NBFC

Middle-Layer NBFCs Hold Largest Slice of Unsecured Loans Pie

The emergence of NBFCs has become pivotal in the Indian financial ecosystem, particularly where traditional banking channels fall short. From lending and leasing to asset management and investment solutions, these diverse groups of financial institutions provide everything, and a wide array of financial services are made available.

However, one area in which NBFCs have seen significant growth and risk exposure is unsecured lending, particularly among the middle-layer NBFCs. According to recent data from RBI, these middle-layer NBFCs now account for the largest share of unsecured loans, with more shares surpassing other tiers in the NBFC hierarchy.

This development is relevant in light of the changing regulatory environment, emerging market dynamics, and evolving consumer demand. The fact that NBFCs have dominated unsecured loans explains their importance in a diversified Indian financial system, especially when scrutiny by the RBI and investors has increased.

This blog will discuss why middle-layer NBFCs dominate unsecured loans, the implications of this trend, and how it fits into the broader narrative of India’s financial sector.

A Brief Outlook on the Structure of NBFCs

The data on unsecured loans becomes particularly important in the context of the NBFC structure in India. In January 2021, the Reserve Bank of India introduced a four-tiered structure for NBFCs based on size, risk profile, and systemic importance. The new regime includes the following:

• Base Layer (BL): Small-scale NBFCs are included in the Base Layer and have low systemic risks. It will predominantly operate in niche markets.
• Middle Layer (ML): These NBFCs are slightly larger, have more diversified customers, and take moderate risks in operations.
• Upper Layer (UL): This layer represents those firms that are systemically important and generally larger and, hence, face greater regulatory scrutiny because of their possible implications for the financial system.
• Top Layer (TL): These NBFCs are classified as the highest risk and attract extreme regulatory measures. So far, this layer has only been conceptual and would kick in whenever companies cross certain risk thresholds.

About Unsecured Loans in Brief

Unsecured loans are credit facilities that do not require the borrower to pledge any collateral. Since these loans are not backed up with physical assets, for example, real estate or vehicles, they are riskier for lenders. As a result, unsecured loans bear higher interest rates than secured loans of comparable size and maturity.

In India, unsecured loans could be personal, business, or credit card debts. These types of loans attract borrowers with quick disbursement, flexible terms, and collateral not required against the loan amount. However, these loans have higher chances of default, especially during economic uncertainty.

Unsecured loans have emerged as an attractive market for NBFCs because of growing demand from individuals and small businesses with limited credit access from formal banks. Without collateral support, such loans become unsafe, attracting more stringent regulator norms on managing them.

Middle-Layer NBFCs – Dominating the Unsecured Loan Market

As per RBI’s September 2024 bulletin, middle-layer NBFCs accounted for the largest share of unsecured loans, 27.3%, by the end of December 2023. Upper-layer NBFCs followed this at 24.3%.

Although the percentage decreased from 31.7% to 22.9%, respectively, in December 2022, middle-layer NBFCs remain the top contenders in unsecured lending. There are a number of reasons for this dominance, and some of these are as follows:

· Customer Reach and Flexibility

The middle-layer NBFCs generally operate in segments where the presence of traditional banks is relatively sparse. Most of their customers are individuals or small businesses not adequately served by formal banking channels owing to a lack of credit history or collateral.

These NBFCs have thus been able to offer unsecured loan products with customer-friendly terms and increased flexibility for customer segments with unique needs of this customer base. It provides flexible loan terms along with faster processing speed.

Personal loans and microfinance products supplied by middle-layer NBFCs have been very important to people in rural and semi-urban areas who need small loans for personal or business use. Small and medium-scale enterprises, usually called SMEs, often depend on these NBFCs to finance their working capital needs when SMEs do not maintain assets to offer as security against loans.

· Better Risk Appetite

Middle-layer NBFCs have more risk appetite than the NBFCs in the upper layer. Even though upper-layer NBFCs are larger, systemically important, and more tightly regulated than middle-layer NBFCs, the latter enjoy more flexibility in extending credit to even the riskier segments of the market. This has helped them capture a larger share of the unsecured loan pie.

This naturally comes with a greater appetite for risk, which can lead to issues of recoveries and defaults. To mitigate these risks, technology-driven credit assessment models, which leverage data analytics to understand borrowers’ creditworthiness better, have been adopted by many more middle-layer NBFCs lately.

· Regulatory Developments

The regulatory environment has shaped unsecured lending among NBFCs. In November 2023, the RBI raised the risk weighting on unsecured credit by 25%, effectively raising the cost of holding such loans on NBFCs’ balance sheets. While this was done to protect against excessive risk-taking, it has led to recalibration in the strategies of middle-layer and upper-layer NBFCs.

Despite this regulatory tightening, middle-layer NBFCs have maintained their lead in unsecured loans. Quick adaptation to these new regulations and portfolio re-alignment have helped them continue serving high-demand markets without significantly reducing their exposure to unsecured loans.

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Effect of Regulatory Changes on Unsecured Lending

The increased risk weight on unsecured loans reflects the RBI’s growing concern over the systemic risks of such lending. By increasing the capital requirement for these loans, the RBI wants to ensure that NBFCs are better equipped to absorb potential losses, particularly during economic stress.

This regulatory shift has brought about strategic reassessment for middle-layer NBFCs. Many companies have started to focus on strengthening their credit underwriting processes by adopting technology to perform better risk assessments.

This becomes more important in unsecured lending, where the absence of any collateral means the full extent of any default flows to the lender. The shift is reflected in the reduced share of unsecured loans from December 2022 to December 2023.

Middle-layer NBFCs have been quite cautious in extending unsecured credit, as reflected in their fall from 31.7% to 27.3%. However, their leading position in the market suggests that the companies remain committed to unsecured lending, though with a more measured approach.

Challenges and the Opportunities Ahead

Middle-layer NBFCs are very important for unsecured lending but face various challenges. Firstly, there is a risk of defaults, particularly in this turbulent economic phase. The rise of interest rates and the build-up pressure due to inflation may lead many borrowers into dire situations to return unsecured loans, increasing Non-Performing Assets (NPAs).

To mitigate this risk, the middle-layer NBFCs must invest more in robust risk management frameworks and leverage data analytics to predict defaults better and mitigate credit risk. Meanwhile, there is an emerging push toward opening their online platforms for expanded digital offerings in pursuit of more customers.

The stringent regulatory oversight would provide an opportunity to differentiate between middle-layer NBFCs based on the quality of their risk management practices. Those who could achieve the right balance between growth and prudence would emerge as leaders in the unsecured lending market.

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To Wrap Up

Middle-layer NBFCs dominate India’s unsecured lending sector. This highlights the importance of their role in bridging the gap between traditional banking and unserved customers. Despite changes in the regulatory framework and changing market conditions, these NBFCs continued to carve out a large share of the unsecured loan pie with flexible, fast, and customer-friendly financial solutions.

However, middle-layer NBFCs must be strategic about credit risk management as the risks associated with unsecured lending become more pronounced.

This can be done by adopting technology, enhancing their credit assessment capabilities, and adhering to evolving regulatory guidelines so that such institutions can thrive in a rapidly changing financial landscape. The role of NBFCs will remain critical in the growing and evolving financial inclusion narrative of the Indian economy. It would be quite a challenge for middle-layer NBFCs to keep their risk exposure in check while meeting the diversified needs of their customers.

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