy Ratio (CAR) = (Tier I Capital + Tier II Capital) /Risk-Weighted Assets

• CAR is inversely proportional to its leverage on the balance sheet, and beyond a point, the leverage cannot be increased as the RBI prescribes a minimum level of CAR.
• CAR also indicates how long the bank can continue to grow without raising further capital

RESOURCE PROFILE & Earnings Ratios:-

The resource base of the NBFC/HFC is analyzed in terms of cost and composition. The proportion of deposits /loans/bonds in the funding mix is examined. Deposit growth rates and their rollover rates are also analyzed. The ability of the NBFC to raise additional resources at competitive rates is also examined. 

Return on Total Assets (%) = PAT/Average assets

• ROTA is a single, ultimate indicator of the overall profitability of the bank/financial institution. Impact of non- interest income, asset quality, fixed cost like employee cost, etc. are all factored into this ratio.

Interest Spread =  (Interest inc./Avg int. earning assets) - (Int. exp/Avg Int bearing liabilities)

• A good indicator of the profitability of the financial institution without taking into account any operational cost. It shows the spread between the yield on an entity’s assets (mainly advances + investments) and the cost of funds (deposits). It also takes into account the yield on investments, which affects the profitability of the entity and forms a significant percentage of the assets. It is the spread the entity has to primarily depend on to cover its employee cost, provisions, tax, etc.

Net Interest Margin (NIM) =  Net Interest Income/ Average assets 

• This ratio is very similar to the Interest Spread and would tend to move in similar lines. The focus here is the overall spread earned on the total assets of the entity.

NPM (Net Profit Margin) = Net profit / Sales.

• It is a profitability ratio that measures the amount of net income that is earned with each rupee of cash generated.

The higher the NPM, the more effective it is at converting sales into profits.

  Cost to Income (%)  = Operating expenses / [Total Income – interest paid].

• This ratio indicates the adequacy of banks/financial institution's total income net of interest expenses in covering the operational expenses. Alternatively can be looked at as the cost involved in generating a unit of revenue.

ASSET QUALITY 

Asset quality plays an important role in indicating the future financial performance of an NBFC. Asset quality holds the potential to affect earnings (higher NPAs could dilute the yields and necessitate higher credit provisions) and capital (lower earnings could slow down the internal capital generation or in extreme situations (loss) could weaken the capital). Further, the asset quality of a bank/NBFC is also impacted by the state of the economy as a whole. 

Gross NPA % =  Gross NPA/Gross Advances (as per RBI Classification) 

• Gross NPA % denotes the percentage of advances that have turned into NPA as against the total outstanding loan book.

Net NPA%  = Net NPA/Net Advances (as per RBI Classification)

• Net NPA% denotes the proportion of advances which turned into NPA after adjusting for the provisions already made by the bank/financial institution

Provision Coverage Ratio =  Provision for NPA / Gross NPA 

• It indicates the extent of provisioning already done on the existing NPAs, thereby indicating the future provisioning requirement in the event of no recovery from the stock of NPAs.

 Price to Book (P/B) = Market capital  / Shareholder’s Equity.

• Simply put, it is the ratio of market cap to its book value (shareholder’s equity). A low P/B bank is not always a better option than the one which trades at higher P/B. 

Some reasons for a bank to trade at lower P/B:

• It generates a low ROE even after using a lot of leverage.
• There is not enough predictability of growth because of its history
• The market expects some deterioration in the asset book of the bank.

OPEX & Growth in AUM:

Assets under management (AUM) refers to the total market value of investments managed by a mutual fund, money management firm, hedge fund, portfolio manager, or other financial services company.

Operating Expenses (OPEX) as a % of AUM tells you how well managed & efficient NBFC’s operations are. Every business needs to grow for its value to appreciate. This growth rate can be compared with other companies.