Financial Inclusion

Need of Alternate Financial Mechanism for Small Traders

Small Retailers, Traders, Wholesalers, and people closely associated with trade sector such as small transporters, farmers, labourers etc. always face the liquidity crunch. It is this sector which is cash starved and though it contributes to GDP more than corporate sector still, when the question of finances comes, this sector is almost ignored by mainstream financial institutions. In such scenario, a vast majority of population has to arrange finances from own sources mainly friends and relatives, mortgage their assets and belongings, private money lenders on hefty interest charges (nearly 5% per month) and NBFCs (almost 2-4% higher interest in comparison to national banks).

The recent report of Dr. Nachiket Mor Committee constituted by Shri Raghu Ram Rajan, Governor, Reserve Bank of India is an eye opener. Dr. Nachiket Mor Committee submitted its report in January, 2014 observed that 90% of small traders and low income group do not have any link with the present Banking system whereas nearly 60% small traders in urban and rural areas do not have any functional Bank account. The Nachiket Mor Committee has recommended creation of “specialized banks” to cater to the financial needs of small traders and low income group.

This recommendation of Dr.Nachiket Mor Committee assumes much significance in view of the fact that the small traders in spite of not having any support from the Government keeps the liquidity rolling even in grave crisis period and as such they deserve special attention and focus of the Government to ensure systematic development of trade and commerce in India. Therefore, utmost attention is required to develop a viable financial mechanism which ensures speedy and hassle free financial assistance to small traders in the Country.  

The CAIT has carried a deep study of the present financial resources available to small traders and have come to the conclusion that on the one hand the Government should develop “specialized Banks” as per recommendation of Dr. Nachiket Mor Committee whereas on the other hand the Non -Banking Finance Companies already working in sector of small traders should be strengthen more with specific guidelines and support of the Government as a measure of immediate assistance. 

The NBFC are one of the preferred sources as based on the business requirements the funds can be mobilized with little paperwork, collaterals though the interests are slightly higher in comparison to banks. However since banks do not finance such small business easily and the local money lenders charge too high percentage of interest, it is always better for any entrepreneur to opt for NBFCs. The CAIT while strongly advocating the need of strengthening NBFCs has conducted a in depth study of the working of the NBFCs and has prepared a detailed note which is produced as under :

Role of NBFC’s in promoting Financial Inclusion

This Note outlines the role played by NBFC sector in serving Small businesses and low income families and in promoting Financial Inclusion of the unbanked. It also makes a set of recommendations to significantly expand Financial Inclusion by NBFC’s.

I.  Structure of NBFC Sector:

Historically NBFC’s were involved in serving Small & Micro Enterprises (SME) and low income families by providing small ticket personal loans, financing of two/three wheelers, truck financing, loans for financing used commercial vehicles & machinery and provide working capital to SMEs. These NBFCs were focused on customers not served by the banking sector and were and are, therefore playing a major role in promoting Financial Inclusions. In this note, we will call these as Small Business Finance Companies – SBFC’s.

However, in the past 2 decades there has been a major growth in NBFCs serving Corporate Sector in areas such as Infrastructure Financing, Corporate Lending, Mezzanine Financing, Real Estate Financing, M & A Financing, Capital Markets Financing, etc. Some of these NBFC’s are owned by Banks, Foreign Banks, Private Equity Funds, etc. In this note we will call them NBFC-Corporate. They do not play any role in Financial Inclusion.

There are other NBFCs such as Micro Finance Institution, Housing Finance Companies, Gold Loan Companies, etc which are not covered in this note.

Due to rapid growth of NBFC-Corporate sector the current structure of NBFC Sector (excluding the Housing Finance Companies) is such that NBFC Corporate account for less than 5% of the total NBFC’s by number but have more than 75% of the total Assets of the NBFC sector of Rs. 10,000 Billion.

SBFC’s who play a very significant role in promoting Financial Inclusion account for by numbers nearly 85% of the total NBFCs but have only 15% of the total Assets of the NBFC sector. Most of the SBFC are very small but there are a few large pan India Organizations such as Shriram Finance, Mahindra Finance, Bajaj Finance, etc. 

The remaining 10% NBFCs are MFI Sector, Gold Loan, etc. By Global Standards NBFC sector in India is rather small around 12% of GDP as against a global average of 52%.

 It is clear for the above that the SBFC sector which is critical to Financial Inclusion is rather small and only One Sixth of the NBFC-Corporate.

II.  Regulatory Policy Framework:

Regulatory Policy frame work for the past decade or so is characterized by the following factors:

1.   Try to limit the growth of NBFC sector by reducing availability of resources available to it. The number of Deposit Taking NBFC’s has come down from 1420 to 310 in the past decade and such NBFCs have only 0.06% of Bank Deposits though NBFC Sector extends around 15% of Bank Loans.

2.   Make no distinction in Regulations governing SBFC’s promoting Financial Inclusion and NBFC-Corporate which play no role in Financial Inclusion. Only NBFC’s serving Infrastructure section within NBFC-Corporate have been given additional support such as ECB financing.

3.   Regulations seem to simply prefer Banks to promote Financial Inclusion and not SBFCs. It is a completely misguided policy. As discussed in the next sections Banks have not and will not be able to promote Financial Inclusion.

4.   Acceptance of deposits by NBFC’s has also been gradually reduced over the years. Currently it is at a maximum of 4 times the Net Owned Funds. Recently the Thorat Committee has even proposed reducing deposit limit from 4 times Net Owned Funds to 2.5 times. This is in spite of RBI mandating adequate safeguards in case of deposits, including having a requirement that deposits should be fully covered by a charge on the NBFC’s assets and regulating the overall borrowing powers of NBFCs.

5.   Capital requirements for NBFC’s have been progressively increased and are currently at 15%, out of which Tier I is at 7.5%. It is proposed by RBI to increase the Tier I capital requirements from 7.5% to 10%. This will further reduce the ability of SBFCs to provide credit.

6.  The current NPA recognition of 180 days past due is proposed to be reduced to 90 days.  This proposal seems to have been made without considering the peculiarities of the Non Corporate SME sector where earnings are seasonal and they are currently used to a particular repayment pattern, which they may find it difficult to alter. Such policies will result in a sharp reduction of credit to the SME sector and availability of financing to them. This reduction in NPA recognition will merely be an accounting change, and will not improve Risk of SBFCs portfolios.

7.  The securitization norms have been changed to reduce availability of funding from the banking sector to the NBFC sector. Earlier, bank funding to the NBFC sector for on-lending to sectors considered as “priority sector” for banks, was permitted, however, now this facility has been withdrawn and SBFCs are deprived of this credit line from the banking sector even though they continue to extend funds to the priority sector. This appears to be quite strange as the bank lendings to the Micro Finance NBFCs are still considered as priority sector lending for the banks. When the end objective of both SBFCs and the NBFC-MFI is to assist in financial inclusion, there appears to be no clear rationale to deny this benefit to the SBFCs.

8.  Concerns have been expressed in terms of increase of banking sector’s overall exposure to NBFC sector in the recent years and what steps should be taken to limit this exposure. However, a majority of this exposure has been to the NBFCs – Corporate sector which grant loans to real estate, corporate and the Infrastructure sector, and not to the SBFCs. In fact increased exposure to SBFCs should be welcomed as it indicates success in Financial Inclusion.

9.  In July 2013 RBI has put further restriction on NBFC’s ability to issue Debentures to retail customers further reducing funding availability and increasing costs of SBFCs. A window of investment which was available to the retail customer to invest in secured liquid debentures of NBFCs has also been shut by the RBI in this process, even though there has not been any past history of default by the NBFC sector in the case of repayment of secured debentures. 

10.  In summary, over the past many years the policy makers and regulators have taken several steps designed to limit the growth of NBFC’s sector which has made it difficult for SBFCs, to serve their SME customers and low income families.

RBI has so far seemed to follow a policy aimed at creating a regulatory regime which will be more or less uniform for banks and NBFCs. A coherent policy which may support priority sector lending SBFCs is missing with the result that the latter are unable to realize their real potential in the area of financial inclusion, an avoidable loss of opportunity as well as capacity which the country’s financial system can ill afford at this stage

III.  Limitations of Banks

All over the world, Banks are under severe criticism for not serving their customers well, taking excessive risks and for high levels of employee compensation. In India, Policy makers and Regulators have relied on the Banks to promote Financial Inclusion of SMEs who do not have access to formal financial products, but the progress over the past several decades has been minimal in this sector. Several initiatives, for Banks to serve the low income families, like Banking Correspondents, mini-branches, etc. have not worked and are unlikely to succeed.

However, the aspirations of their financially excluded low income families and SME owners have increased and they want to improve their economic situation by accessing credit and deposit products. These needs have been addressed largely by the SBFCs who are best suited to end the Financial Exclusion of these low income families and enable them to enter financial mainstream 

SBFCs act in a complementary and supplementary manner to Banks in serving low income families and SMEs. They provide last mile delivery of financial products to the poor who are unlikely to be served by the Banking System for the following reasons:

1)  Banks are complex multi product organizations much more suited to serving large corporate sector and families in middle and upper class. They are not comfortable in serving low income families and SMEs who do not have adequate documentation like tax returns, audited accounts etc. SBFCs are simpler organizations focused on serving low income families and SME sector with deep domain expertise. They offer limited financial products and are able to manage risk very well.

2)  Banks have a very high cost operation as compared to SBFCs. Their cost per transaction is very high; therefore, they cannot serve small customers profitably. As a result, despite repeated directions by the RBI, banks share of credit to SME sector has come down from 16% of total bank credit to 8%. The situation has worsened considerably recently due to inflation led increase in the cost structure of SMEs. The SMEs needed additional funding which was not available from the banking sector. They had to dip into the owners personal funding sources, such as equity infusion by the management and unsecured loans from family, friends, and the Informal sector with high Interest rates.

3)  Bank employees are ill suited to serving these low income families and SMEs.  Average compensation per employees in the Banking sector is Rs. 6 Lakh per year. It is not possible to expect that these employees will have the right service altitude towards poor customers in the SME sector earning less than half or one fourth of their income.

SBFCs, on the other hand, employs people from the same socio-economic sector of their customers are i.e. low income families & SMEs. Their employee compensation level is also less than half of the compensation of Bank employees. SBFCs employees can not only relate to and serve these customers well, but they are also able to much better judge the credit risk of the customer as they are more well networked with the local community.

4)  Low Income families and SMEs, when they access loan from a Bank generally, have to use a middle man who not only takes hefty commission, but this also promotes corruption in the Banks at operating level.

SBFCs employees deal with their customers directly and often at customers place of work or home. Their credit assessment and quality of service therefore is significantly better, and the operations are corruption free.

5)  Because of their deep domain knowledge, close relationship with SME customers the SBFCs are much more flexible and innovative than Banks.

6)  The risk profile of SBFCs is much better and loan loss experience is much lower than the bank’s risk profile.

IV.  Key Policy Changes Requested:

We outline below a set of Recommendations which are based on belief that the Government is keen to promote Financial Inclusion to provide credit & financial services to small businesses & low income families who do not have access to the formal financial system.

1.  Create a special category Small Business Finance Company – SBFC

This is the essential first step for the Policy makers & Regulators to design policies & regulations conducive to promoting Financial Inclusion. This is in line with the recommendation of the key Advisory Group of the Ministry of Finance.

The definition of SBFC is proposed to be those engaged primarily (at least 60% of their portfolio) in serving “SMEs” with individual loan below Rs. 10 lakhs, or “Low Income Families”.

The definition of “SME” is as below*: 

Enterprises                  Employees                   Assets                           Annual Sales

Small                           <50                              <15 Cr                         <15 Cr

Micro                           <10                              <5 Lakhs                      <5 Lakhs

The proposed definition of Low Income Families: Families with monthly income below 10,000 in Rural/ Semi Urban Areas and Rs. 20,000 in Urban Areas.

 *This definition is in conformity with MSME Act of 2006.

2.   Regulations for SBFC’s different from that of other NBFCs

Considering the unique nature of business of the SBFCs which are engaged in financing the Non Corporate MSME sector which do not have access to organized finance, the regulations for these SBFCs should be different from a company providing finance to large corporate or finance against shares etc.

Further, the Hon’ble Finance Minister was reviewing the performance of the NBFC industry as well as their grievances in the meeting that look place on 19 February 2013 at Hotel Trident at Mumbai in the presence of Secretary, DFS and Dy. Governor RBI along with the representatives of the Finance Industry Development Council (FIDC). In that meeting, when it was bought to the notice to the Finance Minister that there are around 12,000 NBFCs, Hon’ble Finance Minister had articulated that regulations for all NBFCs should not be similar and the RBI should consider and work out a suitable mechanism depending upon the type of NBFC, nature etc. It is precisely this issue which we would like to highlight to your kind attention. 

3.   SBFCs should continue to be permitted access to bank finance and lending to SBFCs by banks for on-lending to the Non Corporate MSME sector to be considered as priority sector lending for banks.

This facilities deployment of bank credit to the “priority sector” and is possible for the banks to also verify the end usage of the funds. This facility which was available till April 2011 has been withdrawn, while a similar facility continues to exist for Micro Finance Institutions. As the target segment served by these SBFCs continues to be recognized as “priority sector” for banks, this facility may be permitted. This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance.

4.   No change in the provisioning norms for SBFCs to align them with Banks

The proposal to align the NPA provisioning norms for all NBFCs with that of Banks (i.e.) a 90 days period should not be made applicable for the SBFCs which are engaged in financing the Non Corporate MSME Sector. The borrower segment of these SBFCs comprise small businessmen, trader, truck operators etc. These categories of borrowers do not have predictable cash flows and in most cases, their earnings are seasonal. Their businesses may also be temporarily suspended on account of natural calamities, illness etc. These SBFCs which have a local presence have been able to connect closely with such borrower segment and have demonstrated excellent recoveries ultimately from this sector, even though there may be timing issues. Hence, the blanket imposition of the 90 day rule may not be appropriate for companies lending to this sector. This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance.

5.   No increase in Capital Adequacy Norms for SBFCs 

The SBFCs should not be under compulsion to increase their Capital Adequacy Ratio – the Usha Thorat Committee appointed by RBI has proposed an increase in this for all NBFCs. It may be appreciated that the past track record of the SBFCs engaged in financing the Non Corporate MSME Sector demonstrates that the risks involved in funding to this sector are significantly lesser and any increase in CAR would only result in denial of credit to the end borrower. Correspondingly, the risk weights for these sectors should be lowered. This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance

6.   Deposit taking ability for the SBFCs should not be reduced

The Usha Thorat Committee appointed by RBI had proposed a reduction in the deposit acceptance limits for all NBFCs from the current level of 4 times NoF to 2.5 times NoF. Currently, the SBFCs are facing pressure for funding, as the avenue for banking funding has also reduced post April 2011. When an overall borrowing cap has been prescribed for all NBFCs and monitoring of this is also being done by RBI, there should not be any further caps on borrowing as deposits, especially now that all deposits are also to be adequately secured. This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance

7.   No restriction on private placement of secured debentures

All NBFCs were permitted to issue secured debenture on private placement basis, with suitable safeguards. NBFCs were also in compliance with these norms. However, with effect from July 2013, RBI has placed several restrictions on issuance of secured debentures by NBFCs on private placement basis, which impede resource mobilization.

Funds mobilized through NCDs are key sources of funding for NBFCs. Given the very nature of the borrowing / lending business, one does not understand how such a stipulation can be imposed. Funds requirement is a very dynamic issue for any financial institution, more so for a lending institution. Liquidity needs, opportunities for funds deployment (in loans) are all not static but are dynamic and keep changing on an on-going basis.

The restrictions imposed by the RBI, does not seem to recognize these features in the operating environment for NBFCs. It directly can adversely impact the liquidity position of lenders and also result in NBFCs not being able to address or make use of business opportunities on an on-going basis.

RBI’s concern about the quantum / level of monies mobilized through NCDs is very well addressed by the overall regulatory cap on leverage of 6 times the net owned funds. Within that overall cap, NBFCs should be permitted to raise as much monies as they want and with as much periodicity as they want.

It is our submission that the SBFCs should be permitted to continue to raise secured debentures from the retail public as this would enable them to mobilize funds for on-lending to the on Corporate MSME Sector as well as providing an avenue for the retails public to invest in secured instruments offering better returns. When there is an overall borrowing power imposed on NBFCs, there may not be a need for further restricting resource mobilization by way of issue of secured debentures, especially when adequate safeguards for such issuances have been built in. This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance

8.   Securitization by NBFCs

The current restrictions imposed on securitization transactions by NBFCs in terms of cap on interest rate, should be removed and thereby permit the NBFCs to securities their portfolios with Banks which will enable them to lend further to the MSME Sector. This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance

9.  Capital Adequacy Ratio and Risk weights for SBFCs financing MSME Sector to be different from other NBFCs 

Another area of concern is the application of uniform risk-weight of 100% on the asset portfolio in computing the capital adequacy being maintained by SBFC.

This stipulation does not take into account the different types of loans and assets created by the SBFCs and their differing risk characteristics.

This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance

10.  To remove SLR on fixed deposits

RBI has always required NBFCs to maintain SLR in respect to their public deposits. This had some rationale when the public deposits were fully unsecured. Recently, RBI has mandated that NBFCs have full security cover in respect of their public deposits as well. This has the effect of ensuring that the public deposits are fully secured. When this change has been made & operationalised by NBFCs, the rationale for continuing with SLR goes away, considering this, RBI should dispense with the requirement of SLR by NBFCs, particularly by SBFCs.

11.   Removal of DRR requirement in case of public issues of NCDs by SBFCs

Presently, NBFCs are required to create Debenture Redemption Reserve (DRR) in case of public issues of debentures. This should be exempted in respect of debentures issued by SBFCs as these debentures are fully secured over the assets of the SBFC, independent trustees are appointed to monitor the same and these are essentially working capital debentures where the money gets deployed in self liquidating assets, the proceeds of which are sufficient to meet the redemption of debentures. Though this is a requirement of SEBI, RBI being the regulator for NBFCs should impress upon SEBI the need to do away with this requirement, especially when the financial institutions do not have this requirement.

12.   Tax deductions under Income Tax for NPA provisioning – Accepted by KAG also.

The NPAs provided for by SBFCs should be permitted as a deduction under the Income Tax Act.

This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance

13.   TDS on interest payment on unlisted NCDs

Interest paid on unlisted debentures issued by NBFCs (including SBFC’s) requires tax deduction at source, without any minimum threshold, whereas there is a minimum threshold in case of listed debentures. This distinction should be removed.

This is also in line with the recommendations of the Key Advisory Group of the Ministry of Finance

14.  Deposit taking SBFC’s to be covered by Deposit Insurance 

This will ensure that SBFC’s have increased access to funds from depositors which can then lend to SME borrowers.