ICRA COMMENTS ON RBIs DRAFT GUIDELINES FOR NBFCs

Tighter norms a positive, but no move on parity vs. banks

DECEMBER 2012
ICRA RESEARCH SERVICES

Background and Outlook

The Reserve Bank of India (RBI) has on December 12, 2012 published draft guidelines for non-banking finance companies (NBFCs) based on the recommendations of the Usha Thorat-chaired Working Group on the Issues and Concerns in the NBFC Sector. The guidelines propose, among other things, tightening of the non-performing asset (NPA) recognition and provisioning norms for NBFCs so as to bring them on a par with those applicable for banks. While this is in general a positive step, some NBFCs offering products with annual or quarterly repayments may find their asset quality turn volatile because of this change. Further, increasing the Tier I capital as well as the risk weights for some asset classes, while not aligning (reducing) the same for some other asset classes in which banks enjoy lower risk weights (such as loans for commercial vehicles, construction equipment, and home loans etc), would reduce the NBFCs leveraging capacity vis--vis banks. At the same time, the lack of access to Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act) as well as any liquidity back-up line would continue to weigh on the performance of NBFCs. The draft guidelines could impact the leveraging capacity and earnings of NBFCs significantly. The proposed enhancement of Tier I capital from 7.5% to 10% of risk weighted assets (12% for captive NBFCs and NBFCs in sensitive sectors) and increase in risk weights for certain asset classes will require NBFCs to raise additional Tier I capital of around Rs. 20 billion (around 2.4% of the industry net worth). While the proposed revision in the NPA recognition norm to 90 days (vs. 180 days), along with the adoption of higher provisioning requirements for NPAs and standard assets (in line with that for banks) could lead to a dip in NBFCs' profitability by 15-20 basis points (bps) over the medium term, the higher Tier I capital requirement could translate into a decline of around 115 bps in the sectors return on equity (ROE).

Contacts: Vibha Batra +91 124 4545 302 vibha@icraindia.com Karthik Srinivasan +91 22 3047 0028 karthiks@icraindia.com Jaskirat S. Chadha +91 124 4545308 jaskiratc@icraindia.com

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Key Changes and Impact

The following are the key changes proposed by the RBI to the existing regulatory framework for NBFCs. 1. Increase in Capital Requirements and Risk Weights The following are the proposed RBI capital adequacy requirements and risk weights applicable to NBFCs: Captive NBFCs1 and NBFCs engaged in lending to sensitive sectors (viz. capital market, commodities and real estate)2 to maintain Tier I capital of 12%. Other NBFCs to maintain Tier I of 10%, as against 7.5% currently. Risk weights increased for commercial real estate (CRE) exposures from 100% to 125% and for capital market exposures from 100% to 150% for diversified NBFCs with Tier I capital at 10%.

Table 1: Current minimum capital requirement v/s proposed by RBI Type of NBFC Captive NBFC NBFCs focuses on sensitive sectors Gold loan companies Infrastructure finance companies (IFCs) Other NBFCs of which exposures to commercial real estate of which exposure to capital market of which exposure to other assets ^with effect from April 1, 2014 Source: RBI Current Regulations Minimum Tier I % Risk Weight 7.5% 100% 7.5% 100% 12%^ 100% 10.0% 100% 7.5% 100% 7.5% 100% 7.5% 100% 7.5% 100% Proposed Regulations Minimum Tier I % Risk Weight 12% 100% 12% 100% 12% 100% 10% 100% 10% 100% 10% 125% 10% 150% 10% 100%

In ICRAs view, the higher level of Tier I capital proposed is a credit positive for the NBFC sector. Based on the proposed revised Tier I capital requirements and the higher risk weights on certain types of exposure, ICRA estimates that nine to ten NBFCs would need to augment their Tier I capital by a total of around Rs. 20 billion (2.4% of the industry net worth), assuming that the NBFCs maintain a cushion of 2% over the regulatory minimum Tier I requirement. In ICRAs view, these NBFCs should be in a position to mobilise the additional capital over the three-year period proposed for the purpose under the new norms. NBFCs remain at a disadvantage vis--vis banks with respect to capital requirement on a part of their retail lending books (loans for commercial vehicles, construction equipment, home, gold, etc). For instance, for commercial vehicle or construction equipment loans, banks are permitted to apply 75% risk weight, while NBFCs have to apply a risk weight of 100%. Thus, the capital requirement for banks would be 4.5% under the current norms and 6% (core Tier 8% multiplied by 75% risk weight)

1 2

90% and above of total assets (net of intangibles) are on financing parent companys products/services to the extent of 75% or more of their total assets, net of intangible assets

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under Basel III, while NBFCs would have to maintain Tier I capital of 10% under the proposed norms. Similarly, for home loans the amount of capital provided by banks would be 4% to 10% (Basel III) and in the case of gold loans up to 1.65%, while NBFCs will need to keep a Tier I of 10% on these exposures. 2. Asset Classification and Provisioning Norms RBI proposes to make the following changes to the existing asset classification and provisioning norms applicable to NBFCs: NPA recognition norm to be lowered to 90 days from 180/360 days: There would be a transition period for the switchover, with NBFCs moving to a 120-day NPA recognition norm from April 1, 2014 and to a 90-day norm from April 1, 2015. Provisioning norms: These are proposed to be aligned with the norms currently applicable for banks. Standard asset provisioning: This has been raised to 0.40% from 0.25% with effect from March 31, 2014.

In the case of NBFCs, depending on the asset class, 90+ days delinquencies are typically 1.5-3.5 times (average 2 times) the 180+ days delinquencies. While a change in NPA recognition norm could lead to a spike in the gross NPA level in the short term, the percentage, in ICRAs view, would settle at a lower level over the medium term as NBFCs realign their monitoring and recovery systems to the 90-day format and also due to higher recoveries. In the case of housing finance companies (HFCs), which migrated to the 90-day NPA recognition norm from March 31, 2005, the gross NPA percentage rose from 3.56% in March 2004 to 6.24% in March 2005 and subsequently declined to 4.49% March 2006. Assuming a similar build-up in the NPA level of NBFCs, and taking into account the increase in standard asset provisioning, the revised provisioning requirements (in line with those for banks) and the existing provisions in NBFC balance sheets, ICRA expects the return on assets for NBFCs to dip by around 0.55% in the short term; over the medium term, the decline could be in the range of 15-20 bps. This along with the higher amount of capital requirement could translate into an ROE drop of around 115 bps, in ICRAs view. 3. Acceptance of Deposits The RBI has proposed that all NBFCs-D3, including AFCs4, be credit rated and that unrated NBFCs, including AFCs, not be permitted to accept deposits. Further, the RBI has proposed that the maximum permissible level of public deposit for an NBFC be lowered to 2.5 times their net owned funds (NOF) from the current 4 times. ICRA does not expect this change to have any significant bearing on the funding profile of any major NBFC. 4. Liquidity Management The RBI has proposed that NBFCs cover any asset-liability maturity (ALM) mismatch in the less than 30-day bucket with high quality liquid assets in cash, bank deposits available within 30 days, money market instruments maturing within 30 days, and investments in actively traded debt securities with a credit rating not lower than AA or equivalent. While ICRA rated NBFCs typically maintain unutilized bank limits to cover for such mismatches, the proposed guidelines do not allow the benefit of such limits and as a result NBFCs would be required to keep higher liquid assets, which could increase their cost of doing business.

3 4

Non-Banking Financial CorporationDeposit Accepting Asset Finance Companies

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5.

Corporate Governance and Disclosures RBI has proposed the following changes to enhance corporate governance and disclosure standards of NBFCs: Change in shareholding: NBFCs would be required to seek prior RBI approval for change in control and/or increase of shareholding by 25% or in excess of the paid-up equity capital of the company. Appointment of CEO: RBI approval would be required for appointment of CEO of an NBFC with an asset size in excess of Rs. 10 billion. Disclosure in financial statements: For NBFCs with asset size over Rs. 10 billion, the financial statement would have to include, among other things, disclosures on capital adequacy, Investment and provisions thereon, details of derivative transactions, movement of NPAs and provisions thereon, details of securitisation transactions, ALM profile, exposure to sensitive sectors, and details of single party and group exposures. Enhanced disclosers for NBFCs are a positive.

Some Disadvantages of NBFCs versus Banks

While the RBI is seeking to remove some of the regulatory arbitrage that NBFCs have enjoyed vis--vis banks through the alignment of NPA and provisioning norms, tighter liquidity standards and such other measures, there may be a case for providing NBFCs with some enabling provisions similar to those that the banks enjoy, given that NBFCs are an important source of funds for the self-employed segment. Some such measures would include the following: Access to SARFAESI Act: Although a part of the Usha Thorat committees recommendations, the draft guidelines announced by the RBI have not included provisions granting NBFC access to SARFAESI Act, which has been used effectively by banks to expedite recovery and has also served to improve credit behaviour. Liquidity support: While banks can raise short-term funds from the RBI through the repo window, NBFCs do not enjoy any such benefits. Lower risk weights for some asset classes: The risk weights prescribed for retail assets such as vehicle loans, home loans and gold loans are lower for banks than for NBFCs. While banks balance sheets are more diversified, the credit and market risk on specific asset classes may be similar for both banks and NBFCs.

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