NBFC

Borrowing Costs of Indian NBFCs to Stay Elevated in 2025

The global credit rating agency Fitch has made a forecast in its recent report that borrowing costs for Indian Non-Banking Financial Companies (NBFCs) are expected to remain high through 2025. The prediction arrived at a time when the Indian Financial Sector is witnessing mixed signals regarding interest and lending trends meaning there is both some sign of improvement concerning interest rates as well as lending action.

It is expected from RBI that it will cut its key policy rates. However, the cuts on the borrowing costs of NBFCs will not have much effect and will be limited. The pressure on profitability will continue to bother NBFC due to high borrowing costs. The report further projects that NBFC will be able to continue/ maintain profitability with strong loan growth and disciplined credit management.   

Understanding the Borrowing Cost Structure for NBFCs

To understand why borrowing costs for NBFCs are expected to stay high, it is first important to look at the dynamics of the Indian financial sector. Certain factors like interest rates set by the RBI, lending policies of domestic banks, and liquidity in the financial system influence the borrowing costs for NBFCs. RBI easing the monetary policy by cutting interest rates might not necessarily indicate the borrowing costs for NBFCs would go down.

When the pressure on banks increases due to strict regulations, it makes the banks more cautious and selective while lending to NBFCs. This concerns about managing risk and meeting their regulatory requirements.

Slowdown in Bank Lending to NBFCs

One major concern highlighted in the report of Fitch is the slowdown in the pace of bank lending to NBFCs. As of August 2024, the year-on-year credit growth extended by domestic banks to NBFCs had significantly dropped, from a height of 32% in 2023 to just 14%.

There are several reasons that have attributed to this slowdown in lending. The reduced surplus liquidity in the banking system initially forced banks to be more selective in their lending practices. Another reason is the increased risk weights by RBI on loans to financial leasing companies (FLCs) from 2023 onwards. This regulatory shift made it expensive for banks to lend to such entities contributing to an overall drop in credit flow to NBFCs. 

Impact of Regulatory Measures

The strict regulations imposed by the RBI make the condition further challenging for the NBFCs.  Increased risk weights and stricter lending guidelines for credit access have made banks cautious when providing credit to NBFCs, particularly those involved in financial leasing.  Such regulatory implementation prevents the financial system from being overly dependent on banks for credit provision. These measures being a part of the RBI’s broader strategy enhance financial stability.

Fitch specifies that despite the challenges, Financial Leasing Companies (FLCS)will still be able to borrow money but at a higher price. They might not rely solely on local banks but have to turn towards domestic capital markets (where money is raised within the country, like issuing bonds) or international funding sources (like borrowing from global financial markets). The borrowing rates of this source would be lower than those charged by local banks.

The shift in funding sources will help reduce their debt by easing pressure on leverage ratios compared to their equity (ownership). Currently, the average debt-to-equity ratio for Fitch-monitored NBFCs is around 4.4 times, but as loan growth slows down, this pressure on leverage is expected to ease. As loan growth slows down, the leverage of NBFCs is expected to stabilize, reducing the risk of excessive debt accumulation, which is a good thing for their financial stability.

Strong Loan Growth to Support Profitability

The strong growth in loans would be one factor to boost for NBFC to stay resilient in the high borrowing cost. Despite the slowdown in credit from domestic banks, NBFCs continue to see robust when it comes to demand for loans, particularly in the retail segment. Personal loans, vehicle loans, and housing loans have contributed to the profitability of NBFCs in recent years due to their growth.

Observing Fitch’s report indicates that even if the lending to NBFC has declined affecting its overall growth, the sector would yet continue to maintain strong loan volumes. Demand from the middle class who are increasingly being financially included and an improving economic environment will continue to fuel demand for loans across India. Such moderation in growth rates will still not suffice to soften demand, so non-banking financial companies should continue profiting.

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Asset Quality Challenges

While the overall outlook for NBFCs remains positive, it gives some special indications of possible risks such as asset quality risk. Certain parts of the NBFC market like unsecured personal loans, and microfinance have shown some early signs of weakness concerning asset quality. There has been an increase in defaults, and credit risk associated with these loans has grown concern over time.  

As per Fitch’s opinion, the deterioration in asset quality will remain to be manageable. One of the key factors contributing to this will be the improved risk management and recovery practices adopted by NBFCs in recent years.  Many of the NBFCs have tightened their credit policies since mid-2024 by disallowing higher-risk borrowers to access loans from them.

The tightened credit standards are expected to cure the asset quality of segments like unsecured personal loans and microfinance within the next year. It is likely also to control emerging issues concerning asset quality, the RBI’s increased scrutiny of the sector and the risk weights on certain types of loans have contributed to NBFCs adopting a more reticent approach toward high-risk borrowers. Thus, the asset quality of NBFCs is expected to stabilize, and the risk of defaults should remain under control.

Role of Capital Markets and Offshore Funding

With the growth of bank lending, NBFCs have slowed down. Therefore, those businesses had no choice but to turn to capital markets and offshore funding sources to raise capital. However, this is expected to relieve some pressure off borrowing costs.

The pricing of funds in the capital markets and from international sources is becoming attractive and competitive compared to domestic bank loans, which have higher interest rates due to the regulatory measures in place. According to Fitch, this trend will enable the NBFC to manage its overall leverage ratios by reducing the strain from sky-high borrowing costs.

By tapping into capital markets and international funding sources, NBFCs can access funds at more favourable rates, which should help them maintain their operations and continue to lend to their customers.

Future Outlook for the NBFC Sector

Looking forward, Fitch has also predicted that the NBFC sector in India will continue to face challenges related to borrowing costs and asset quality. Fitch believes the overall economy will remain active, providing lending opportunities, although the growth rate of the Indian economy is expected to moderate slightly from 8.2% in FY24. However, the overall outlook will remain stable due to several factors. Strong loan growth, improved credit risk management practices, and the availability of alternative funding sources will help NBFCs navigate the high borrowing cost environment.

Keeping aside the challenges, the Indian economy is expected to continue to remain relatively strong and is expected to support further continued demand for credit. The efforts by the RBI will also help in efficiently managing inflation and maintaining financial stability playing a crucial role in supporting the overall financial system of India. However, the pace of economic growth is expected to moderate slightly in 2025, which could affect the demand for loans in the medium term.

In a Nutshell

According to Fitch’s prediction borrowing costs for Indian non-banking financial companies (NBFCs) are expected to remain elevated till 2025. RBI easing the monetary policy by cutting interest rates might not necessarily indicate the borrowing costs for NBFCs would go down but better management of risk, and access to alternate funding sources will help these companies maintain profitability.

Regulatory measures that aim to strengthen the financial system are also likely to contain asset quality problems but might have to face some short-term challenges. This cannot pass without a few near-term bumps. Altogether, the NBFC sector is placed safely to withstand all these challenges, but it will have to learn to live and adapt to rather cautious lending practices and higher borrowing costs in the years to come. 

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