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16.7.2011

NON BANKING FINANCIAL COMPANIES

I) An overview of NBFCs in India

They are financial intermediaries and function as middlemen-collect savings and supply
credit

A) Defining a non-banking finance company-1972 banking commission

“financial institutions whose liabilities are not accepted or used as means of payment
in the settlement of debts”

All those institutions which accept deposits, and give loans but do not provide chequing
facilities can be called NBFCs

Nature of an NBFC :

 An institution-company, corporation or firm-legal entity

 Provides financing or credit
 Make investments
 Hire purchase

The reserve bank and NBFCs : annual schedules and returns to be submitted

B) Structural characteristics of NBFCs

 Group membership
 Forms of organizations-mostly partnership firms
 Management-legal provisions like audit, inspection, accounts
 Capital and resources-initial capital by partners
 Loans, advances and investments-some loans given to third party as well
 Regional and localized organizations-puts limit on regional expansion
 Informal functioning-indiscriminate lending lands the firm in trouble
C) Progress of NBFCs in recent years

84 times growth in 16 years

They are comprised of following :

 HPFC-hire purchase finance companies

 LC-loan companies-83 times
 IC-investment company
 HFC-housing finance company-828 times
 MBFC-mutual benefit financial company-52 times
 ELC-equipment leasing company
 MNBC-Miscellaneous non banking company
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Total resources have grown 98 times in the 16 years prior to 2001. Leasing companies non
existent in 1976 and raised over 10,000 crores in 1994

II Commercial banks and NBFCs

A Similarities-both are financial intermediaries

 Capital –raise capital by selling shares

 Deposits-cumulative and recurring deposits. Several innovative schemes of savings by
NBFCs
 Loans and advances-the very long term loans are avoided
 Investments-greater risk as they need higher profitability
 Other functions-seed capital and hire purchase credit. Underwrite, accept bills,
guarantee loans and issue LOC
 Organization-large ones have regional and zonal offices
 Control-need to be regulated and controlled

B) Differences

 Transaction balances-hold savings and use for asset demand

 Role in money and capital markets-specialise in only a few types of lending
 Credit creation-banks are more than financial intermediaries
 The spectrum of alternatives-banks are multipurpose agency
 Safety and yield of funds-banks have to maintain liquidity ratios and deposit rates are
controlled
 Individual finance-banks concentrate on medium and large institutions
 Regulation and control-malpractices more prevalent in NBFCs

C Role and importance of NBFCs in the economy

The rates of interest offered by the NBFCs on time deposits, are slightly higher than those
offered by commercial banks. They provide credits to sections of the economy which would
otherwise be starved.

III lease financing

A) Nature and types of lease. Can be short term or long term

The more important classification is finance lease or operating lease
In both these cases the lessor-the party which gives on lease
 Finances the investment
 Double risk-investment and giving asset to third party
 Indirectly participates in the risk of the enterprise
a) Finance lease-until all installments are paid the ownership remains with the financier.
The lessee is the owner in practice though the lessor is legal owner
 Ownership with lessee
 Lessee has the option to purchase
 Period of lease roughly equals the life of assets
 Lease payments cover costs plus interest on the price
b) Operating lease : cars, ships, aircrafts
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 Ownership remains with lessor

 There is no purchase option
 Short period lease
 Lease payments have no correlation

The finance lease are of four types :

1) Leveraged lease-leasing company provides equity capital. Funds borrowed from

development bank
2) Sale and lease book-asset is sold to leasing company. And takes back on lease from
leasing company. This releases lots of funds for utilization. Pay rent for the use of
the asset
3) Cross border lease-the lessee is in some other country
4) Foreign to foreign lease-three parties involved may be in three different countries

Lease distinguished from hire purchase :

The hire purchaser takes the equipment on lease and the lease rental is shown as an
expense which is tax deductible. But the hire purchaser cannot claim depreciation and
the asset may not appear in the balance sheet.

B Role of lease finance

 Widening the capital market-increased borrowers and lenders and transactions

 Liquidity adjustments-several alternatives depending on the circumstances
 Sharing of risks-lease rather than outright purchase
 New channels of investment for banks-one more channel for diversification
 Hope for small operators-opportunity for investment to the small savers
 Flexibility in financing-provide wide range of options
 Economic development-lease financing is a new practice and it opens up avenues

C Functional benefits of lease finance

 A helping hand to the financially weak-cash outflow much less

 The convenience of flexibility-when assets are required for short period
 Meeting the threat of obsolescence-computer and white goods
 Availing after sales services-functional benefit if for additional charge after sales
service is given to the lessor
 Additional financial product-tax benefits for lessor
 Simplicity and flexibility-simple procedure compared to bank borrowing
 Marketing strategy-creates additional demand for capital goods
 Tapping industrial potential

D Problems of leasing companies

o Tax problems-there are no uniform practices

o Legal problems-single act required to regulate the lease industry
o Accounting problems-separate lease rental from finance income
o Problems related to fund raising-attracting public deposits is becoming difficult
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IV Hire purchase finance and consumer credit(hire purchase act 1972)

o The owners deliver the possession of goods to the hirer for the use of the hirer
o Legally the ownership is vested in the lender
o Credit to the hirer by the owner on condition of rent which included capital and
interest
o Ownership is transferred on payment of the last installment

There are four types :

1) Consumer installment credit-white goods

2) Commercial credit-industrial goods
3) Hire purchase by dealer/producer to consumer-extends facility to buyer
4) Hire purchase by Financer to the user-dealer sells car but price paid by automobile
finance company to which it is hypothecated

The hire purchase quotes a flat rate over the period to calculate the monthly installment

A Functions of hire purchase institutions

o Installment credit-against hypothecation or against warehouse receipts

o Financing of purchase of equipment, vehicles-after hypothecation
o Purchase of old assets-term lending institutions do not give loans
o Consumer credit eg white goods purchase
 Realization of security difficult in case of default
 Valuation in case of second hand difficult
 Borrowers avail credit from more than one institution following fraudulent
practice
 Follow up of hypothecated asset difficult
 Proper accounts not maintained and finance is given without proper investigation

Working of Hire-purchase and consumer credit( and installment credit are used
interchangeably) : enables purchase of goods which can be fractionally liquidated through a
contractual obligation. Hire purchase finance given against stock of goods with wholesale
traders.

Role of hire purchase finance :

 Saving on capital investment-expands productive investment

 Risk sharing promotes entrepreneurship
 Consumer credit-enticing consumers to become extravagant which is undesirable
 Development of financial markets-diversifies the options available
 Raising rate of saving-wide choice from which choice can be made. This helps the
macro economy by raising savings

VI) Housing finance

A Objectives of housing finance

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35% are below the poverty line

 LT proposition
 Great risk
 Those who need loans have very little security

The objectives of housing finance :

 Meeting housing needs-very diverse needs

 Diversification of investment-due to fierce competition
 New approach to financing-mortgage loan
 Finance for a domestic industry-after globalization the housing finance became a
substitute for the financial institutions
B) Functioning of housing finance companies-procedural sequence
 Amount based on repaying capacity
 Co-applicants allowed
 Net cash inflow –expenses is calculated
 Hidden costs-interest cost, one time payment of processing, pre-payment
charges,commitment charges on unwithdrawn amount
 Monthly reducing interest rates as it reduces the amount on month to month
basis
 EMI calculation
 Margin money plan or the balloon repayment plan(for young and promising
executives)
 Free accident insurance or waival of last installment given as incentive
 For repairs also loans are available
 Documents-create mortgage, memorandum of deposit of title deeds, assignment
of other policies, up to date payment of IT, guarantee from personal guarantors,
Power of attorney to mortgage in case of mishap
C) Institutions providing housing finance
 Hudco- at subsidized rates of interest. 15% of total loans to rural areas. 55% to
economically weaker sections for 8-10 years and covers 60% of cost of houses
 Apex Coop housing finance societies-HDFC set up in 1977 accounts for over 50% of
the disbursements of housing loans by the HFCs. Till 2001 had sanctioned Rs 31094
crores
 Housing boards
 Indira aawas yogana
 LIC
 GIC
 Commercial banks
 Urban cooperative banks
 Private housing finance companies

National housing bank is fully owned subsidiary of the RBI to axt as the apex housing
finance institution

Initiatives by the RBI :

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 Setting up of NHB : July 1988 . started home loan account schemes which sanction
loans upto 1.5 times accumulated savings
 Revising guidelines for commercial banks : Nov 1988
 1.5% of incremental deposits during preceding 12 months is earmarked for
housing finance
 From 1990 term loan limits to HFCs raised to 3 times the net owned funds
(NOFs) of HFCs
 Restrictions on term loan for housing per individual has been removed
 Margin requirement has been fixed at 20 to 35% and repayment period fixed at
15 years
 Housing finance subsidiaries of banks-Canfin, GIC, LIC, PNB, SBI are examples
D) Sources of finance : for HFCs
 Deposits-very small part of total funds
 Domestic term loans-term loans upto 10 years maturity account for 55-85% of
lendable resources
 Capital markets-new HFCs raise capital-7 to 8% of total funds. Bonds
/debentures used only by HDFC.
 NHB refinancing-for HFCs having social objectives
 External sources-HDFC has raised external resources.On govt guarantee
international financial institutions have shown interest.
E) Progress of housing finance-no of HFCs rose from 5 in 1976 to 45 nos in 1997.but
resources available satisfy only half the total requirement. HFCs are the major
beneficiaries of NHB refinance facility
Some reforms like securitization of mortgages will enable the trading in the
secondary market, thereby imparting liquidity to and reducing risk of this type of
finance. Insurance of mortgage and variable interest rates can also serve to reduce
the risks.

VII Venture capital finance-specialised funds which undertake to finance risky new
industries or old risk enterprises

A) Meaning and objectives :

Objectives of venture capital funds :

 To encourage innovation and hi-tech process of production : foster technological

experimentation
 To provide a launching pad to new enterprises-supplies own fund as equity capital
and serves as launching pad
 To provide managerial and marketing assistance-online operational advice.VC can
offload his shares in the stock market at high prices
 To supplement the suppliers won capital : 25% is margin requirement out of which
owner is able to arrange 5-10%
B) Functions and working in India-the difficulty was seed capital
 Bridge finance-to close the gap for margin requirement. ICICI and IDBI floated
TDICI(Technology development and information company of india)
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 Information and consultancy-supplementary services not available. Little hand

holding does help
 Conditional loans-TDICI participates upto 49% or a conditional loan-royalty on sales
ranging from 2% to 8%. Given 5 years to break even or the loan can be written off.
 Participation by public and private sector agencies-ANZ Grindlays Bank makes direct
equity participation in new companies. New fund is Credit capital venture fund
(India) of CVF and 20th Century finance. 1985 was the year the government stepped
in. National equity fund formed in 1989 for financing small scale industries in rural
areas
C) Difficulties in india :
 No sizeable source of income like pension fund, or insurance fund
 Banks involved in priority sector lending
 VCFs may not spread because of investment climate not too bright
 Scams scares away likely investors
D) Importance of venture capital finance-VCFs need to be given a place
o Narasimhan committee’s views-guidelines for floating VCFs very restrictive.
Required tax concessions and be treated on par with MFs.
o Official view-2000 onwards NVFSIT-NVF for software and IT industry. To be
managed by SIDBI. The risky investments were made more attractive to
NRIs.SEBI has been made the single point nodal agency for registration and
regulation of capital funds, whether domestic or overseas.
o Investment of knowledge-need to widen the industrial base so high tech
industries will need to grow fast
o Growth of an equity cult-venture capital investment is genuine risk sharing as
opposed to the feigned risk bearing by speculators
o New industrial culture-need to usher in sustainable development

VIII Merchant banking- are issue houses rendering such services to corporate bodies or
industrial projects as floating of new ventures , execution, consultancy, M&A assistance

A) The need for a merchant bank-National and Grindlays bank were the pioneers and
then SBI
Technological advances-special expertise
Encouragement to small firms-need help to finance and launch
Procedural complexities-formalities introduced to stall fraudsters
Balanced regional development-catalytic agent for backward regions
Overseas collaborations-launching subsidiaries and setting up companies abroad to
be encouraged
Mobilizing savings-through prospectus and advertisements
B) Functions of merchant bank-issue houses and underwriting institutions
 Spade work and preparatory work-pre investment surveys and market studies,
raising resources from banks and financial institutions, FE resources for imports,
foreign collaboration and advice for setting up turn key projects in foreign
countries
 Issue management-through prospectus
 SEBI green signal
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 Underwriting the issue to be floated

 Finalise the prospectus
 Application to the stock exchanges
 Select registrars, brokers, bankers
 Organizing through the advertising agency the conference of brokers, bankers
and investors
 Coordinating and preparing register of allottment
 Issue management of debentures-a) make issue attractive , b) finalise mortgage
deeds
 Underwriting and consultancy-SEBI has made it mandatory
 Pre investment studies or investors-basically profitability prospects
 Financial management and capital structuring-proper capital structure
 Project finance-legal help is also provided and documents are prepared
 Working capital-medium term credit syndication and non-traditional sources like
issue of debentures
 Foreign currency finance-assistance in syndication of finance
 Other functions-portfolio management, discounting operations
C) The role of merchant banking in india-merchant banks have to observe stipulated
capital adequacy norms and abide by code of conduct as per SEBI
 Widening of the new issue market-promote new companies
 Responsibility towards the investors-transparency and disclosures
 Raising the level of competitiveness of industries-sophisticated planning and
management
 Catalytic agent-for transformation of corporate sector
 Injecting professionalism-and provide expert services
 Diversification and broad basing of companies-soundness of investment proposals
became a must
 Promotion and development-both functions are catered for

Regulation of NBFCs

SEBI-regulatory powers delegated by RBI. Immediate controlling authority of capital market

transactions

RBI-supreme authority in the financial market

As per Narasimhan committee , 1991 the ceiling on bank loans to the NBFCs was reduced to
three times their Net owned funds(NOF) in 1995

Asper A C Shah committee recommendations, NBFCs with of NOF of Rs 50 lakhs and above
were asked to register with the RBI. They also need to obtain credit rating.

The regulatory arrangements for the banking and the non-banking segments of the financial
system rests with RBI

A) Regulatory provisions of the RBI(Amendment) Act 1997

 3 times NOF imposed on the bank borrowings by NBFCs
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 Non-convertible debentures fall under the regulated deposits category while the
convertible debentures fall under the exempted category of borrowings from the
banking system
 Finance and leasing companies accessing capital markets till norms tightened in
1996
 Prundential guidelines for registered NBFCs. Credit rating of P2 of CRISIL. The
leasing and hire purchase finance companies which complied and reached the rating
were freed from interest rates. Others had to accept a ceiling of 15%.
 Registered MFFCs, Nidhis, were exempted from the interest rates ceiling of 15% if
they complied with the GOI directions, had positive NOF and had a NOF: Deposit
ratio of 1:20. The ban on advertisements and payment of brokerage continues. For
interest rate exemption will have to apply to RBI.
 NBFC shall create a reserve fund to which 20% of the net profit shall be transferred
each year. Assets in approved securities in the range of 5-25%. All this is as per RBI
(Amendment) Act 1997(section 45B). Liquid assets limit is 10% and raised to 12.5
% for equipment leasing and hire purchase companies.

B) Reserve banks directions for NBFCs. Jan 2 1998

 New classification of companies-on basis of acceptance of deposits
 Rules prescribed-
 Public deposit defined as in Companies act
 NOF<25 lakhs then cannot accept public deposit
 Upper limit based on credit rating and as a multiple of NOF
 Some norms
 16% pa prescribed for interests on public deposits
 Brokerage payable 2%
 Annual returns and financial statements only for those who accept public deposits
 NPAs are to be defined with reference to over-dues exceeding 12 months, capital
adequacy 12% for NOF> 25 lakhs, limits of credit 25% and 45% for single entity
and group of entities of NOF,and no NBFC can grant loans against the security of
its own shares
 Other regulations for protecting interests of depositors
 Liquidity requirements of 15% of assets
 Auditors certificate
 Caution to depositors on risk and responsibility involved
 Disclosure of rating level and agency on the application form

The areas of caution

a) NBFCs not dependent on bank borrowings ignore the RBI directions.

b) For accessing stock market for capital did not comply with RBI directives
c) Ceilings on interest rate on loans become ineffective if the other conditions of the
loan are found suitable for their borrowers
d) Dodge the interest rate ceiling
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