Risk Management Framework for NBFCs

Swetha Dhinesh

15 May, 2023

In India, the SEBI and the Reserve Bank of India^[1] both regulate NBFCs. They are essential to the financial industry. They assist with the loan process. By meeting the varied lending needs of various economic sectors, NBFCs play a significant role in the Indian financial system. They are important in the financial system due to their capacity to offer specialised financial products and services catered to the unique requirements of various societal groups. An NBFC functioning in the financial industry is subject to inherent risks. Over time, the NBFC industry has changed significantly in terms of its operations, size, technical complexity, and expansion into additional markets for financial services and goods. In this blog, we will examine the risk management framework for the NBFCs

Non-Banking Financial Companies

According to the RBI, a non-banking financial company is one that is registered under the Companies Act of 1956. Obtaining loans and credit facilities, purchasing bonds, stocks, or shares, leasing property, financing assets, offering insurance, exchanging currencies, running hedge funds, participating in chit trades, etc., are all examples of activities that a non-banking financial company engages in. 

Risk Management

The identification, evaluation, and reaction to risk elements that occur in the company are inherent in the operation of a business, and they are all included in risk management. Effective risk management is acting proactively rather than reactively in an effort to influence the business’s future events as much as feasible. As a result, sound management in risk can potentially reduce the likelihood of a risk happening and its possible consequences.

Major Risk Factors of NBFCs

Beyond being successful in the financial sector, NBFCs face challenges in the form of risk. Some of the major risk factors faced by NBFCs in their day-to-day activities are given below. The major risk factors faced by NBFCs are:

Credit Risk 

• A credit risk is the risk of default on a debt that may arise from a borrower failing to make required payments. Due to certain things, legal actions taken by defaulting borrowers and security providers, a stagnant market for collateral, or a decline in market value, the company and its subsidiaries may not be able to realise the full value of its collateral or may experience a delay in realising such value.
• The company may suffer a loss if the expected value of the collateral security is not realised. Any such losses can have a negative impact on the company’s financial situation and operational outcomes. 
• The company is subject to credit risk for any loan activity as a result of counterparty and borrower repayment default. Despite the greatest efforts, there can be no guarantee that a repayment failure won’t happen; in such a case, it might have an impact on the company’s operational results. 

Liquidity Risk 

• Liquidity risk is the possibility that there won’t be enough money on hand to cover an obligation when it is due. A lack of cash to cover a due liability is known as liquidity risk. For instance, I am in good financial shape and can easily meet my long-term and short-term responsibilities. How skillfully I manage my resources to meet my debt obligations is a major factor.

• The biggest factor in a mismatch between assets and liabilities is the differing maturities between assets and liabilities. Liquidity management is a significant risk for any financial institution since, in the event that counterparties who provided short-term funding demanded repayment, the NBFC would be unable to do so because all of its capital would be locked up in long-term loans.

Market Risk 

• Risk of loss due to price movements in any market the institution is trading in, such as currency, stocks, bonds, commodities etc. Market Risk threats to our long-term competitive advantage that results from decisions we make about markets, resources, and delivery methods. 
• Risks associated with our industry’s fundamental characteristics, such as its competitive landscape, technical environment, degree of connectivity to the economy, and regulatory framework, are considered market risks.

Operational Risk 

• Operational risk is the risk of loss as a result of errors, breaches, interruptions or damages, either intentional or accidental, caused by individuals, internal processes, systems, or external events.
• ORM is inherent in human ability, technological inefficiency, and systemic flaws that don’t show up right away and can’t be measured. They progressively reduce the organisation’s effectiveness, and only when significant harm has been done do stakeholders start to pay notice.

Risk management in NBFCs

The execution of risk-management techniques in the sector to guarantee that the business models remain viable, sufficiently ring-fenced, and sustainable continues to be difficult against the background of an obvious expansion in the scope of operations and growing regulatory rigour. Asset quality standards will highlight any weaknesses in the framework’s credit risk management. In contrast, risk-adjusted yields on investments, treasury earnings, and “mark to market” commitments can highlight market risk management issues. Here are the tips to mitigate certain levels of risk that NBFCs are facing:

• Any operational risk management (OPM) slackness within the company cannot be brought to light immediately, which causes its difficulty to build up. Appropriate OPM strategies should cover the entire entity from bottom to top and vice versa. 
• As the best defence and to be able to de-risk the company in the long run, NBFCs should be able to establish strict standard operating procedures. Additionally, standardising operational risk management practises and obtaining certification might assist in reducing hazards.
• The sustainability of the organisations may be threatened if operational risks are not controlled. Beyond being successful in expanding their businesses, NBFCs face a challenging task in controlling operational risk. A sound risk prioritisation strategy can help businesses thrive in the thriving economy that is about to emerge in the coming years.
• To avoid market risk, management has to periodically evaluate its business model, taking into account the regions in which it plans to operate. They have to stay competitive and adjust their markets as needed, and management regularly analyses how its peers in the industry stack up against one another.

• The risk that a borrower won’t fulfil his obligations, such as failing to repay the loan, etc. The risk of default due to non-payment of any contractual obligation on the part of the borrower can be tackled with prior assessment. 

• NBFCs are at a higher risk of default than Banks because they are exposed to non-traditional segments and riskier segments, which increases the likelihood of NPAs and raises the question of whether they will recover their investment. Effective and detailed KYC and credit appraisal systems will be the best solution.

• Credit assessment with robust risk controls enables an institution to evaluate risks and ensure adherence to stringent standards of governance and regulatory requirements.
• Inadequacies can be found and rectified before they develop into crises if efficient risk management models and risk management methods are implemented in the NBFC Sector.

Conclusion 

Our current era of banking, which began with nationalised banks, is marked by NBFC’s growth and success. NBFC is part of the banking revolution that happened. And NBFCs are currently responsible for the last mile of financial service distribution. The RBI and the Ministry of Finance periodically announced different initiatives to help borrowers and institutions get through this unprecedented and difficult period. But, it is the responsibility of every institution to take prior steps to mitigate the risk they are anticipated to face in the business. 

Read our Article: Capital adequacy norms for NBFCs in India