Small NBFCs could Witness Sharp Increase in Funding Costs

Kiran Malik

01 Jun, 2024

In recent times, the financial industry has undergone significant changes and reforms, especially with respect to the funding costs of Non-Banking Financial Companies (NBFCs). The Reserve Bank of India (RBI) has implemented a number of policies to improve the transparency and accountability of the sector, including the introduction of the Liquidity Coverage Ratio (LCR), and guidelines for the adoption of Ind AS accounting standards. However, these measures have also resulted in some unintended consequences, particularly for small NBFCs.

Small NBFCs are those that have a total asset size of less than Rs. 500 cr. unlike larger NBFCs, which have access to a wide range of funding sources, including bank loans, commercial paper, and bonds, small NBFCs typically rely on a few sources of funding, such as loans from banks and financial institutions, and funding from private investors. As a result, they are particularly vulnerable to fluctuations in funding costs.

Drivers of funding costs for NBFCs

• One of the key drivers of funding costs for NBFCs is the cost of borrowing from banks. Following the liquidity crisis in the NBFC sector in 2018, banks have become more cautious about lending to NBFCs, particularly smaller ones. This has resulted in a sharp increase in the cost of borrowing for small NBFCs, as banks have increased the interest rates on loans, and tightened their lending criteria.
• In addition to the cost of borrowing, another factor that affects the funding costs of NBFCs is the availability of funding. Unlike larger NBFCs, which have access to a wider range of funding sources, smaller NBFCs are often restricted to a few sources, such as bank loans and funding from private investors. This can make it difficult for them to raise sufficient funds to meet their lending requirements, particularly during times of economic uncertainty.

Factors that impact the funding costs of Non-Banking Financial Companies (NBFCs)

Following are some factors that impact the funding costs of NBFCs:

• Cost of borrowing: The cost of borrowing is one of the most significant drivers of funding costs for NBFCs. NBFCs typically rely on banks and financial institutions for funding, and the interest rates they pay on these loans can have a major impact on their profitability. In recent years, the cost of borrowing has increased for NBFCs, particularly smaller ones, due to a number of factors, including increased regulatory scrutiny and the liquidity crisis in the NBFC sector.
• Availability of funding: Another important factor that impacts funding costs is the availability of funding. Unlike larger NBFCs, which have access to a wide range of funding sources, smaller NBFCs often rely on a few sources of funding, such as bank loans and funding from private investors. During times of economic uncertainty, these sources of funding may become more limited, making it difficult for NBFCs to raise sufficient funds to meet their lending requirements.
• Credit rating: The credit rating of an NBFC can also impact its funding costs. A higher credit rating indicates that the NBFC is less risky and more likely to repay its loans, which can lead to lower interest rates and better terms. On the other hand, a lower credit rating can result in higher funding costs, as lenders may perceive the NBFC to be riskier and require higher interest rates and more stringent lending criteria.
• Economic conditions: The overall economic conditions in the country can also impact the funding costs of NBFCs. During times of economic growth, interest rates may be lower, and lenders may be more willing to lend to NBFCs, leading to lower funding costs. However, during times of economic uncertainty, such as during a recession or financial crisis, interest rates may increase, and lenders may be more cautious about lending, leading to higher funding costs.
• Regulatory environment: The regulatory environment in which NBFCs operate can also impact their funding costs. For example, the Reserve Bank of India (RBI) has implemented a number of policies in recent years to improve the transparency and accountability of the NBFC sector, including the introduction of the Liquidity Coverage Ratio (LCR) and guidelines for the adoption of Ind AS accounting standards. While these policies have helped to improve the overall health of the sector, they have also resulted in higher compliance costs for NBFCs, which can increase their funding costs.
• Competition: The level of competition in the NBFC sector can also impact funding costs. If there are a large number of NBFCs operating in a particular market, lenders may be more willing to offer lower interest rates and better terms in order to attract borrowers. On the other hand, if there are only a few NBFCs operating in a market, lenders may have more bargaining power, leading to higher interest rates and less favorable terms.

Steps small NBFCs can take to mitigate the impact of higher funding costs

Small NBFCs can take several steps to mitigate the impact of higher funding costs. Some of these steps include:

• Diversify funding sources: Small NBFCs should look to diversify their sources of funding to reduce their reliance on a few lenders. They can explore alternative sources of funding such as debt capital markets, securitization, and raising funds from private equity investors.
• Focus on building a strong credit rating: A higher credit rating can help NBFCs to access funding at lower interest rates. Small NBFCs can focus on improving their credit rating by maintaining strong financials, managing their liquidity well, and building a track record of timely repayments.
• Embrace technology: Embracing technology can help NBFCs to reduce their operating costs and improve their efficiency. This, in turn, can help to mitigate the impact of higher funding costs. Small NBFCs can explore adopting digital lending platforms, automating their back-office operations, and leveraging artificial intelligence and machine learning to streamline their lending processes.
• on building a niche market: Small NBFCs can focus on building a niche market and catering to a specific segment of borrowers. By doing so, they can differentiate themselves from larger NBFCs and banks, and build a loyal customer base. This can help them to compete effectively and maintain their profitability even in the face of higher funding costs.
• Maintain strong relationships with lenders: Small NBFCs should maintain strong relationships with their lenders and keep them informed about their financial performance and growth plans. By doing so, they can build trust and credibility with their lenders, which can help them to negotiate better terms and lower interest rates.
• Maintain a strong focus on risk management: Small NBFCs should maintain a strong focus on risk management, particularly in the current environment where regulatory scrutiny has increased. They should have robust risk management frameworks in place, including strong underwriting standards, credit monitoring systems, and stress testing mechanisms. This can help to mitigate the risk of default and improve their credit rating, leading to lower funding costs.

Conclusion

Small NBFCs are facing significant challenges in the current environment, with higher funding costs being a major concern. However, by diversifying funding sources, focusing on building a strong credit rating, embracing technology, building a niche market, maintaining strong relationships with lenders, and maintaining a strong focus on risk management, small NBFCs can mitigate the impact of higher funding costs and remain competitive. While the road ahead may be challenging, small NBFCs that are able to adapt to changing market conditions and adopt a proactive approach to managing their funding costs are likely to emerge as winners in the long run. Ultimately, a focus on building a sustainable business model and delivering value to customers remains key for the success of any NBFC, large or small.

Also Read:
Decoding the Growth of NBFCs in India
What is a Non Banking Financial Company (NBFC)?
Non-Banking Financial Institutions: What They Are and How They Work?