What’s the news?

• India’s Non-Banking Financial Company (NBFC) sector is on a path of recovery after a turbulent period following the collapse of IL&FS and the challenges posed by the COVID-19 pandemic.

Central idea

• India’s NBFC sector’s revival aids credit flow in tandem with banks, bolstered by upgraded outlooks from ICRA due to enhanced oversight, wider bank credit, robust market performance, reduced NPAs, and higher provisions. However, Ind-Ra and Fitch’s caution highlights concerns over certain NBFCs’ unsecured credit exposures.

Non-Banking Financial Company (NBFC)

• A NBFC is a financial institution that offers various financial services similar to those offered by traditional banks, but it does not hold a banking license and cannot accept deposits from the public.
• NBFCs provide services such as loans and credit, investment and wealth management, insurance services, money market operations, and other financial products.
• They play a crucial role in extending credit to sectors of the economy that might not be served by traditional banks, contributing to financial inclusion and overall economic growth.

What is credit inadequacy?

• Credit inadequacy refers to the insufficiency of available credit or loans to meet the financial needs and investment requirements of various sectors within an economy.
• In the context of India, it signifies a situation where the amount of credit available from traditional banking sources is limited and falls short of what is required to support economic growth, business expansion, and other investment activities.

What are credit sources?

• Credit sources refer to the origins or channels through which funds are made available for lending or borrowing purposes.

Credit sources within the Indian financial system

• Credit Flow through Financial Intermediaries (Banks and NBFCs):

• This channel involves banks and Non-Banking Financial Companies (NBFCs) acting as intermediaries between savers and borrowers.
• Banks collect deposits from individuals and businesses and then lend these funds to borrowers in the form of loans.
• NBFCs, while similar to banks, cannot accept deposits but can still provide credit by borrowing from other financial institutions or markets and lending those funds to borrowers.

• Market credit through bond markets:

• This channel involves borrowing and lending directly through the financial markets.
• Various participants, like mutual funds, insurance companies, and banks, engage in the bond market.
• Borrowers issue bonds, which are essentially debt instruments, and investors purchase these bonds, effectively lending money to the issuers in return for interest payments.

Evolution of credit and banking sector challenges

• Historical Credit Growth:

• Between 1991 and the early 2000s, annual bank credit expanded by 15% on average.
• From 2003 to 2008, the growth rate surged to 28%, driven by optimistic disbursements for the commercial sector due to positive growth outlook.

• Challenges and Non-Performing Assets (NPAs):

• The rapid credit expansion of 2003-2008 led to an increase in non-performing assets (NPAs) during the early 2010s.
• The Reserve Bank of India (RBI) introduced asset quality reviews in 2016 as NPAs rose from 3.4% to 10% between 2013 and 2017.
• The rise in bad assets hampered banks appetite for commercial sector exposure, leading to a shift towards retail loans.

• Credit Slowdown and NBFC Emergence:

• Bank credit growth declined after 2016, reaching 10% annually pre-Covid, and further dropping to 7% during the pandemic.
• This slowdown created an opportunity for Non-Banking Financial Companies (NBFCs) to step in and bridge the credit gap.
• NBFCs compensated for reduced bank credit, particularly in MSMEs and real estate, where they contributed 60% of incremental credit flows between 2014 and 2018.

• Disruption and Liquidity Crisis:

• A major infrastructural lending-focused NBFC’s collapse in 2018 created a sector-wide contagion.
• Both commercial banks and NBFCs experienced a sharp decline in incremental credit, resulting in liquidity challenges.
• This crisis highlighted the vulnerability of NBFCs due to concentrated liability books and disrupted funding sources.

Significance of NBFCs in a capital-constrained nation like India?

• Filling the Credit Gap: In a country where credit flow is limited, NBFCs step in to bridge the credit gap, particularly in sectors like MSMEs and real estate. They contribute 60% of incremental credit flows to these sectors, supporting their growth and development.
• Niche Expertise: NBFCs possess specialized sectoral expertise and flexibility in underwriting. They can evaluate borrowers based on unconventional parameters, extending credit to segments that traditional banks might consider riskier.
• Financial Inclusion: NBFCs extend credit to underserved and remote regions where traditional banks have limited reach. This contributes to financial inclusion by providing loans to individuals and businesses that might otherwise be excluded from the formal credit system.
• Timely Investment: With quick and efficient loan processing, NBFCs enable timely investment and economic activity. This agility is crucial in addressing credit needs promptly, supporting growth in various sectors.
• Alternative Funding: NBFCs raise funds through diverse channels such as bank borrowings, market issuances, and commercial papers. This alternative funding approach ensures that credit is available even when traditional banking sources face limitations.
• Complementary Role: NBFCs complement traditional banks by extending credit and financial services. They serve as an alternative credit avenue, ensuring a broader spectrum of borrowers can access the funds needed for their ventures.
• MSME and Real Estate Focus: NBFCs’ emphasis on MSME and real estate financing fills a critical gap. These sectors, vital for India’s growth, often face challenges in accessing credit from traditional banks due to perceived risks or constraints.
• Sectoral Growth: NBFCs, with their specialized approach, contribute to sectoral growth. For instance, they supported 60% of incremental credit flows to MSMEs and real estate developers between 2014 and 2018, facilitating expansion in these key sectors.
• Diversified Credit Landscape: NBFCs enhance the overall credit landscape by offering an alternative credit channel. Their presence helps distribute credit more evenly across sectors, promoting balanced economic growth.

How can NBFCs be used to address the problem of credit inadequacy in India?

• Targeted Credit Access: NBFCs can cater to segments that traditional banks might find riskier or less viable, such as MSMEs and real estate developers. Their specialized approach, nimbleness, and sectoral expertise allow them to provide tailored credit solutions to these underserved sectors.
• Financial Inclusion: NBFCs extend credit to areas where traditional banks have limited reach, fostering financial inclusion. They can provide loans to individuals and businesses in remote and underserved regions, contributing to economic growth across the nation.
• Flexibility in Underwriting: NBFCs often adopt innovative and tech-enabled approaches for assessing creditworthiness. This enables them to evaluate borrowers based on unconventional parameters, extending credit to those who might not meet traditional banking criteria.
• Quick and Efficient Processes: NBFCs, with streamlined operations, can offer faster loan approvals and disbursements. This agility in processing loans can bridge the credit gap more rapidly, supporting timely investment and economic activities.
• Sectoral Focus: NBFCs can concentrate on specific sectors or niches, catering to unique credit requirements. For instance, they can offer specialized real estate financing or support to micro and small businesses, contributing to sectoral growth.
• Liquidity Channels: NBFCs can raise funds through various channels, including bank borrowings, market issuances, and commercial papers. This diversity in funding sources enables them to overcome liquidity challenges more effectively.
• Diversification of Funding Sources: For sustainable growth, NBFCs can diversify their funding sources to reduce reliance on specific channels, reducing vulnerability to liquidity shocks, as highlighted in the article.
• Complementing the Banking System: NBFCs complement traditional banks in extending credit and financial services. Their presence provides an alternative credit avenue, ensuring that credit is available to a wider spectrum of borrowers.

Conclusion

• In a country where financial inclusion and access to bank credit remain challenges, NBFCs play a vital role in reaching underserved segments. Learning from the crisis of 2018–2021, diversifying funding sources, and implementing short-term liquidity buffers can fortify NBFCs against future shocks.

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