A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 4 - Financial Sector Reforms

Financial Markets - An Assessment of Reforms

Credit Risk, Capitalisation and Efficiency - Development Finance Institutions &
Non-Banking Financial Companies

Development Finance Institutions

Development finance institutions (DFIs) were set up in the country at various points of time starting from the late 1940s to cater to the medium to long-term financing requirements as the capital market in India had not developed sufficiently. The endorsement of planned industrialisation at the national level provided the critical inducement for establishment of DFIs at both all-India and State-levels. In order to perform their role, DFIs were extended funds in the form of Long-Term Operations (LTO) Fund of the Reserve Bank and Government guaranteed bonds, which constituted major sources of their funds. Funds from these sources were not only available at concessional rates, but also on a long-term basis with their maturity ranging from 10-15 years. On the asset side, their operations were marked by near absence of competition.

The Reserve Bank started monitoring the operations of DFIs in 1990 with a view to taking an integrated view of the operations of financial institutions and commercial banks and for providing a more comprehensive basis for the conduct of monetary and credit policies. DFIs were brought within the supervisory jurisdiction of the Board for Financial Supervision from 1994.

The main objectives of reforms in the case of DFIs were to impart market orientation to their operations and strengthen them by applying prudential norms. Following reforms in the financial sector, market borrowing allocations of Government guaranteed bonds were gradually phased out for DFIs. Their access to low cost funds of the Reserve Bank was also discontinued. Prudential norms relating to capital adequacy, income recognition, asset classification and provisioning were prescribed in 1994 and were progressively strengthened.

Notwithstanding withdrawal of two major sources of funds, operations of DFIs were not adversely affected during the early years of the reform, as there were several factors that worked to their advantage. Lending interest rates both for banks and DFIs were deregulated in the early 1990s. However, this was the period when the inflation rate was very high. As a result, interest rates ruled very high. While the marginal cost of funds for DFIs increased sharply, they had the advantage of recycling some of the past concessional borrowings at high rate of interest (DFIs raised funds in the maturity range of 10-15 years but lent on a 5-7 year basis). Taking advantage of flexibility provided to them in the matter of raising and deploying external commercial borrowings, DFIs also raised significant funds from the international market. In view of the booming conditions in the domestic capital market, some of the DFIs could also raise resources successfully both by way of debt and equity at handsome premia. On the asset side, there was a good demand for funds due to acceleration of economic activity in general and industrial sector in particular. This is evident from their sanctions and disbursements, which grew rapidly between 1992-93 and 1997-98.

DFIs also took several steps to reposition themselves and reorient their operations in the competitive environment by offering innovative products and diversifying their activities into new areas of business (such as investment banking, stock broking, custodial services, etc.) so as to harness the synergies and to reduce the risk arising out of narrow specialisation. DFIs were reasonably successful in diversifying into some non-traditional products, especially fee and commission based business. As a result of all these factors, profitability of DFIs, in general, improved significantly between 1993-94 and 1997-98 (Table 6.17). At the same time, DFIs were subjected to income recognition and provisioning norms from the year ended March 1994.

Things, however, started changing for DFIs some time in 1998-99. Interest rates started softening gradually in the second half of the 1990s. The industrial sector also started decelerating from 1996-97. This affected DFIs in the following years in two ways. On the one hand, the main business of DFIs was adversely affected as reflected in the slowdown of their sanctions and disbursements. On the other hand, it affected the asset quality of DFIs adversely as some of the traditional industries to which DFIs had significant exposures were affected badly both due to high cost of funds borrowed in the past and slowdown of the industrial sector. As a result of liberalisation of trade and industrial sectors, competition in the commodity market increased. While some companies were able to cope with the increased competition effectively, some others were not. This also had an adverse effect on the asset quality of DFIs. In a declining interest rate scenario, high cost of funds raised by DFIs in the past became a cause of concern. As a result, some of the DFIs by exercising call option redeemed the long-term bonds long before their final maturity. Competition on the asset side also increased with some banks stepping up their project finance activity. All these factors significantly impinged on the profitability of DFIs. As DFIs have high NPAs, they would be required to provide for them, which is likely to put a further pressure on their profitability. Net interest income and net profits declined sharply in the recent years. In tandem with the decline in interest rates, while the ratio of interest expended to total assets declined in the case of banks, it remained almost stagnant in the case of DFIs. Increase in the cost of funds, on the one hand, and lending at very competitive rates on the other resulted in decline in spread and profitability of DFIs.

While asset quality of DFIs in general deteriorated over the years, some DFIs were affected more than others. Asset impairment of two DFIs, i.e., IFCI and IIBI was significant at above 20 per cent (Table 6.19). Despite decline in profitability and asset quality, DFIs were able to maintain CRAR. However, growing NPAs and declining profitability could also impinge on the capital adequacy of certain DFIs in future.

A comparison of performance of DFIs with SCBs, based on certain operational and prudential indicators shows that the asset quality of DFIs as a group stood significantly lower than that of the commercial banking sector as at end-March 2002. The ratio of spread to total assets for DFIs was also much lower than that of banks. The profitability of DFIs declined in recent years, in contrast with the profitability of SCBs, which showed a considerable improvement (Table 6.18). Thus, on the whole, financial performance of DFIs has been adversely affected in the post-reform period, though they have been able to maintain comfortable capital position.

DFIs were set up with the specific objective of meeting the medium to long-term requirement of funds. However, DFIs in the present form are finding it difficult to sustain their operations. Their business has slowed down and their operations have become less profitable. This has raised issues relating to the viability of DFIs. It is not clear, however, whether the perceived lack of viability emanates from the structural constraints under which they operate or simply from the legacy of the past.

The Narasimham Committee II (1998) had recommended that DFIs should, over a period of time, convert themselves into banks or NBFCs. There would then be only two forms of intermediaries, i.e., banks and NBFCs. The Reserve Bank in the Discussion Paper released in January 1999 indicated that DFIs should have the freedom to retain their status and specialise in their own activities. However, if a DFI chooses to become a bank, that option should also be available. In response to interest evinced by DFIs, the Reserve Bank issued guidelines setting out various operational and regulatory parameters that need to be complied with by DFIs if they are to become banks. ICICI, one of the major DFIs, along with two of its subsidiaries has recently merged with the ICICI Bank. However, to fill the void being created by the disappearance of DFIs, urgent steps are required to be taken to develop the private corporate debt market and introduce appropriate instruments to reduce the risk arising out of long-term financing by other players such as banks.

Non-Banking Financial Companies (NBFCs) in India offer a wide variety of financial services and play an important role in providing credit to the unorganised sector and to small borrowers at the local level. NBFCs are of various types such as equipment leasing companies, hire purchase companies, loan and investment companies etc. In terms of relative importance of various activities financed by NBFCs, hire-purchase finance is the largest activity, accounting for over one-third of their total assets, followed by loans and inter-corporate deposits, equipment leasing and investment. In terms of public deposit taking activities, Residuary Non-Banking Companies (RNBCs), which have certain similarities with banks in terms of their asset composition, hold the largest deposits.

Though NBFCs in India have existed for long, there was a sudden proliferation of such entities between the late 1980s and the mid-1990s. While, on an average basis, deposits of NBFCs as a proportion of bank deposits were 0.8 per cent during 1985-86 to 1989-90, they shot up to 9.5 per cent by 1996-97. This sharp jump in NBFC deposits was mostly on account of the high rates of interest offered on such deposits.

Although NBFCs were regulated by the Reserve Bank, the focus was mainly on the liability side. Given the lack of adequate regulation and supervision mechanism for most types of NBFCs, funds mobilised by many such companies were deployed into unsustainable uses. In 1994, prudential regulations as prescribed for commercial banks were extended to NBFCs. However, keeping in view various systemic issues, the need was felt for further strengthening of the regulatory and supervisory framework for NBFCs. Accordingly, the Reserve Bank (Amendment) Act enacted in 1997 conferred extensive powers on the Reserve Bank for regulation and supervision of NBFCs. Given the immense diversity among NBFCs, norms were strengthened particularly for public deposit taking and systemically important NBFCs. As against the uniform CRAR of 8 per cent across all NBFCs earlier, the CRAR requirement now ranges between 12-15 per cent depending on the principal line of business activity of an NBFC.

Distribution of NBFCs in terms of the level of CRAR maintained by them indicates that compliance with CRAR requirement has generally improved since 1998 (Table 6.20). Apart from capital adequacy ratio, two other ratios, viz. the ratio of public deposits to net owned funds and public deposits to total assets were also examined with a view to assessing the stability of the sector. The public deposits to net owned funds ratio of NBFCs declined considerably between 1998 and 1999 and has remained generally stable since then. The public deposits to assets ratio, on the other hand, declined continuously from 1998.

Information regarding the extent of NPAs in the NBFC sector was not available on a consistent basis. However, according to the limited information available, the asset quality of NBFCs deteriorated in the late 1990s. This was evident from supervisory returns submitted by around 50 NBFCs, according to which the NPAs of such entities as proportion of total assets, which were 7.1 per cent as at end-September 1998, increased to 9.3 per cent as at end-March 1999.

Consolidated information on financial performance of NBFCs was available for only three years and, therefore, it was difficult to draw any firm conclusion about the impact of the reform measures. There are, however, indications that the reform process has not as yet resulted in any noticeable improvement in the operational efficiency of NBFCs. In fact, profitability position showed some signs of deterioration in recent years.

In recent years, operations of NBFCs witnessed significant changes especially on the liability side. With the tightening of regulations, many of the NBFCs with insufficient capital base have been weeded out. This combined with the tightening of regulations for raising deposits resulted in reduction in size of this sector. Although the definition of public deposits of NBFCs has been revised and no strict comparison is possible between deposits of NBFCs before and after 1998, there are clear indications of a sharp decline in the relative importance of NBFC deposits. The ratio of NBFC deposits to total bank deposits declined from the peak of 9.5 per cent in 1996-97 to 1.1 per cent in 2000-01. Public deposits of NBFCs including RNBCs as at end-March 1998 were just 19 per cent of the total deposits and 45 per cent of the regulated deposits of NBFCs as at end-March 1997.

It is significant to note that between 1988-89 and 2000-01, considerable changes were noticed in the share of different types of NBFCs in total public deposits held by them. While the shares of RNBCs and hire purchase finance companies increased significantly, those of loan and investment companies fell sharply. RNBCs were the only category of NBFCs whose public deposit increased in absolute terms between 1998 and 2001. As on March 31, 2001, RNBCs accounted for over 30 per cent of the assets and nearly two-thirds of the public deposits of the NBFC sector, while their net owned fund was negative. RNBCs have important systemic implications, given their large size.

The decline in deposits of NBFCs in the recent years, however, was not captured by the banking sector in a significant way. This was evident from the average annual growth rate of bank deposits, which after the tightening of norms for NBFCs (i.e., 1998-2001) increased only marginally in comparison with the period prior to the introduction of such norms.

The decline in the deposits of NBFCs should not be a matter of concern as in several other countries public deposit is generally not a significant source of funding for NBFCs. As the share of deposits declined, other sources of funds, especially borrowing from banks, market borrowings, borrowings from the Government and inter-corporate borrowings emerged as major sources of funding for NBFCs. As a result of changes in the financing pattern of NBFCs, their cost of funds also increased. High cost of funds could induce NBFCs into excessive risk-taking and may, thereby, result in adverse selection. Deposit insurance, as has been suggested in some quarters, may reduce the risk premium demanded by depositors and may, therefore, reduce some cost of funds for these companies. However, the extension of deposit insurance to NBFCs could create a serious moral hazard problem that might be difficult to tackle.

While NBFCs may not have much control over the cost of funds, they can improve their profitability by operating more efficiently. The operating cost of NBFCs as a group increased in the recent years as indicated earlier. In fact, their operating cost stood much higher than that of even co-operative banks. Therefore, NBFCs need to make concerted efforts to reduce their high operating expenses.

As NBFCs provide important services in certain niche areas of the financial sector, improvement in the efficiency of these entities is of crucial importance. The Reserve Bank continues to pursue with various State Governments the case for enacting legislation for protection of interest of depositors in financial establishments. Creating public awareness about activities and risk-profile of NBFCs is yet another important area, which needs to be focussed upon even as an extensive publicity campaign has already been taken up using the print and electronic media to educate the depositors. Improvement in corporate governance practices and financial disclosures by NBFCs also need to be focused upon in future.