In the early 2000s, one of the first things that a newly-appointed CEO of an NBFC (non-bank finance company) did was to call a brainstorming session with senior executives, the topic being “Do we have a future?” And the conclusion of the discussion - yes, we really do not have a future.
Please do not bother to guess which NBFC it was. Every one of them has gone through this in some form or the other. The core of the problem is that their business model runs largely on borrowings. There are deposit-taking NBFCs, but hemmed in by several restrictions which make raising deposits burdensome. Moreover, NBFCs cannot take low-cost demand deposits.
This desperation is cyclical. In times of tight liquidity, NBFCs wallow in self-pity, and when that reverses, triumphalism reigns. Borrowings, being second order intermediation (i.e. banks take deposits and lend to NBFCs), become more expensive than deposits during tight liquidity and have been cheaper than deposits during excess liquidity situations.
The undercurrent may be cyclical, but the real feeling is secular. Even in comfortable times, eight out of ten NBFCs in private will extol the virtues of deposits. Global events, like the demise or near-demise of Bear Sterns, Lehman and Northern Rock cement this belief. ICICI and IDBI turning a new leaf after conversion to banks lend further credence to this argument.
This urge does take bizarre forms sometimes. There were allegedly 17 bidders for United Western Bank when it was put on the block by RBI some years ago. The winner paid 30% more than the then-prevailing market price for this bank with a shocking record of misgovernance and losses.
There is a long line of hopefuls for the new banking licences that are proposed to be given out by RBI, with no timeframe for the same. One NBFC that has converted a few of its branches into model bank branches, ready to ”go” when they get a licence. Another NBFC has already got a full banking team in place, including an investor relations person. One non-bank that does only infrastructure financing said sometime back that they want to become a bank because in 5-6 years the need for infrastructure financing would be largely over (policymakers will be gladdened by this exalted assessment of India’s infrastructure).
At one plane, the phenomenon looks perfectly irrational. Non-deposit takers survive even in mature markets (look at GE Capital). In India, well-managed NBFCs deliver 6-7% points higher returns on equity than the best-managed banks. Their cost structures are leaner and regulatory obligations lower. They provide value in areas where banks have entered and either failed or limited their operations. Moreover, it was not lack of deposits but inadequate risk management that was the undoing of some non-banks.
None of these is lost on the non-banks - they are run by smart individuals, with ear constantly to the ground. But deep in their minds they know that they are progressively being rendered less significant.
For one, regulatory tentacles are closing in on them, slowly and surely. In this respect, the last two-year period itself would have scared off the most intrepid of NBFCs. It began with imposition of general provisioning, followed by higher capital requirements, a scathing attack on microfinance institutions and tightening of screws on gold loan companies. Apparently, the imposition of general provisioning was the first time that RBI took a measure totally out of the blue, with no prior warning to the affected players. The regulator has publicly proclaimed that major reforms of the ”shadow banking system” (read NBFCs) is their next big target. RBI’s concern is that it is systemically important but subject to less regulations.
Secondly, bottlenecks to franchise expansion for banks are easing up. Branch openings in specified non-urban areas have been de-licenced, and agents (business correspondents) can be used in rural areas, partially relaxing an earlier RBI rule that deposits can be raised only by a bank’s employees. RBI has also been generally liberal with branch licences in the last five years.
This is what makes the bank branch and deposit-taking so valuable. The bargaining power of retail is less than that of institutions, and for non-banks, depending only on institutional money (borrowings) is not viable in the long term. This makes retail deposits sticky - rollover rates for deposits are high for all banks. The implicit guarantee of survival by RBI and the government adds to the charm.
Tailpiece - Now that savings accounts rates are deregulated, many non-banks feel that if they become banks, they can attract savings accounts by offering high rates. This is what I call the real estate syndrome - grab the land and everything else will fall in place!
Dipankar Choudhury was Director of Indian Financial Services Research at Deutsche Bank, and is currently an independent consultant focusing on banks and financial services.