Those who are closely following the fortunes of the NBFC industry however see a positive outcome of these events. They feel that the bureaucrats in the RBI, the Finance ministry and the finance minister himself will now be in a better position to appreciate their plight following the RBI guidelines of January-98 which virtually passed a death sentence on the NBFC industry. One of the key recommendations in the guidelines was the linking of the Credit Rating of an NBFC to its Deposit acceptance limit. The situation emerging out of this strange decision is similar to that of an investment fund, which is forced, to disinvest Indian stocks because of the Moody’s down gradation. The difference is that in the case of NBFCs they are expected to voluntarily reduce their Deposits by a substantial amount if the Credit Rating agency official decides to downgrade the credit rating. In other words, they are expected to commit suicide because of the decision of the Credit Rating agency, which is more often based on the report of a wiz-kid from one of the IIMs who was not even born when the subject company started its business.

Let us now briefly analyze whether the RBI guidelines were at all necessary and why it is considered detrimental to the industry.

The attention of the regulatory bodies to the NBFC industry was first drawn in 1996 when the Non Banking Firms (NBFF) collapsed. These firms were raising public deposits and deploying them in high-risk ventures such as real estate. They were partnership entities and were not governed by the company laws. They offered high rates of interest and were conspicuous by their high pressure advertising. Except the similarities in names, these firms had nothing in common with the NBFC s on which we are focussing our attention today and who provide hire-purchase or lease finance for acquisition of business assets. But un- informed investors, bureaucrats as well as journalists could not differentiate the risk profiles in these two segments and carried a wrong image of the NBFC s.

Knowledgeable and conservative investors were however always aware of the risks in NBFF business and were content with their investments in NBFC s. Those who have lost money by investing in NBFF s were the greedy lot who would continue to lose money irrespective of the regulatory framework.

In a bid to save these speculators, the regulations are now threatening the very existence of NBFC s who are doing a useful service to the society. They have been mobilizing savings from the community and deploying them into productive ventures even in semi urban and rural areas. They are generating investment opportunities to the investors and also assisting in the sale of Trucks, Cars, Two wheelers, white goods etc. With the scaling down of the operations of such companies, the Truck segment is already inching towards sickness. Ashok Leyland was recently forced to shut down its factory and Telco announced a steep fall in their profits. Soon other industries would start feeling the pinch of the vacuum in Credit availability due to the closure of NBFC s. The services rendered by the 30,000 NBFC s scattered all over the country cannot be replaced by either Banks or a handful of large NBFCs. In due course, this would increase the cost of borrowing to the consumers even in cities where the MNC s may setup shops to finance their own international brands of Cars or White goods.

When CRB capital markets failed, RBI was perhaps reminded of the Security scam and reacted with undue harshness on the NBFC industry. Instead of identifying and eliminating the reasons for CRB failure, it focussed it’s attention on shifting responsibility to Credit Rating agencies to guard itself against criticism for any other NBFC failure. It was evident that the main reason for CRB failure was that it’s assets were mostly in the form of equity investments acquired through it’s Merchant Banking and underwriting activities which depreciated heavily after the stock market recession. This kind of business ought to have been supported through equity and not Deposits. It was unfortunate that the company had raised Deposits to finance its activities and the RBI, SEBI, and the Credit Rating agencies had all abetted the crime. Until SEBI made the cardinal error of prescribing the networth criteria for Merchant Bank licensing , the Merchant Banking activity was run as a skill based business and the Merchant Banking companies did not access public deposits. Deposits were accessed only by the Hire purchase and Leasing companies who invested the depositor’s money in business assets. The networth criteria introduced by SEBI for merchant banking removed this vital distinction between these two types of companies. (The rules have now been changed to keep the two activities separate) This encouraged the Asset based Finance companies to diversify into Merchant Banking and vice versa. This lead to CRB type of pure merchant Banking companies raising Deposits and investing the funds in risky assets such as promoter’s equity, eventually damaging the reputation of the industry itself. The Credit rating agencies in fact provided a false sense of security to the Depositors and eventually contributed to higher losses. We cannot forget that CRB did have a satisfactory Credit rating until it finally started defaulting. So also was ITC Classic.

We may therefore conclude that the causes for CRB failure were nothing to do with the industry in general and particularly the companies, which were in asset based financing business. RBI was also wrong to conclude that the Depositors interests would be protected by regulations and more so through the Credit rating system.

The present trend in the RBI thinking appears to be to let NBFC s do business only if they can do so without resorting to Deposits from the public. This again betrays a lack of understanding of the business. In fact Deposits are the right instruments for NBFC s in view of the nature of their revenue generation which is steady and fixed. The only uncertainty in revenue comes out of the delayed recovery of loans if any. Such defaults and bad debts are inevitable but may normally affect less than 10 % of the revenue flow. If the revenue loss arising out of such delayed recoveries are adequately provided out of the profits, the borrowing NBFCs can easily service their deposits to any extent.

Additionally the NBFC business cannot have spectacular earnings and hence is not very attractive for equity investors. Considering the present cost of funds of around 18 % p. a. and the average return on advances of around 26 % p. a., no NBFC can provide an adequate dividend return of say 25 % to its share holders (at a healthy pay out ratio of 1:2), unless they are geared to the extent of 15: 1. Only companies who are able to earn around 30 % p. a. on their advances can survive at a lesser level of borrowing. Since the Financial Institutions insist on a debt equity ratio of only about 6:1, it is impossible for NBFC s to have viable business without resorting to Deposit mobilization. In fact, if a higher gearing is allowed, the cost of lending can be brought down significantly and benefit the end users of funds.

Considering the critical role played by NBFC s in the economy we hope that the government will wake up before it is too late and initiate some pragmatic steps to revive the industry.

Some of the steps that are urgently required are,

A revival of NBFC industry would also be very much welcome by the Depositor community who knows that NBFC deposits could be safe and rewarding if properly handled. The finance minister should also remember the solemn promise made by BJP in their election manifesto, which clearly recognized the possible influence of vested interests in hurriedly pushing through the legislation just before the previous elections. Otherwise he may have to face the prospect of being accused of "selective amnesia".

Na.Vijayashankar

(naavi@iname.com)