NBFCs’ Collection Efficiency Takes a Hit Post Demonetisation

By Bindu Ananth & Kshama Fernandes

Non-banking finance companies (NBFCs) represent an important linkage between the formal banking sector and informal segments of the real economy in India (wage labourers, smallholder farmers, unorganised retail, and domestic workers) through the channelling of credit from the former to the latter.

They have a significant presence in the microfinance, small business finance and commercial vehicles finance segments. Of the 11,682 NBFCs registered with the Reserve Bank of India as of end-March 2016, 209 were systemically important non-deposit taking NBFCs which are subject to more stringent prudential norms and provisioning requirements. Loans & advances by these entities alone accounted for around Rs 10.7 lakh crore. Through the data lens of collection efficiencies and disbursement volumes of over 100 NBFCs, we take stock of the impact of demonetisation on them. This also provides insights on the ultimate impact on the informal economy in India.

From November 9 onwards, NBFCs were not permitted to accept repayments in Rs 500 and Rs 1,000 denomination notes. Given the lack of access to bank accounts, most NBFCs accept repayments in cash from their customers. The average collection efficiency of microfinance NBFCs was 99.02% for the 12 month period preceding Nov 16. As of end November, collection efficiencies dropped significantly for these NBFCs and ranged from 60% to 90%.

Vehicle finance NBFCs reported a collection efficiency ranging from 60% to 70% with a higher cheque bounce rate and reduced overdue collections. Vehicles engaged in the movement of goods/ passengers which are “discretionary” witnessed an increase in idle time of 15-20 days a month from the normal levels of 8-10 days. Nondiscretionary goods, including agri produce and dairy, witnessed a lower impact.

Small business lending NBFCs reported a collection efficiency ranging from 65% to 85% with entities lending to small manufacturers and traders being at the low end of the range. Informal salaried customers have been as affected as self-employed customers with collection efficiencies of around 70%. This is true across urban and rural locations. In the affordable housing finance segment, collections continue to hold strong. These are largely selfoccupied homes. LTVs in this segment are much lower and reflect significant borrower equity in the asset. The norm for fixed obligation to income ratios in the informal segment is significantly lower and may provide a reasonable cushion to absorb short-term cashflow shocks.

Many microfinance NBFCs had put disbursements on hold for all of November 2016 and are now restarting disbursements gradually. Some restarted disbursements partly from their own collections. In the vehicle finance segment, disbursements are at 50-60% of normal levels on account of the slowdown in demand. Fresh disbursements in the small business lending segment have almost stopped with fresh logins dropping to 25% of the normal monthly volumes. Overall, disbursements have been affected also due to shortage of currency in the banking channel and a weekly cap on cash withdrawal. Going forward, we also expect an impact on disbursements in used vehicle finance due to the anticipated crunch on margins for fresh borrowing by the end-customers.

In pockets of UP and Maharashtra, demonetisation has fuelled some political risk factors in the form of demand for loan waivers by local politicians. This needs to be tracked closely and prevented from escalating by local offices of the RBI and the district administration. Going forward, NBFCs will need to re-engineer operations to significantly move away from cash collections. The task of opening bank accounts with full functionality for rural customers is far from complete. The availability of payment mechanisms such as the Unified Payment Interface (UPI) on feature phones will greatly help this category of customers from the advances in this area. There is also a need for a sharp increase in cashin/cash-out points, particularly in remote rural India to facilitate ease of transactions as the progression to cashless/ less-cash economies will take time.

The disruption will have a marginal impact on profitability of NBFCs due to foregone disbursement. We want to share our concerns on the negative liquidity and income impact on customers of these NBFCs which may not show up in collection data of lenders. Salaried workers in the informal sector have been hurt through delayed payment of wages and self-employed workers have seen significantly lower business volumes. Disruptions in credit impact consumption for low-income households in terms of reduced expenditure on essential items such as food and health. There could be a possible loss of trust in formal financial institutions. We need to work hard to restore an environment that will ensure predictability and credibility of these institutions among this large segment of India’s working poor.

This article first appeared in Economic Times.


Funding options for non-bank originators – Mezzanine instruments

By Satya Srinivasan, IFMR Blog Team

Recently, we flagged off our new blog series on financing options for non-bank originators with our first post that explored debt-funding options in some depth. We progress southward on the balance sheet this week to explore financing instruments that are quasi-equity by design – mezzanine finance. This is the second installment in a series of blog posts that explore financing options for non-bank originators.

Providers of debt often look to cushion their risk with equity. While the microfinance sector has seen a growth in private equity funding in the past decade, this infusion has been restricted to the larger organisations in the sector. There are several hundred organisations in the Indian microfinance sector that are unable to attract equity due to their legal structure. This either results in limited access to debt funding or a situation of over-leverage, which could threaten the sustainability of the business in times of a crisis. In a situation where the legal structure is not conducive to equity investments or early equity investment dilutes the promoter’s stake, one has to look at capital structures that provide similar levels of comfort to senior debt providers.

Mezzanine finance is a hybrid variety of capital that straddles the vast and unexplored space between senior debt and equity. Mezzanine instruments combine various characteristics of debt and equity. The risk classification of these instruments depends on whether they have predominantly debt or equity characteristics and can be classified accordingly within the mezzanine space. For instance, the instrument could be in the form of subordinated debt, which has predominantly debt characteristics due to a fixed repayment schedule. The other example of a mezzanine instrument is preference shares, where the mezzanine provider takes risk which is only slightly less than an equity provider since the holder of the shares get preference when dividend is paid out. In the event that the business does not make profits, a preference share holder does not get a return, while the subordinated debt provider would still get the fixed payout that was decided.

One has to look closely at mezzanine debt to understand what gives it a hybrid nature.

Mezzanine debt is subordinated to senior, unsubordinated debt capital but ranks ahead of equity in the capital structure. The subordination to senior debt happens in two ways – senior lenders are often times, secured and subordinate mezzanine debt is unsecured. Secondly, the tenure of subordinate mezzanine funds is longer, which provides a cushion to senior debt. This means that in case a business goes bankrupt, the senior lender recovers dues first, followed by the mezzanine provider and finally the promoter/equity provider gets his/her share. Obviously, since the risk is higher in mezzanine instruments, the cost of funds tends to be higher.

Mezzanine financing, while more expensive than senior debt, also poses certain advantages to non-bank originators (established as NBFCs) that balances the cost of raising capital –

  1. Mezzanine funds, due to their innovative structure are classified under Tier II capital. Non-bank originators can leverage this capital with banks to raise additional funds. This effectively reduces the total cost of funds. For example, Tier II capital can be used to leverage bank finance up to 5 times. Hence for every 1 rupee of mezzanine debt raised, a maximum of Rs 5 can be raised as senior debt from a bank. If the interest rate for the mezzanine debt is 30% and the interest rate for the senior debt is 12%, the total interest paid would be 90 p on total debt of Rs 6. This is 15% of the loan amount and only 3% more than the cost of debt from banks.
  2. Mezzanine funds can also help in adhering to capital adequacy norms. For instance if the total risk weighted assets of a non-bank originator is Rs 100 and its networth is Rs 10. The CRAR (Capital to Risk-weighted assets Ratio) is 10% which is below the prescribed norm of 15% (effective from April 2011). If the non-bank originator were to go for an alternate capital structure with Rs 10 equity and Rs 5 worth sub-debt then the CRAR would become 15%, which is the prescribed, minimum CRAR.

Non-bank originators cater to households with highly complicated financial lives and the slightest shift in the provision of continuous, flexible, reliable and convenient access to financial services can trigger a setback in the intricate financial lives of low-income households. It becomes imperative therefore for a rigorous and effective due diligence process to be in place before access to mezzanine debt is made available to non-bank originators. IFMR Mezzanine Finance Private Limited, whose objective is to provide deserving non-bank originators access to long term funds through mezzanine products, has a thorough and comprehensive due-diligence process. It scrutinises and defines standards for a range of parameters including leadership, financial performance, processes, products and strategy.

Saurabh, from IFMR Mezzanine who works for the due-diligence team, sums up the characteristics of the “ideal candidate” to receive mezzanine funding, as we put it to him – ‘good promoter background, sound governance, standard processes and robust systems, established lending relationship with a bank which will be crucial to their ability to leverage the mezzanine funds, sound audit and internal control systems and finally good risk management practices’, he says. A little surprised by the weightage to financial parameters in the exhaustive list, we ask him if an indicator like PAR (PAR or Portfolio at Risk is the outstanding amount that is overdue past a certain period of time and is measured by dividing the Outstanding amount on loans overdue past a given date by the Gross loan portfolio outstanding) does not have any influence on their assessment of how strong the non-bank originator is. ‘PAR is important for a short term lender. From a long term stability point of view, it is important to examine the volatility in PAR. A high volatility is an alarming indicator, while a consistent PAR, while high is still indicative of stable processes’, says Saurabh.

Mezzanine funding is an innovatively engineered financing option, which seeks to offer non-bank originators much-needed capital. Due to its unique structure mezzanine funds can be employed to fuel growth, to seek standard funding and even to adhere to regulatory capital norms without any dilution in the promoter’s stake. Mezzanine financing, which was earlier only part of buy-outs and venture capital deals, can now fill the capital vacuum in the microfinance sector, provided, investments are backed by a rigorous due-diligence process that evaluates not only financial performance but also lays down benchmarks for corporate governance, best practices, systems, processes, risk-management and strategy.

With inputs from Jayshree Venkatesan, IFMR Mezzanine


Who should govern NBFCs?

Does the RBI’s claim to regulate NBFC (MFIs) have more merit than Federal state governments’ claims? An analysis of constitutional provisions by Vishnu Peri, IFMR Mezzanine Finance.

A verdict on the Malegam committee report’s efficaciousness is still out. However there is a consensus arising about the benefits of a few suggestions. One of these being, if the recommendations of the Malegam report are accepted, the need for a separate Andhra Pradesh Micro Finance Institutions (Regulation of Money Lending) Act (henceforth the Act) will not survive.

The AP state government has responded to the report in general and this recommendation in particular with dour criticism and expression of support for its legislation. Further the AP government is claiming the protection and empowering cloak of the Indian constitution for the continuance of its Act. Rural development principal secretary R Subrahmanyam was cited in a news report claiming:

“According to the List II of the Constitution, the regulation of money lending is the original jurisdiction of the state government. An Act is the will of the people. Accordingly, whether or not the need for AP MFI (Regulation of Money Lending) Act exists will be decided only by the AP Legislature and not by the RBI”.

Other criticisms were levelled at the report which was submitted to the RBI in a 5 page report, excerpts of which can be found in the public domain. However for the purpose of this article we will focus only on the above statement, whereby state government regulation is given primacy over central regulation.

The constitutional powers debate:

The primary issue in our context is one of jurisdiction. Is regulation by federal units of India valid if a class of institutions are already under the purview of ‘central watchdogs’.

The primary argument utilised by the AP govt deals with the concept of separation of powers which is enshrined by the Indian constitution via Article 246. This article combined with Schedule VII lists the areas which are the exclusive domains of the Centre, the State and common areas of interest.

Under List I which lists central government’s sphere of responsibility the following entries are relevant:

Entry 38: Reserve Bank of India.

Entry 43: Incorporation, regulation and winding up of trading corporations including banking, insurance and financial corporations but not including co-operative societies.

Entry 44: Incorporation, regulation and winding up of corporations, whether trading or not, with objects not confined to one State, but not including universities.

Under List II which lists state government’s sphere of responsibility the following entries are relevant:

Entry 30: Money-lending and money-lenders; relief of agricultural indebtedness.

Entry 32: Incorporation, regulation and winding up of corporations, other than those specified in List I, and universities; incorporated trading, literary, scientific, religious and other societies and associations; co-operative societies.

The Rural development principal secretary R Subrahmanyam is depending on entry 30 List II cited above to derive sustenance for the Act. A preliminary reading of the above entries leads us to see AP government’s Act as a case of constitutional over reach; especially when the act seeks to infringe onto RBI’s turf. The entries and hence the constitution is clear that the state government can only regulate those financial corporations which are not regulated by the central govt. Further the RBI is under the exclusive control of central regulation. Money lending under entry 30 list II cannot be given such a wide interpretation so as to encompass areas under exclusive central regulation and thus defeat the language and spirit of the constitution.

If we assume the above argument to be valid, RBI and its regulatory powers are derived from List I and will be equivalent to central government regulation. Thus in the present context we are dealing with over-regulation of NBFCs’ by state and central laws.

With the insertion of chapter IIIB in the RBI act, it has become compulsory for NBFCs to register with the RBI, which has specified various restrictions in the context of income recognition, asset classification,capital adequacy norm, provisioning requirements and disclosures in the balance sheet.

The objects and reasons for insertion of Chapter-IIIB would assume importance in order to better understand the controversy. The same reads as under:

……..For ensuring more effective supervision and management of the monetary and credit system by the Reserve Bank, it is desirable that the Reserve Bank should be enabled to regulate the conditions ……… The Reserve Bank should also be empowered to give any financial institution or institutions directions in respect of matters, in which the Reserve Bank, as the Central Banking institution of the country, may be interfered from the point of view of control over the credit policy. The Reserve Bank’s powers in relation to commercial Banks should also be enhanced and extended in certain directions, so as to provide for stricter supervision of the operations and working*…….. (emphasis added)

The aforesaid makes it clear that the intention of the Parliament to insert the provisions of Chapter-IIIB inter alia is to control and regulate the conditions for acceptance of deposit and to control the credit policy of Non-Banking Finance Companies and the financial institutions**.The overarching nature of RBI regulation can be seen through section 45Q:

“The provisions of this Chapter shall have effect notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law.”

This non-obstante clause overrides provision of any other law for the time being in force. Further, besides section 45Q, section 45JA is important as it allows the RBI to direct all or a class of financial institutions and to formulate policy for the same. This will put the burden on RBI to direct MFI NBFCs as it has the wherewithal and legislative competence for the same; not state governments who have experience of only regulating state corporations and money lenders. The Malegam report supports this notion when it forwards the idea that the State is often not the best agency to act as a regulator and this task is best left to an independent regulator.

The High Courts of Maharashtra and Gujarat have upheld the primacy of RBI over state regulation on these same grounds, in the cases of Vijay P vs. State of Maharashtra*** and Sundaram Finance vs. State of Gujarat****.

The Malegam report records that ideally there should not be any overlap of regulation and regulators for the smooth functioning of financial services. The above points buttress this argument and show that legally speaking there cannot be any overlap and the NBFCs must either be governed by List I or II. __________________________________________________________________________________________



***(2005) 128 Comp Cas 196 (Bom)