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The Indian financial market is significantly impacted by Non-Banking Financial Companies (NBFCs). Non-Banking Financial Companies and banks are both regulated by the Reserve Bank of India, but there are some key differences in how they are treated in terms of regulation. NBFCs are given more freedom in terms of governance and operational issues, regardless of priority sector targets and statutory reserve requirements. However, there are also legal limitations on the selection of services and funding options that NBFCs may provide.
An organisation’s credit rating serves as an indicator of its capacity to repay the loans. Agencies issue these ratings after taking into account each entity’s annual income, total debt, and anticipated future profitability. In this blog, we’ll discuss the credit rating of NBFCs, their core parameter and the work of credit rating agencies.
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Credit rating is a calculation of the borrower’s ability to repay the loan on time and in accordance with the loan agreement made by a recognised credit rating agency of the borrower. Investors and lenders look at the credit rating of entities to determine their loan repayment capability. A company’s capacity to repay the loans on time and a sound repayment history are both indicated by a positive credit rating. On the other hand, a borrower with a fair or low credit rating indicates to the lenders that they might not be able to complete their payments on time.
Rating agencies consider core elements like asset quality, capitalisation, and earnings to be the primary factors determining a finance company’s credit risk profile. The interaction of these factors influences the NBFC/HFC’s capacity to assess, value, and manage its risks, as well as its ability to keep sufficient capital to absorb losses during challenging periods and to ensure profitable growth. The evaluation of these key characteristics will often serve as the foundation for the financial company’s standalone rating.
Instead of just assessing assets and debt levels as of a specific date, the ratings are established on a “going concern basis”. Some of India’s top credit rating agencies are CRISIL, ICRA, CARE Limited, and others. They follow certain procedures to examine an NBFC’s management, operations, and other aspects. Additionally, not all NBFCs are treated equally when it comes to these criteria. Every NBFC is unique, and the weighting of each indicator varies depending on its performance and other factors.
A well-established NBFC, for instance, might be performing well in the capital adequacy criterion (a required reserve that every financial institution must have). However, because it has only recently begun operations, a newly established NBFC will not have enough data to be rated on its performance or capital sufficiency.
Let’s look at the seven criteria that rating agencies use to determine what constitutes an NBFC while keeping certain crucial considerations in mind.
Assets are divided into standard, sub-standard, questionable, and loss categories by rating agencies. In order to better understand its operation, the recovery history of the suspect and lost assets is also carefully examined.
When evaluating Non-Banking financial companies, one of the most essential factors is asset quality. The asset class in which an NBFC operates affects asset quality. NBFCs are in the business of taking on credit risk and making a profit after accounting for the anticipated level of credit charges. These credit costs are factored into the pricing of loans in that market based on the characteristics of the asset class. Through effective risk management, collection, and recovery frameworks, NBFCs work to keep credit costs under control and within expected levels. The amount of delinquencies found in the loan portfolio has the biggest impact on credit expenses.
A worsening of the loan portfolio’s delinquencies not only reduces profitability through higher credit costs but also puts strain on the capital cushion available to absorb losses and may result in limited market access, which can have a negative impact on the chances for growth.
This qualitative criterion assesses the management’s competence and the effectiveness of the governance framework. This dimension includes things like expectations from stakeholders, efficient management rules and procedures, etc. The grading organisation evaluates the degree of governance and leadership here.
A strong promoter and a strategic fit with the parent can help NBFCs earnings, liquidity, capitalisation and credit profile. It suggests that ownership structure could significantly impact an NBFCs credit profile.
The liquidity of Non-Banking Financial Companies must be sufficient to pay debt obligations. The debt commitments and funding efforts should not be disregarded. Rating agencies emphasise that Non-Banking Financial Companies should keep a healthy level of liquidity for efficient operations.
For the efficient operation of its funding activities, an NBFC must maintain a healthy liquidity profile. It must also timely honour its loan obligations. In order to maintain future profitability, an NBFC must also effectively manage interest rate risk. The rating agencies will consider the company’s liquid policy, the maturity gaps, and the backups available to close such gaps and satisfy future disbursement needs when evaluating an NBFC’s liquidity profile. The quality and diversity of the NBFCs funding sources are also major considerations for evaluation.
There are two sorts of risks involved:
a. Business risk – It includes management’s failure to turn the enterprise into a profitable one.
b. Financial risk – This risk arises when a company cannot meet its financial obligations and presents a poor financial situation to its stakeholders.
The relative value of each of these characteristics might vary between organisations depending on their capacity to alter the overall risk profile of the company in question. However, agencies use several parameters to evaluate an NBFC’s business and financial risks.
To ensure that the organisation operates on a “going concern basis,” the operating environment takes into account the growth of NBFCs and the quality of asset categories. An NBFC’s operational environment has a substantial impact on its credit rating because it can significantly affect its growth prospects and asset quality. Rating agencies will consider the regulatory environment, industry prospects relating to the asset class being financed, and general economic conditions when evaluating the operational environment.
An important component of the rating parameter is profitability. Agencies search for successful Non-Banking Financial Companies with the potential to earn more money but who are not as well-established. By separating the company’s income into fee-based and fund-based activities, rating agencies assess the income composition of the business. Additionally, core earnings are revealed by subtracting nonrecurring income from the total income. Risks are evaluated along with the potential for earnings growth and each company’s sector contribution to the core earnings. The interest yields are compared to the asset class and type of operations to see if they are appropriate.
For Non-Banking Financial Companies to continue to operate as a going concern and to produce internal capital that can be used for future growth, profitable operations are necessary.
According to this criterion, the authorities determine if an NBFC has enough assets to cover any losses. A high capital adequacy ratio indicates that the corporation is better able to handle failures and safeguard the interests of debt holders.
The capital of an NBFC offers a level of protection to debt holders’ earnings. Therefore, its sufficiency is crucial for ratings. The riskiness of the product and the level of detail in the portfolio have a big impact on how much capital is needed to safeguard debt holders of an NBFC to the desired extent.
Before assigning a rating to a specific entity, CRAs consider a number of factors, including their financial statements, type and level of debt, lending and borrowing history, ability to repay debt, past credit repayment behaviour, etc. These credit rating agencies offer additional information in addition to an entity’s credit rating to assist lenders, investors, and financial institutions in their analysis and decision-making.
An entity may be able to obtain credit more quickly and at a high rate of interest if it has a good or high credit rating, which signals greater creditworthiness and a reduced risk of default for the lenders. The credit ratings that are given to businesses also act as a standard for rules governing the financial sector.
Credit rating helps investors make a decision because they take into account a variety of qualitative and quantitative factors. But if you consider only credit rating when making choices, you won’t achieve the goal of return optimisation. Therefore, the greatest investment approach would be to place your money in assets that meet your level of risk tolerance so that you can generate future returns, so think wisely before investing.
Read our Article: Capital adequacy norms for NBFCs in India
I am a driven and meticulous professional who completed B.Com BL (Hons) from Tamil Nadu Dr. Ambedkar Law University and completed Master of Laws in specialization (Criminal Law with Cyber Crimes). I have extensive experience in Criminal Litigation and want to utilise my legal knowledge in writing also I have proficiency in writing legitimate content with comprehensive research. My core areas of interest are Business Law, Intellectual Property Rights, and Cyber crimes.
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