CHAPTER I

INTRODUCTION AND DESIGN OF THE STUDY

NBFCs: A HISTORICAL BACKGROUND

Non-Banking Finance Companies (NBFCs) in India have

evolved over the last fifty years to emerge as notable alternate sources of

credit intermediation. The non-bank sector in India is wide and encompasses

several financial intermediaries like the loan and investment companies,

housing finance companies, infrastructure finance companies, asset finance

companies, core investment companies, micro finance companies and

factoring companies. In a broad sense, the NBFCs include stock brokers,

insurance companies, chit fund companies, etc. The NBFCs are also into

distribution of financial products, acting as business correspondents to banks,

and facilitating remittances. The sector regulated by the Reserve Bank of

India has changed dynamically since the time an enhanced regulatory

framework was placed on them in 1996 in the wake of the failure of large

sized NBFCs. The changes in the sector have partly been regulation induced;

the prudential regulations on systemically important NBFCs and deposit

taking NBFCs made them financially sound and better managed, while the

light touch regulation on them gave them ample head room to be innovative,

and dynamic. Today, while the numbers of registered NBFCs have come

down, from the peak of 14,077 in 2002 to 12,029 by March 2014, those in the

business found a niche for themselves, in the financial fabric of the country.

In a country like India, where large sections of the population

are still unbanked, there is space for several forms of financial intermediation.

1
Without sounding clichéd, the NBFCs have emerged as a very important and

significant segment, financing small and medium enterprises, second hand

vehicles, and other productive sectors of the economy and have very

effectively tried to bridge the gaps in credit intermediation. They have played

a supplementary role to banks in financial intermediation and a

complementary role in the financial inclusion agenda of the Reserve Bank of

India. NBFCs bring the much needed diversity to the financial sector thereby

diversifying the risks, increasing liquidity in the markets, thereby promoting

financial stability, and bringing efficiency to the financial sector.

Although regulated, NBFCs sector is considered as a shadow

banking sector. This is because they are lightly regulated; there are pockets

within the sector that are not subjected to regulation and or supervision and

they are also allowed to conduct activities that may not fall under regulation.

The Principal Business Criteria (PBC) for registration allows NBFCs the

freedom to conduct other activities, beyond financial activities, from their

balance sheets. There are several large entities, undertaking financial business,

but do not come within the definition of the NBFC. Here, there are several

corporate treasuries. Examples of light touch regulation are as follows: The

registered NBFCs are not supervised as intensively as banks; the reporting

requirements are very little as compared to banks; capital and other prudential

requirements on banks based on Basel III have not been required of the

NBFCs; there are no or less pre-emptions in the form of CRR or SLR for

NBFCs; nor is prescription of priority sector lending requirements; unlike

banks, there are no restrictions on the number of NBFCs that can be set up by

a single group nor is there any restriction on the number of branches of

2
NBFCs; and corporate governance have not been as stringent as that for

banks. There are also no regulations on connected lending for NBFCs.

NBFCs today have grown considerably in size, form and

complexity and operations with a variety of market products and instruments,

technological sophistication, entry into areas such as payment systems, capital

markets, derivatives and structured products. Some of the NBFCs are

operating as conglomerates with business interests spread to sectors like

insurance, broking, mutual fund and real estate. The inter-connectedness with

other financial intermediaries has increased with increased access to public

funds through NCDs, CPs, borrowings from banks and financial institutions.

NBFCs being financial entities, are exposed to risks arising out of

counterparty failures, funding and asset concentration, interest rate

movements and risks pertaining to liquidity and solvency. Risks of the NBFCs

sector can hence be easily transmitted to the financial sector or the NBFCs can

get affected by adverse developments in the financial sector. We can easily

draw reference to the 2008 financial crisis when the NBFCs sector came

under pressure due to the funding inter-linkages between NBFCs and mutual

funds. The ripple effects of the turmoil in the western economies led to

liquidity issues and redemption pressures on mutual funds which in turn led to

funding issues for NBFCs as mutual funds were unable to roll over the

corporate debt papers of NBFCs. Many had to downsize their balance sheets

or enter into distressed sale of their loan portfolios. A slew of measures had to

be taken then, both conventional and unconventional to assist the NBFCs.

The institution of hire purchase or installment credit is well

organized in countries like U.K and U.S. In India hire purchase credit first
3
made its appearance after the First World War. The system grew steadily in

the 30s and 40s. It was only after the Second World War that the growth

picked up momentum. Hire purchase credit in India is given by hire purchase

finance companies and state financial corporation as well as by a large

number of firms and individuals.

In a broader sense, NBFC means a company whose principal

business is financing, in whatever form, but not qualified enough to be called

a bank as defined in Banking Regulation Act, 1949. NBFCs offer a variety of

services. The service mix of NBFCs has all dimensions-width, depth and

consistency-the three essential characteristics of any product mix. Width

refers to variety, depth refers to range in each variety and consistency refers to

overall synergy of the service mix. With their diversified structure and

methods of business NBFCs are serving the economy in a variety of ways.1

Growth and diversification of non-banking financial companies

are integral parts of the development process of the financial market of the

economy. NBFCs and unincorporated bodies have been competing and

complementing the services of commercial banks since yester-years all over

the world. While the financial system in a country generally develops through

a process of gradual evolution, it has been observed that there was a stage in

evolutionary process wherein the growth of NBFCs were more pronounced

during the first three decades of 20th century and two of the top five

commercial lenders are NBFCs and three of the four top providers of

1
L.M Bhole, “Management of Financial Institutions and Financial
Markets”, Tata McGraw Hill Publishing Limited, New Delhi. 1998
pp. 20-25.
4
consortium finance are non-bank firms. In many countries, NBFCs have been

able to serve the household, farm and small enterprises sectors on a

sustainable basis. It was Gurley and Shaw (Money in the Theory of Finance,

1960)2 which, for the first time, established that the NBFCs compete with the

monetary system and there is need to regulate them.

The literature on the emergence of finance companies can be

explained in three alternative ways on the basis of the existing theoretical

literature.

The first strand of literature is based on the experience of the

growth of non-banking intermediaries in the industrial economies such as the

US during the 1960s.This literature suggests that the impetus for the

emergence and growth of Non-Bank Financial Intermediaries (NBFIs) may

have come mainly from the competitive handicaps (such as reserve

requirements) imposed on commercial banks for the purpose of monetary

control. Gurley and Shaw (1960) argued that the techniques of monetary

control discriminated against banks in their competition with non-bank

financial intermediaries. They argued in favour of extending the central

bank’s regulatory powers with respect to the liabilities of NBFIs as well.

Growth of non-banking financial intermediaries has also been explained in

terms of financial innovations which are undertaken in response to credit

control measures by the central bank.

The second strand of literature follows from the work of

McKinnon and Shaw (1973) who were mainly concerned with the

2
Gurley and Shaw, “Money in Theory of Finance”, Indian Edition,
Motilal Banarasi, Delhi, 1960 p.64.
5
consequences of ‘repressive controls’ on the formal credit sector (especially

banks) and its effects on the structure of the financial sector and the allocation

of credit in developing economies3. According to them, financial systems in

most developing countries are characterized by financial repression which,

among other things, includes public ownership of banks, high reserve ratios,

interest rate ceilings, directed credit programmes, restrictions on market entry

for banks, etc. Distortionary controls like a ceiling on loan and deposit rates,

etc. raise the demand for credit, but depress its supply. A parallel market for

credit develops in the informal sector in response to the unsatisfied demand

for credit. In such a fragmented credit market, favoured borrowers get credit

from banks at subsidized rates, while others seek credit in inefficient

expensive informal markets. This segment assumes the form of urban markets

and private finance companies.

The third strand is based on the work of Stiglitz and Weiss

(1999) who showed that in the presence of informational asymmetries, the

problem of adverse selection and moral hazard could characterize credit

markets. Banks could therefore ration credit using non-price means. This

rationing may be particularly severe in the case of certain categories of

borrowers, such as small enterprises, traders, etc. Higher proportionate

transaction costs on small sized loans, absence of marketable collateral, etc.

may lead to these categories of borrowers being rationed out by banks. Large

banks could also find it difficult to collect the information required for lending

to small firms and traders.

3
McKinnon & Shaw “Money and Capital in Economic Development”,
Brookings Institution, Washington, DC, 1973.
6
 Apart from the theoretical evidence of NBFCs, the experience

worldwide shows that the important factor contributing towards the growth of

NBFCs are changes in the international financial markets and the increasing

integration of domestic and international markets and the rapid development

of technology in the financial sector like introduction of new communication

and transmission system which reduce transaction costs and speed up

information flows. To an extent, all these factors have contributed to the

growth of NBFCs in India, especially during the later part of eighties.

In Indian multi-tier financial system, the NBFC sector stands

apart for more than one reason. Though the sector is essentially doing the job

of financial intermediation, it is still not fully comparable with the other

segments of the Indian financial system. This is so in view of the wide

variations in the profile of the players in this sector in terms of their nature of

activity (leasing, investment, lease, hire purchase, chit fund, pure deposit

mobilsation, fee based activity, etc.), the volume of activity, the sources of

funding they rely on (public deposits and non-public deposits), method of

raising resources, development pattern, etc. This has naturally resulted in the

creation of multifarious categories of NBFCs and therefore, leads to diverse

regulatory dispensation by RBI.

In India, such marked growth in the non-bank financial sector

was noticed in the last two decades. During the last two decades NBFCs have

witnessed a marked growth. Some of the factors which have contributed to

this growth have been lesser regulation over this sector, higher deposit interest

7
rates offered by this sector, higher level of customer orientation, the speed

with which it caters to customer needs and so forth.4

Started to cater to the needs of the society, NBFCs later on

developed into institutions that can provide services similar to those of banks.

The tailor-made services, higher level customer orientation, simplicity and the

speed of their services have attracted customers to these companies. The

monetary and credit policy followed by the country has left a section, of the

borrowers outside the purview of the commercial banks and NBFCs cater to

the needs of this section.

The NBFCs are also seen as the outer fringe of organized

financial sector, the core of which is constituted by commercial banks. 5

However, there are only tangential contacts between the two segments in

various forms such as bill discounting and lines of credit from banks to certain

categories of NBFCs. During the beginning of 1990, Indian economy was

going through a period of increased financialisation. Extensive financial

deepening occurred and the share of assets of the financial institutions to the

GDP increased considerably. The Indian financial system has since then

grown rapidly with considerable stability and increased saving rate. 6

4
Pahwa, “Guide to Non-Banking Financial Companies”, Vinod Law
Publications, Lucknow, 1998, pp. 8-10.
5
Chandle Lester. V, “The Economics of Money and Banking”, Third
Edition, Harper and Brother, New York, 1959, p. 325.
6
Rangarajan .C, “The Role of NBFCs in Financial Development”, 1998,
RBI Bulletin, September 1998, p. 1241.
8
 The September 2008, Global Financial Crisis has put more

pressure for this industry because of funding inter-linkages among NBFCs,

mutual funds and commercial banks. The ripple effect of the turmoil in

American and European markets led to liquidity issues and heavy redemption

pressure on the mutual funds in India, as several investors, especially

institutional investors, started pulling out their investments in liquid and

money market funds. Mutual funds are the major subscribers to commercial

papers and debentures issued by NBFCs, The redemption pressure on MFs

translated into funding issues for NBFCs, as they found raising fresh liabilities

or rolling over of the maturing liabilities very difficult. Drying up of these

sources of funds along with the fact that banks were increasingly becoming

risk averse, heightened their funding problems, exacerbating the liquidity

tightness. RBI undertook many measures, both conventional as well as

unconventional, to enhance availability of liquidity to NBFCs such as

allowing augmentation of capital funds of NBFCs through issue of Perpetual

Debt Instruments (PDIs), enabling, as a temporary measure, access to short

term foreign currency borrowings under the approval route, providing

liquidity support under Liquidity Adjustment Facility (LAF) to commercial

banks to meet the funding requirements of NBFCs, Housing Finance

Companies (HFCs) and Mutual Funds, and relaxing of restrictions on lending

and buy-back in respect of the certificates of deposit (CDs) held by mutual

fund.7

7
Anand Sinha, Deputy Governor, Reserve Bank of India (2013)
“Regulation of Shadow Banking – Issues and Challenges.” www.rbi.org.
9
 NBFCs operations can largely be categorized into equipment

leasing, hire purchase, investments and loans. There are 12,029 NBFCs, of

which 241 are public deposit accepting companies. At end-March 2014, about

5 per cent of NBFCs – as deposit taking companies had an asset size of more

than Rs. 5,000 million and accounted for about 97 per cent of total assets of

all NBFCs-D.

However, the size of NBFCs is very small compared to the

banking industry. The number of NBFCs (Deposit taking) is consistently

declining over a period of time. It declined from 875 in 2003 to 777 in 2004

and further to 241 in 2014. The key differentiating factor working in favour of

NBFCs is service. Today, a borrower is looking for more convenience, quick

appraisal and decision making, higher amount of loan to value and longer

term of repayment.

Non-Banking Finance Institutions play a crucial role in

broadening access to financial services, enhancing competition and

diversification of financial sector. The details pertaining to deposits with the

NBFCs are furnished in Table 1.1. The table reveals that the regulated

deposits of NBFCs increased from an average of 0.18 percent of GDP during

the period from 1970-71 to 1989-90 to 1.09 percent during the period from

1991-92 to 2012-13. They witnessed a steady growth thereafter to 0.45

percent of GDP during 1990-91 to 1992-93 as depicted in the Table 1.1.

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 Table 1.1
Deposits of Non-Banking Financial Companies as a Percentage of
Commercial Banks and Gross Domestic Product

Deposits as % of Aggregate
Deposits as %
Period Deposits of Scheduled
of GDP
Commercial Banks (SCBs)
1970-71 to 1974-75 0.71 0.12
1975-76 to 1979-80 0.68 0.16
1980-81 to 1984-85 0.46 0.14
1985-1989 to 1989-90 0.81 0.30
1990-91 to 1992-93 1.18 0.45
1993-94 5.02 2.02
1994-95 6.01 2.52
1995-96 8.11 3.28
1996-97 9.47 3.90
1997-98 3.70 1.57
1998-99 2.62 1.16
1999-00 2.20 0.87
2000-01 1.71 0.77
2001-02 1.56 0.76
2002-03 1.50 0.78
2003-04 1.20 0.70
2004-05 1.20 0.68
2005-06 1.10 0.69
2006-07 0.92 0.69
2007-08 0.73 0.62
2008-09 0.53 0.51
2009-10 0.38 0.38
2010-11 0.23 0.24
2011-12 0.16 0.18
2012-13 0.17 0.17
Source: RBI Bulletin, Various Issues.
Note: 1. Data for 1998-2013 relate to public deposits whereas data for 1971-
1997 relate to the Regulated deposits.

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 During the period 1993-94 to 1996-97, they experienced a sharp

rise from 2.02 percent of GDP to 3.90 per cent. From 1997-98 to 2012-13,

they experienced a sharp decline from3.90 per cent from 0.17 per cent. The

trend in the growth in total deposits with NBFCs as a percentage of aggregate

deposits exhibited more or less a similar trend, rising from 0.71 in 1970-75 to

1.18 percent during 1990-93. During the period from 1993-94 to 1996-97,

deposits with NBFCs experienced a sharper rise from 5.02 per cent of

commercial bank deposits to 9.47 per cent as given in the Table 1.1. In recent

years from 1998 onwards, however, deposits with NBFCs have witnessed a

decline due to strict supervisory and regulatory framework of 1998.

It may be recalled that until some years back, the prudential

norms applicable to banking and non-banking financial companies were not

uniform. Moreover, within the NBFC group, the prudential norms applicable

to deposit taking NBFCs (NBFC-D) were more stringent than those for non-

deposit taking NBFCs (NBFC-ND).Since the NBFC-ND was not subject to

any exposure norms, they could take large exposures. The absence of capital

adequacy requirements resulted in high leverage by the NBFCs. Since 2000,

however, the RBI has initiated measures to reduce the scope of ‘regulatory

arbitrage’ between banks, NBFCs-D and NBFCs-ND

The NBFCs-ND has inter-linkage with financial markets, banks

and other financial institutions. They have witnessed substantial growth in

number, product variety and size in the case of non-deposit taking NBFCs;

NBFCs-ND with an asset size of Rs. 100 crore and above have been classified

as Systemically Important NBFCs (NBFC-ND-SI) and these are subjected to

limited regulations. A system of monthly reporting on important parameters

12
such as capital market exposure has been introduced. A system of Asset-

Liability Management (ALM) reporting and additional disclosures in the

balance sheet were also introduced.

With a view to further strengthening their resilience, their

Capital to Risk-Weighted Assets Ratio (CRAR) has been enhanced to 12 per

cent to be reached by 31 March 2009 and further to 15 per cent by 31 March

2010. In order to address their funding requirements, NBFCs-ND-SI have

been permitted to augment their capital funds by issuance of Perpetual Debt

Instruments (PDI) in rupees subject to certain conditions.

In October 2008, the issue of transient liquidity strain faced by

NBFCs-ND-SI was addressed and as a temporary measure, they were also

permitted to raise short term foreign currency borrowings under the approval

route, subject to certain conditions. On 1 November 2008, the facility of

liquidity support, which was earlier introduced for mutual funds, was

extended to NBFCs.

With a view to protecting the interest of the depositors, the RBI

initiated steps for creating a charge on the SLR securities in favour of

depositors. In order to contain the systemic risk relating to NBFC-D,

measures were initiated to ensure that only financially sound NBFCs accept

deposits. It was, therefore, prescribed in June 2008 that NBFCs with net

owned funds (NOF) of less than Rs.200 lakh may freeze their deposits at the

level held by them. Asset Finance Companies (AFCs) with minimum grade

credit rating and CRAR of 12 per cent may bring down public deposits to a

level that is 1.5 times their Net Owned Funds (NOF), while all other

13
companies may bring down their public deposits to a level equal to their NOF

by 31 March 2009.

The issues relating to Residuary Non-Banking Companies

(RNBCs), which have raised substantial deposits from public, in the last few

years and thus have acquired high leverage position, are being addressed

under the provisions of the RBI Act. In fact, two of the three RNBCs holding

almost 99.9 per cent of the RNBC segment have agreed to migrate to another

business model and the companies would reduce their deposit to nil by the

year 2015. The third company, with miniscule deposit, has been converted

into a non-deposit taking NBFC.

Along with measures for enhancing the financial strength of

NBFCs, initiatives to inculcate fair corporate governance practices and good

treatment of customers were also undertaken. The RBI in February 2008 laid

down guidelines for registration of Mortgage Guarantee Companies.

Prudential and investment guidelines applicable to them were also evolved.

NON-BANKING FINANCIAL ENTITIES REGULATED BY RBI

The developments in the NBFC sector in terms of policies and

performance during 2001-02 and for the subsequent periods (to the extent

information is available) are discussed in the subsequent paragraphs.

Non-banking financial entities partially or wholly regulated by

the RBI include (a) NBFCs comprising Equipment Leasing (EL), Hire

Purchase Finance (HP), Loan (LC), Investment (IC), including Primary

Dealers (PDs) and Residuary Non-Banking Companies (RNBC); (b) Mutual

14
Benefit Financial Company (MBFC), i.e., Nidhi Company; (NC) Mutual

Benefit Company (MBC), i.e., Potential Nidhi Company; (c) Miscellaneous

Non-Banking Company (MNBC), i.e., chit fund company. A chart on the

same is given below.

Chart 1.1

Non-Banking Financial Institutions in India

MEANING AND TYPES OF NBFCs

Section 45I of the Reserve Bank of India Act, 1934 defines a

‘‘non-banking financial company’’ as

(i) a financial institution which is a company;

15
 (ii) a non-banking institution which is a company and which has as its

principal business the receiving of deposits, under any scheme of

arrangement or in any other manner, or lending in any manner;

(iii) Such other non-banking institution or class of such institutions, as the

bank may, with the previous approval of the central government and

by notification in the Official Gazette, specify;

Hence in short an NBFC may be defined as a company

registered under the Companies Act, 1956 and also registered under the

provisions of Section 45-IA of the Reserve Bank of India Act, 1934 and

which provides banking services without meeting the legal definition of bank

such as holding a banking license. NBFCs are basically engaged in the

business of loans and advances, acquisition of shares / stocks / bonds /

debentures / securities issued by government or local authority or other

securities of like marketable nature, leasing, hire-purchase, insurance business

and chit business but does not include any institution whose principle business

is that of agricultural activity or any industrial activity or sale, purchase or

construction of immovable property.

NBFCS VS CONVENTIONAL BANKS

· An NBFC cannot accept demand deposits, and therefore, cannot offer

a cheque facility.

· It is not a part of payment and settlement system which is precisely

the reason why it cannot issue cheques to its customers

16
 · Deposit insurance facility of Deposit Insurance Credit Guarantee

Corporation (DICGC) is not available for NBFC depositors unlike in

case of banks.

· SARFAESI Act provisions have not currently been extended to

NBFCs. Besides the above, NBFCs pretty much do everything that

banks do.

CLASSIFICATION OF NBFCS BASED ON THE NATURE OF

BUSINESS

The NBFCs that are registered with RBI are basically divided

into 5 categories depending upon their nature of business:

· Loan Company

· Investment Company

· Asset Finance Company

· Infrastructure Finance Company

· Core Investment Company

Reclassification of NBFCs with effect from 6th December, 2006

However in terms of the NBFC Acceptance of Public Deposits

(Reserve Bank) Directions, 1988 with effect from December 6, 2006, NBFCs

registered with RBI have been reclassified as:

v Loan Company (LC)

Loan company means any company which is a financial

institution carrying on as its principal business the providing of finance

17
whether by making loans or advances or otherwise for any activity other than

its own but does not include an asset finance company.

v Investment Company(IC)

Investment Company is a company which is a financial

institution carrying on as its principal business the acquisition of securities.

v Asset Finance Company (AFC)

AFC would be defined as any company which is a financial

institution carrying on as its principal business the financing of physical assets

and supporting productive / economic activity, such as automobiles, tractors,

lathe machines, generator sets, earth moving and material handling

equipments, moving on own power and general purpose industrial machines.

Financing of physical assets may be by way of loans, lease or hire purchase

transactions.

Principal business for this purpose is defined as aggregate of

financing real / physical assets supporting economic activity and income

arising there from is not less than 60% of its total assets and total income

respectively.

v Infrastructure Finance Company (IFC)

IFC is a non-banking finance company a) which deploys at least

75 per cent of its total assets in infrastructure loans, b) has a minimum Net

Owned Funds of Rs. 300 crore, c) has a minimum credit rating of ‘A ‘or

equivalent d) and a CRAR of 15%.

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v Core Investment Companies

The Reserve Bank of India vide its Notification No. DNBS (PD)

CC.No. 197/03.10.001/2010-11 dated August 12, 2010, defined a new class of

NBFCs by the name ‘Core Investment Companies’ (CIC) was added.

Core Investment Companies in terms of RBI’s notification

means: a non-banking financial company carrying on the business of

acquisition of shares and securities and which satisfies the following

conditions as on the date of the last audited balance sheet:-

(i) it holds not less than 90% of its net assets in the form of investment

in equity shares, preference shares, bonds, debentures, debt or loans

in group companies;

(ii) its investments in the equity shares (including instruments

compulsorily convertible into equity shares within a period not

exceeding 10 years from the date of issue) in group companies

constitutes not less than 60% of its net assets Net assets, for the

purpose of this proviso, would mean total assets excluding –

• Cash and bank balances;

• Investment in money market instruments and money market

mutual funds

• Advance payments of taxes; and

• Deferred tax payment.

(iii) it does not trade in its investments in shares, bonds, debentures, debt

or loans in group companies except through block sale for the

purpose of dilution or disinvestment;

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 (iv) it does not carry on any other financial activity referred to in Section

45 I (c) and 45 I (f) of the Reserve Bank of India Act, 1934 except:

• Investment in

o bank deposits,

o money market instruments, including money market mutual

funds,

o government securities, and

o bonds or debentures issued by group companies;

• Granting of loans to group companies; and

• Issuing guarantees on behalf of group companies.

The above-mentioned types of NBFCs may be further classified

into:

· NBFCs accepting public deposit (NBFCs-D) and

· NBFCs not accepting / holding public deposit (NBFCs-ND).

FURTHER CLASSIFICATION OF NBFCS-ND BASED ON THE SIZE

OF ASSET

NBFCs-ND may also be classified into (i) Systematic

Investment and (ii) Non-Systematic Investment NBFCs based on the size of

its asset.

v Systemically Important NBFCs-ND

An NBFC–ND with an asset size of Rs.100 crore and more as

per the last audited balance sheet is considered as Systemically Important

NBFCs–ND (NBFC-ND-SI). However NBFCs– ND– SI are required to

20
maintain a minimum CRAR of 10 per cent. No NBFC–ND–SI is allowed to:

a) lend to any single borrower / group of borrowers exceeding 15 per cent /

25 per cent of its owned fund; b) invest in the shares of another company /

single group of companies exceeding 15 per cent / 25 per cent of its owned

fund; and (iii) lend and invest (loans / investments taken together) exceeding

25 per cent of its owned fund to a single party and 40 per cent of its owned

fund to a single group of parties.

v Non-Systematically Important NBFCs-ND

A NBFC–ND whose asset size does not exceed Rs.100 crore as

per the last audited balance sheet may be considered as Non-Systemically

Important NBFCs–ND (NBFC-ND-NSI).

RESIDUARY NON-BANKING COMPANIES

The deposit taking activities of the Residuary Non-Banking

Companies (RNBCs) are governed by the provisions of the Residuary Non-

Banking Companies (Reserve Bank) Directions, 1987. In view of low or

negligible NOF, the quantum of deposits which can be accepted by these

companies is not linked to their NOF and for the purpose of safeguarding

depositors’ interest, they are directed to invest at least 80 per cent of their

deposit liabilities in the securities as per a prescribed investment pattern.

These securities are required to be entrusted to a public sector bank and can be

withdrawn only for the purpose of repayment to the depositors.

With effect from November 1997, these companies are required

to pay interest on their deposits which shall not be less than 6 per cent per

21
annum on daily deposit schemes, 5 per cent for daily deposits up to two years

and 8 per cent on other deposit schemes of higher duration or term deposits.

Other provisions relating to (a) minimum and maximum period of deposits;

(b) prohibition from forfeiture of any part of the deposit or interest payable

thereon; (c) disclosure requirements in the application form and advertisement

soliciting deposits; (d) furnishing of periodical returns and information to the

RBI, which are in force since May 1987, have been kept unaltered.

The operations of RNBCs are characterized by a host of features

including (a) systematic understatement of their deposit liability, (b) payment

of high rates of commission; (c) discontinuation of deposit certificates to the

tune of 80 to 90 per cent in some of the schemes; (d) forfeiture of deposits;

(e) low or negligible rate of return on deposits; (f) appropriation of capital

receipt to revenue account and consequent non-disclosure of the entire deposit

liability in the books of account / balance sheets; (g) negative or negligible

NOF; (h) levy of service charges on the depositors; etc. The RBI adopted

several measures to remove these unsatisfactory features.

The track record of regulatory compliance for RNBCs has been

significantly lower vis-à-vis other NBFC groups. Monitoring and inspection

of these companies, from time to time, revealed continuance of many

unsatisfactory features including non-compliance with the core provisions of

the directions, diversion of the depositors’ money to associate concerns and /

or investment in illiquid assets and violations of investment requirements /

interests of the depositors. The RBI could only prohibit the errant companies

from accepting deposits any further. However, keeping in view both the

depositors’ interests as well as the interests of the employees of these

22
companies, imposing prohibition of orders in all cases was not a solution to

the problem, particularly in the case of large RNBCs with substantial public

deposits. Accordingly, persistent efforts were made by the RBI to spruce up

their operations and ensure compliance with the directions. In cases where

adherence to directions was found unavoidable, the RBI has had to resort to

issue prohibition orders on a case-by-case basis.

However, in many cases, the actions initiated by the RBI were

constrained when some of the companies approached the courts of law and

obtained stay orders and at the same time continue to mobilize deposits. Some

of the ingenious promoted or floated new companies started accepting

deposits through new entities or shifted their areas of operations to other

states.

Equipped with the new regulatory framework of Chapter III-B

of the RBI Act, 1997, the RBI extended prudential norms to the RNBCs. The

requirement for compulsory registration for RNBCs before commencing

business coupled with other concerted actions against such companies has

curbed the unhealthy tendency of mushrooming growth of these companies.

The inspections and monitoring of the RNBCs have been stepped up to ensure

that the erring companies should rectify the irregularities and fall in line with

the regulatory framework.

NON-BANKING FINANCIAL COMPANY - MICRO FINANCE

INSTITUTION (NBFC-MFI)

NBFC-MFI is a non-deposit taking NBFC having not less than

85% of its assets in the nature of qualifying assets which satisfy the following

criteria:
23
 · loan disbursed by an NBFC-MFI to a borrower with a rural

household annual income not exceeding Rs. 60,000 or urban and

semi-urban household income not exceeding Rs. 1,20,000;

· loan amount does not exceed Rs. 35,000 in the first cycle and Rs.

50,000 in subsequent cycles;

· total indebtedness of the borrower does not exceed Rs. 50,000;

· tenure of the loan not to be less than 24 months for loan amount in

excess of Rs. 15,000 with prepayment without penalty;

· loan to be extended without collateral;

· aggregate amount of loans, given for income generation, is not less

than 75 per cent of the total loans given by the MFIs;

· loan is repayable on weekly, fortnightly or monthly installments at

the choice of the borrower

MUTUAL BENEFIT FINANCIAL COMPANIES (NIDHIS)

A NIDHI company, notified under Section 620A of the

Companies Act, is classified as ‘Mutual Benefit Financial Company’ (MBFC)

by the RBI and is regulated by the RBI for its deposit taking activities and by

the Department of Company Affairs for its operational matters as also the

deployment of funds. The companies incorporated after 9 January 1997 have

been considered as Mutual Benefit Companies only if they have a minimum

NOF of Rs. 25 lakhs and have obtained a Certificate of Registration from the

RBI under the provisions of the RBI Act, i.e. from the provisions of RBI

24
Directions except those relating to (a) interest rate on deposits; (b) prohibition

from paying brokerage on deposits; (c) ban on advertisements, and

(d) requirements of submission of certain returns. However, they are allowed

to deal only with their shareholders both for the purpose of accepting deposits

and making loans.

On the other hand, the companies which are purportedly

working like NIDHIS without their names being notified under Section 620A

of the Companies Act were adversely affected by the RBI’s direction to class

such companies as loan companies, as they could not obtain the special

dispensation available to notified NIDHI companies was created subject to

certain norms, till they are notified as NIDHI companies.

CHIT FUND COMPANIES

Operations of chit fund companies are governed under Chit

Funds Act, 1982, which is administered by state governments. However, their

deposit taking activities are regulated by the RBI and they are allowed to

accept a miniscule amount of deposits, i.e., up to 25 per cent of their NOF

from the public and up to 15 per cent from their shareholders. The concerns

regarding the protection of depositors’ interests are further minimized to a

great extent as the chit fund companies usually accept deposits from their chit

subscribers. Merchant banking companies have been exempted from the

provisions of the RBI Act, provided they are registered with SEBI. These

relate to (a) compulsory registration; (b) maintenance of liquid assets; and

(c) creation of reserve fund as well as all provisions relating to deposit

acceptance and prudential norms.

25
ALIGNMENT OF THE RBI’S REGULATIONS WITH COMPANIES

(AMENDMENT) ACT, 2000

Changes were effected in the RBI directions to NBFCs to align

with those contained in the Companies Act, 1956, as amended by the

Companies (Amendment) Act, 2000. Accordingly, all NBFCs were advised to

report to the company law board the defaults, if any, in repayment of matured

deposits or payment of interest to small depositors within 60 days of such

default. In addition to NBFCs with asset size of Rs. 50 crore and more, those

with paid-up capital of not less than Rs. 5 crore have to constitute audit

committees. Such committees would have the same powers, functions and

duties as laid down in Companies Act, 1956. Moreover, some NBFCs, which

were hitherto private limited companies holding public deposits, have now

become public limited companies under the Companies Act. Such NBFCs

have to approach the RBI after obtaining a fresh certificate of incorporation

from the Registrar of Companies, for change of name in the CoR to reflect

their status as public limited companies.

LIQUID ASSET SECURITIES OF NBFCS

Effective from 1 October 2002, all NBFCs should necessarily

hold their investments in government securities either in Constituent’s

Subsidiary General Ledger Account (CSGL) with a scheduled commercial

bank or Stock Holding Corporation of India Ltd, (SHCIL) or in a

dematerialized account with depositories [National Securities Depository Ltd,

(NSDL) / Central Depository Services (India) Ltd, (CDSL)] through a

depository participant registered with SEBI. The facility of holding

26
government securities in physical form, therefore, stands withdrawn.

Government guaranteed bonds, which have not been dematerialized may be

kept in physical form till such time these are dematerialized. Only one CSGL

or a dematerialised account can be opened by any NBFC. In case the CSGL

account is opened with a scheduled commercial bank, the account holder has

to open a designated funds account (for all CSGL related transactions) with

the same bank. In case the CSGL account is opened with any of the non-

banking institutions indicated above, the particulars of the designated funds

account (with a bank) should be intimated to that institution. The NBFCs

maintaining the CSGL account for sales before putting through the

transaction. No further transactions in government securities should be

undertaken by NBFCs with any broker in physical form with immediate

effect. All further transactions of purchase and sale of government securities

have to be compulsorily through CSGL / demat account. Government

securities held in physical form were to be dematerialized by 31 October

2002.

ACCOUNTING STANDARDS

In terms of Accounting Standards (AS) 19 (Accounting for

Leases) issued by the Institute of Chartered Accountants of India (ICAI), it

was clarified that (i) the prudential norms applicable to hire purchase assets

would, mutatis mutandis, be applicable to the financial leases written on or

after 1 April 2001; and (ii) the leases written up to 31 March 2001 would

continue to be governed by the prudential norms relating to leased accounts,

as hitherto.

27
STATUTORY AUDITORS

NBFCs have to reiterate in their letter of appointment to

statutory auditors their statutory responsibility to report directly to the RBI the

violations, if any, of the provisions of the RBI Act or Directions issued there

under, and noticed by them in the course of their audit.

ASSET LIABILITY MANAGEMENT

Based on the guidelines issued in July 2001, effective 31 March

2002, asset liability management system in all NBFCs with public deposits of

Rs. 20 crore and above as also NBFCs with asset size of Rs. 100 crore and

above has been made operational. Based on liabilities, NBFCs are classified

into two categories - Category “A” companies (NBFCs-D), and Category “B”

companies (NBFCs not raising public deposits or NBFCs-ND). NBFCs-D is

subject to requirements of capital adequacy, maintaining liquid assets,

exposure norms (including restrictions on exposure to investments in land,

building and unquoted shares), ALM discipline and reporting requirements.

Category “B” companies, in contrast, were subject to minimal regulation till

2006. However, since April 1, 2007, non-deposit taking NBFCs with assets of

Rs. 1 billion and above have been classified as NBFCs- ND-SI and prudential

regulations such as capital adequacy requirements and exposure norms along

with reporting requirements have been made applicable to them. Capital

Market Exposure (CME) and Asset Liability Management (ALM) reporting

and disclosure norms were also made applicable to them at different points of

time.

28
PRIMARY DEALERS

In order to strengthen the market infrastructure of the

government securities market and make it vibrant, liquid and broad based, the

Primary Dealers (PDs) system in the government securities market was

introduced by the RBI in 1995. The PD system has developed substantially

over the years and presently it serves as an effective conduit for conducting

open market operations. There were 19 PDs in existence as at March-end

2008 of which 9 are stand-alone bank entities.

During 2000-01, the scheme of liquidity support to PDs was fine

tuned to provide at two levels: (a) assured support at a fixed rate and quantum;

and (b) discretionary support to be extended through Liquidity Adjustment

Facility (LAF).In May 2001, the assured liquidity support was further

bifurcated into ‘Normal’ (two-third) facility at the bank rate and ‘backstops’

(one-third) facility with a higher interest rate provided at a variable rate linked

to cut-off rates emerging in regular LAF auctions. In the absence of LAF

operations, the rate is fixed at 200 to 300 basis points over National Stock

Exchange-Mumbai interbank offered rate (NSE-MIBOR) as may be decided

by the RBI.

The RBI prescribed new guidelines in January 2002 to improve

the risk management system of PDs. Accordingly, the capital adequacy

requirements of PDs take into account both credit risk and market risk. The

PDs are required to maintain the higher of the market risk capital calculated

through a standardized model and the Value at Risk (VaR) method. PDs

without a VaR system in place are required to maintain 7 per cent risk capital.

29
In January 2002, PDs were advised to provide back-testing results for the year

ended 31 December 2001 and follow a prudent distribution policy so as to

build up sufficient reserves even in excess of regulatory requirements which

can act as a cushion against any adverse interest rate movements in the future.

The need for putting in place appropriate exposure limits and reviewing those

limits periodically by the PDs was also emphasized. Furthermore, in view of

the risks involved in accepting Inter-Corporate Deposits (ICDs) and deploying

those funds in non-SLR bonds, PDs were advised to restrict acceptance of

ICDs after due consideration of the risks involved.ALM discipline has also

been extended to PDs during the year. Unlike other NBFCs, the entire

portfolio of government securities of PDs has been allowed to be treated as

liquid.

The off-site surveillance of PDs is done on the basis of three

basic returns, viz., PDR I, II and III. PDR I is a daily statement of sources and

uses of funds and is used to monitor the deployment of call borrowing and the

RBI liquidity support, leverage and the duration of PDs portfolio.PDR I return

has been revised to capture more details on sources like ICDs, CPs, etc. PDR

II is a monthly statement on the basis of which the bidding commitments,

success ratio, underwriting performance, secondary market turnover of PDs,

etc., are monitored.

PDR III is a quarterly return on the basis of which the capital

adequacy of the PDs is monitored. Apart from these regular returns, additional

details are called for as and when necessary. The ALM guidelines for NBFCs

with some modifications were also made applicable to PDs.

30
 The regulatory guidelines issued in July 2006 prohibited PDs

from setting-up step-down subsidiaries. Accordingly, PDs that already had

step-down subsidiaries (in India and abroad) were required to restructure the

ownership pattern of those subsidiaries.

Mutual Benefit Financial Companies (Nidhis)

Mutual Benefit Financial Companies (Nidhis) have been

exempted from the core provisions of the RBI Act, 1934 and directions,

excepting those relating to ceiling on interest rate, maintenance of register of

deposits, issue of deposit receipt to depositors, and submission of return on

deposits in Form NBS-I.As part of the implementation of the

recommendations of an Expert Group to examine various aspects of the

functioning of Nidhi companies (Chairman being Shri P. Sabanayagam), the

Central Government prescribed entry point norms and NOF to deposit ratio,

liquid asset requirement, etc. These measures are expected to strengthen the

functioning of these companies. In July 2001, the central government

announced guidelines relating to acceptance of deposits, business activity,

prudential norms, etc., which were further awarded in April 2002.

UNINCORPORATED BODIES

The time limit for repayment of public deposits, except those

from sources permitted by the RBI Act, 1934, held by all the unincorporated

bodies engaged in financial business expired on 31 March 2000. Accordingly,

the RBI cautioned unincorporated bodies engaged in financial business to

neither accept any deposit from members of the public, nor issue

advertisements soliciting deposits. Consequently, members of the public were

31
also cautioned about the risk of depositing money with such unincorporated

bodies.

SOURCES OF FUNDS OF NBFCS

NBFCs have been playing as a media between investors and

users of funds. The main function of NBFCs is to invite deposit and lend

money in the form of leasing, hire purchase or granting loans. In finance, this

is called financial intermediation. It may be mentioned that in case of NBFCs

dependent on one source of funds for entire requirements, there arises a

greater risk in their operations. It results in problems contributing to

increasing or decreasing its reliance on different sources of borrowings. The

NBFCs which were relying completely on public deposits are facing problems

now after the introduction of RBI (Amendment) Act, 1997 and the several

restrictions regarding acceptance of public deposits imposed therein. The

main objective of such restrictions is to protect the interest of small investors.

Total sources of funds for NBFCs may be divided into two

categories.

v Owned Funds: The promoters of NBFCs can start their business

in the form of non-banking business with the prescribed amount

of money and initially invest money depending on the

requirement of business and the scale of operations. Investment by

promoters in the initial stage is own as owners’ funds. Such funds

should be enlarged by issue of equity capital. Finally, this consists

of equity share capital, preference share capital and reserves and

surplus.
32
 v Borrowed Funds: Operations of NBFCs in India generally

depend on borrowed funds. Borrowed funds are necessary for

different fund-based activities of NBFCs, be it leasing, hire

purchase or loans. NBFCs can raise borrowed funds from one

source or multiple sources depending upon the scale of operations

or requirement of funds. In leasing decisions, the normal practice

is to assure borrowing for making comparisons in cash flows,

bonds, commercial paper, bank borrowings, inter-corporate

deposits, etc. Besides the public deposits, there are different

sources of borrowed funds which is required for the efficient

functioning of NBFCs. That source is:

· Commercial Banks;

· Commercial Finance Companies;

· Loan from Financial Institutions;

· Debentures;

· Insurance and Pension Funds;

· Inter-corporate Deposits;

· Money Market.

v Borrowing from Commercial Banks

Apart from public deposits collected by NBFCs, borrowing from

commercial banks is a major source of finance. Banks provide short-term

funds which they raise from loanable funds by way of demand deposits and

which can be withdrawn quickly by the investors. This restricts the banks in

providing long-term loans. It is well-known that banks have extended credit

33
exposure to the NBFC sector. Banks prefer to lend to a single borrower

instead of large number of small customers. It is beneficial for credit

administration and more likely to satisfy the credit appraisal requirements

than in the case of individual customers. After the CRB fiasco, banks are

unwilling to extend credit to the NBFCs. This has created problems in the

working capital management of this segment. Commercial banks are lending

credit to NBFCs with high precautionary measures and they provide credit not

more than twice of NOF. They also consider credit rating in granting loans to

NBFCs.

v Commercial Finance Companies

NBFCs raise funds from investment companies as borrowed

funds. Cost of borrowed funds from commercial finance companies is

generally higher than other sources of borrowed funds. If a lease company

raises funds from investment companies and provides assets on lease basis,

such company earns a very small margin from these funds. Therefore, NBFCs

engaged in leasing business, borrow from this source when they fail to avail

all other sources. Small NBFCs which have no access to borrow funds from

other sources, generally take this source of borrowing.

v Inter-Corporate Deposits

It is a very short-term fund for NBFCs, generally not more than

one year. It is a source of borrowing from one company to another. It is a

popular source of borrowing for NBFCs to meet their short term requirements.

This arrangement should be used as a temporary use of funds and should not

be used as a permanent source of funds. RBI has advised the NBFCs not to
34
heavily depend on ICDs for making investments in lease or hire-purchase

assets since this may create an asset-liability mismatch. The rate of interest on

ICDs is normally higher than other sources of borrowings. RBI has also

prescribed the ceiling limit on ICDs – borrowing. It is two times of the NOFs

in case of leasing and hire-purchase business within the overall ceiling limit.

v Money Market

Sometimes NBFCs raise resources for short-term requirements

from the money market. These money market instruments are commercial

papers and certificate of deposits etc.

v Debentures

NBFCs issue debentures to raise funds from the capital market

as per guidelines issued by Securities and Exchange Board of India (SEBI)

under the SEBI Act, 1992.Debenture is a document issued by a company to

the lender of funds. It is fixed interest bearing document. The debenture can

be secured or unsecured. The interest paid on debentures is a deductible

expenditure under the income tax law but the payment of interest is

obligatory, irrespective of the profit or loss.

v Insurance and Pension Funds

It has been argued that financial development of a country is

synergistic with the economic development. Insurance and pension funds

support economic growth by providing long-term loans to NBFCs,

particularly those engaged in the leasing business. These institutions provide

for longer term than banks’ demand deposits.

35
v Loans from Financial Institutions

Financial institutions like Industrial Credit and Investment

Corporation of India Ltd (ICICI), Industrial Development Bank of India

(IDBI) and Industrial Finance Corporation of India (IFCI) have been

extending funds to NBFCs to promote their businesses. After the CRB capital

market fiasco, major financial institutions are unwilling to extend loans to the

NBFCs. This has raised an important question about the reliability of the

judging procedures of credit rating agencies relating to the financial position

of the NBFCs. At present they are cautious in dealing with NBFCs.

REASONS FOR POPULARITY OF NBFCS WITH THE CUSTOMERS

NBFCs are popular with the customers for the following

reasons:

v Procedural Convenience

Government attitude with regard to providing finance to

industries has changed since 1991, and as a policy matter, the government

imposed restrictions on banks to provide term loan as well as cash credit

facilities to the industries. Not only that, in getting finance from banks,

industries have to follow rigid legal formalities which not only create major

problems in starting the projects but also the possibility of cost over runs.

NBFCs providing lease finance which is free from cumbersome procedures,

compliance of covenants and regulations as compared to procuring finance

from financial institutions. Leasing finance is the quickest finance available

for meeting the costs of capital expenditure of business enterprises. It allows a

36
client to acquire assets at a fast pace. Thus, in case of NBFCs, the process of

providing finance to industries is not lengthy and as a result their businesses

improve steadily.

v Effect on Borrowing Capacity

The term borrowing capacity signifies the scope which the

company enjoys to increase its borrowed capital without damaging the credit

rating and market price of its shares. It is needless to mention that, if a firm

increases debt without increasing the equity, the borrowing capacity of the

firm is reduced. Leasing is not borrowing and as such the borrowing capacity

of the firms remains intact and preserved for future borrowing. Lease is

equivalent to borrowing and it commits a firm to a schedule of fixed

payments. Equipment leasing under the garb of NBFCs does not appear as

debt on a firm’s debt-equity ratio. Thus, it helps in increasing the borrowing

capacity of the firm in the sense that it is off balance sheet items of finance.

On the other hand, companies which have exhausted their borrowing capacity

can pursue their growth of operations by means of lease finance to acquire

additional equipment for increasing their production capacities.

v Shifting Obsolescence Risk

It is undeniably true that if any industry does not use modern

technology, it cannot compete with other industries using the same. However,

it should be kept in mind that any such plant or equipment carries the risk of

obsolescence. This particular fact raises a great question mark to the

entrepreneurs who have been suffering from financial crisis. The risk of

100 per cent is shared by the lessor under the lease agreement. So, an
37
entrepreneur opts for leasing because under this agreement the risk of

obsolescence shifts from the user to the owner.

v Piecemeal Financing Device

Lease financing is a less costly and more convenient piecemeal

financing device particularly in those circumstances when a firm is expanding

by adding relatively smaller amounts of fixed assets at regular intervals. In

such a scenario, the firm will have to locate a series of funds to finance its

growth. However, with the passage of time, the cost of financing will

increase, thereby posing unnecessary hardship on the financial position of the

firm for raising funds from other sources. Hence, NBFCs by means of

offering the leasing facility helps the firm to avoid high cost of piecemeal

financing.

v Cash and Tied Up in Fixed Assets

NBFCs provide equipment to the entrepreneurs under the lease

agreements and the firm uses the assets without incurring huge capital

expenditure. Hence, the surplus cash can be utilised by the firm for the

building of additional manufacturing capacity or financing the working

capital. If the return on working capital is higher than the cost of leasing then

the acquirer may opt for leasing the equipment instead of buying it.

v Boon for Small Firms

Small firms which have no access to raise funds from capital

markets can acquire assets by means of leasing arrangements from NBFCs.

Thus, NBFCs serve the small firms in arranging funds for launching of new

38
business or for expanding the existing one. Therefore, NBFCs help to create

better employment opportunities for the society.

v Image of the Country

Among the many factors responsible for under development,

lack of capital formation is considered to be a factor of prime importance. In

case of India, lease financing is beneficial for importing ships, aircrafts, etc.,

instead of borrowing. This will create a better image of the nation than being a

borrower with no pressing service charges for unpaid loans. Thus, large-sized

NBFCs can help big companies and also the government to acquire capital

assets under the lease agreements. Overall, NBFCs contribute to the country’s

economic growth.

v Loan Financing to Small Operators

Small road transport operators generally acquire their vehicles

by taking finance from NBFCs. Loan financing from NBFCs is easier than the

bank financing. The auto finance sector has traditionally been dominated by

the NBFCs.

v Wide Area Network

With the increasing services sector activity in India, NBFCs

have been playing a critical role in providing the credit. NBFCs have

extensive networks and many have appointed a large number of agents who

collect money from small depositors through door to door service. Thus

NBFCs provide a good investment opportunity for the small investors.

39
v Attractive Rates of Return

The NBFCs have flourished well for the reasons that they have

offered attractive rates of return to the depositors. On many occasions, they

have offered attractive gifts to their depositors through their brokers and

agents. They even offer at least 4 per cent more interest on their deposit than

the public sector banks on 1-3 year maturity deposits. This helps them in

establishing a better position to collect deposits from the small investors.

RATIONALE BEHIND THE STUDY

The financial sector contributes to economic growth through

five main channels: (1) facilitating the trading, hedging, diversifying, and

pooling of risk; (2) allocating resources; (3) monitoring and exerting corporate

control; (4) mobilizing savings; and (5) facilitating the exchange of goods and

services8. The Indian financial sector includes NBFCs in the performance of

the above said functions. NBFCs serve the nation in economic reconstruction

in the same way, as non-government voluntary organizations rejuvenate the

social structure. The importance of NBFCs have been felt vehemently for

uplifting the various sectors of the economy and boosting the rate of economic

growth, having learnt the lessons from the experiences of the developed

nations where NBFCs have played a vital role in market based free

economics.

8
Levine R., N. Loayza, and T. Beck, “Financial Intermediation and
Growth, Causality and Causes”, World Bank Country Economics
Department Papers 2059, Washington, D.C.1999.
40
 In India, the role of NBFCs has been well recognized by the

government since the seventies. RBI’s regulations for giving boost to their

fund raising, endeavor in the form of fixed deposits from the public were

enforced as early as in 1977 to ensure their continued growth. The growth of

NBFCs has helped the industrial development to a greater extent. The

common characteristic feature of these institutions is that they mobilise

savings and facilitate the financing of different activities, but do not accept

deposits from the public at large. The NBFCs play an important dual role in

the financial system. They complement the role commercial banks, filling

gaps in their range of services, but they also compete with commercial banks

and force them to be more efficient and responsive to the needs of their

customers. Most NBFCs are also actively involved in the securities markets

and in the mobilisation and allocation of long-term financial resources. The

state of development of NBFCs is usually a good indicator of the state of

development of the financial system as a hole. There are many factors

influencing the growth of NBFCs in India, especially during the last four

decades, notably in the eighties.9

The growth of financial intermediaries including NBFCs, in

general helps the process of financial deepening of the economy. In India, it is

worth noting that it has been the NBFCs which have grown very rapidly since

the imitation of the process of economic liberalization in 1991. From 1992,

the mobilization of deposits gained further momentum. During the first half of

the 1990s, NBFCs also started to gather substantial funds from the stock

market.

9
Srinivasan “Future of Non-Banking”, The Hindu, Dated 17th March
1999, p. 26.
41
 Though the era of rapid growth of capital markets in India had

started in the late 1980s itself, the deregulation of control over capital issues

in 1992 made it easier for NBFCs to raise capital on the stock markets. These

developments, in addition to the explosion in their numbers, clearly

distinguish the first half of the 1990s from the past, as far as the NBFCs are

concerned.10

The growth of NBFCs, which flourished during the first half of

the 1990s, was later affected with the collapse of relatively large NBFCs in

the private sector in 1997 due to the scams. This soon affected the working of

NBFCs. Though reforms were introduced in the areas of business relating to

NBFCs, it is the regulatory framework of 1998 which tightened the working

of NBFCs. Though there is greater need for credit, the downfall of NBFCs,

affected the availability flow of funds. The existence of NBFCs in India has

coincided with a major structural transformation in the Indian financial

system, which has an important bearing on the conduct of monetary policy.

Because of the financial widening and deepening, there was a shift from

monetary assets to non-monetary assets such as contractual savings and other

assets including shares, debentures, units etc., As the NBFCs and the

commercial banks act as financial intermediaries, the question arises as to

whether these NBFCs have been posing any competition for the commercial

banks. This is the question raised from the fact that there was a manifold

increase in the number of NBFCs in the nineties. The total number of NBFCs

in 1996 was nearly 52000, before the introduction of amendment to RBI Act

in 1997.11 To get the complete picture on the importance of NBFCs as

10
Anand MR. (ed.) “Indian Capital Market Trends and Dimension”, Tata
McGraw Publishing Ltd., New Delhi, 2000 pp. 180-190.
11
Saravanan P, “A Study on Working Capital Management in Non-
Banking Finance Companies”, Finance India, Vol. XV, No.3, September
2001, pp. 987-994.
42
compared to commercial banks as financial intermediaries, the share of bank

deposits and non-bank deposits in the gross savings of the household sector in

the financial assets is presented in Table 1.2.

Table 1.2
Savings of the Household Sector

Financial Assets of As% of Non-Bank As % of

Bank
Year Household Sector Financial Deposits Financial
Deposits
(in crore) Assets (in crore) Assets
1980-81 12,118 5,550 45.8 378 3.10
1985-86 25,562 10,603 41.5 1,423 5.6
1990-91 58,908 18,771 31.9 1,286 2.2
1991-92 68,045 17,848 26.3 2,218 3.3
1992-93 80,354 29,518 36.8 6,035 7.5
1993-94 1,09,618 36,236 33.1 11,654 10.6
1994-95 1,45,501 55,835 38.9 11,547 7.9
1996-97 1,24,338 39,941 32 13,198 10.6
1997-98 1,58,518 50,902 32.1 25,980 16.3
1998-99 1,71,740 74,099 43.1 6,733 3.9
1999-
2,07,390 79,433 38.3 7,957 3.8
2000
2000-01 2,39,058 82,892 34.7 8,736 3.6
2001-02 2,56,735 94,703 36.98 12,221 4.7
2002-03 2,91,406 1,10,253 37.8 8,437 3.0
2003-04 3,87,108 1,41,973 36.7 15,238 4.0
2004-05 4,34,317 1,58,393 36.5 3,370 0.8
2005-06 5,97,867 2,74,747 46.2 6,130 1.0
2006-07 7,68,967 4,17,228 55.6 7,873 1.0
2007-08 7,34,699 4,06,448 55.3 8,772 1.2
2008-09 7,26,889 3,83,679 52.8 14,742 2.0
2009-10 9,89,800 3,62,000 36.6 18,520 1.9
2010-11 10,79,900 5,53,400 47.9 5,100 0.5
2011-12 9,56,500 4,98,500 52.1 20,900 2.2
2012-13 10,96,900 5,63,200 51.3 20,400 1.9

Source: Report on Currency and Finance, RBI1997-98. And Annual Report

up to 2012-13

43
 As it is evident from the Table 1.2, till the year 1997, which is

before the introduction of Regulatory Framework 1998, the NBFCs’ deposits

to the total financial assets show an increasing trend. Whereas the bank

deposits to the total financial assets do not show a steady increase or decrease.

The increasing trend in the NBFCs deposits highlights the ability of NBFCs in

the mobilization of deposits from the public when compared to the banks in

the nineties. The deposit percentages of NBFCs and banks to the total

financial assets clearly bring out this feature. However, after 1997, the trend

relating to the NBFCs’ deposits to the total deposits shows a downfall due to

the New Regulatory Framework 1998.

Regarding the financial sector reforms, in most developing

countries, they have been focused largely on the formal banking sector and the

securities market. Much emphasis has been laid in the literature on the

possible increase in savings and improvement in the allocative efficiency of

the financial sector, especially banks, following financial liberalisation.

The response of other non-bank financial intermediaries in the

informal sector and the semi-formal sector following such reforms has

received comparatively less attention. Given the increasing importance of

non-banking intermediaries, even in the developing countries, their

functioning deserves greater attention of researchers and policy makers.

It is interesting to note that in most developing countries, it has

been the semi-organized segment, particularly the finance companies, rather

than banks, that have expanded rapidly with the first flush of financial

liberalization. In Nigeria after 1986, Lewis and Stein note that with a

44
relaxation of barriers to entry in financial services, the market conditions

encouraged the emergence of new financial institutions (apart from banks

which continued to be dominant). They go on to state that the wholesale entry

of new firms drastically changed the structure and competitive environment of

the sector. A diversifying array of market made the system more opaque and

unstable, many of the new entrants focused on rent seeking, speculation and

fraud, rather than conventional intermediation. The flow of personnel and

capital to NBFCs created a vortex of activity which altered the character of

financial markets and eventually undermined the foundation of the sector.

Hence, NBFCs provided an additional link between deficit units

and surplus units. Their role cannot be replaced by banks. In fact both NBFCs

and banks can be powerful engines of growth.12Considering the role being

played by NBFCs in the economic development of the country, and the

problems that these NBFCs have been facing, examining the impact of

financial sector reforms on NBFCs is felt inevitable.

SCOPE OF THE STUDY

In order to analyse the impact of financial sector reforms on

NBFCs, two companies are considered. They are Shriram Transport Finance

Limited and Mahindra and Mahindra Financial Services Limited. The criteria

adopted for the selection of these companies was based on the nature of their

business and their coverage of areas. Till the year 1998, nearly more than

75 per cent of RoC registered NBFCs were in south India.

12
Khan, Mohd, “Indian Financial System” Tata McGraw Ltd, 2000,
pp. 45-50
45
 Of these, more than 50 per cent were in southern states. Hence

the selection may be based on market capitalization of listed companies.

However, after 1998, due to the failure of many NBFCs, the number of

NBFCs with RBI in southern states has declined.

OBJECTIVIES OF THE STUDY

The overall objective of the present study is to understand the

impact of financial sector reforms on the NBFCs. However, the specific

objectives of the study are:

1. To analyze the role of NBFCs, after financial sector reforms.

2. To study the impact of NBFCs, after the slowdown due to post-

reform and financial crisis.

3. To study the complex nature of recommendations of various

committees appointed by RBI.

4. To examine the mismatch of asset and liability of NBFCs.

5. To evaluate the working of hire purchase and leasing companies

with reference to the performance of two leading NBFCs in India.

6. To compare the deposit pattern of NBFCs with commercial banks.

HYPOTHESIS

Based on the objectives, the researcher proposes the following

hypothesis:

Research Question (1)

Is there any significant relationship between loans and advances

made by NBFCs and long term liabilities raised by NBFCs after mandatory

credit rating from Credit rating agencies.

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 Null Hypothesis (H0): There is no significant relationship between

Loans and advances of NBFCs and Long term liabilities of NBFCs.

Alternative Hypothesis (H1): There is a significant relationship

between Loans and advances of NBFCs and Long term liabilities of NBFCs.

Research Question (2)

Whether the impact of reforms and global financial crisis have

affected the NBFCs business like Number of Companies registered, Quantum

of raising different sources and Loans and advances provide by these

institutions and Investment made by these institutions.

Null Hypothesis (H0): There is no significant difference exists

between pre-reform period. Post-reform period and Global financial crisis.

Alternate Hypothesis (Ha): There is a significant difference

exists between pre-reform period, post-reform period and the Global financial

crisis the indicators of NBFCs used to analyse the impact are:

(i) The number of NBFCs

(ii) The quantum of deposits

(iii) The loans and investments

Research Question (3)

Is there any significant difference between MMFS and STFC in

their performance over the last 5 years for the two selected companies?

Null Hypothesis (H0): There is no significant difference

between Mahindra and Mahindra Financial Services (MMFS) and Shriram

Transport Finance Company (STFC)

47
 Alternative Hypothesis (H1): There is a significant difference

between Mahindra and Mahindra Financial Services (MMFS) and Shriram

Transport Finance Company (STFC)

METHODOLOGY

Selection of NBFCs for Overall Study

NBFCs considered for the study on impact of financial sector

reforms are those which reported to the RBI every year. Though the number

of NBFCs registered with RoC is large, only 20 per cent to 40 per cent of

them reported to the RBI till the end of 1998. Due to the new registration

process introduced in 1998, from the year 1999 to 2013, the number of

NBFCs reported to the RBI to the number of NBFCs with RoC declined to

4.50% on an average. The registered NBFCs include deposit taking and non-

deposit taking NBFCs. Hence, the overall study on the impact of financial

sector reforms on NBFCs includes only those that reported to the RBI during

1985-2013.

SOURCES OF DATA

Data have been collected from secondary sources which include:

1. Annual Reports of banks, financial institutions, RBI Reports such as

RBI Bulletin, currency and finance, trends and Progress of Banking,

CMIE etc.

2. Leading Indian journals in the field of commerce and economics

such as Journal of Economics, The Economist, Journal of Finance,

Journal of Commerce, Business Today, Business World, Vikalpa,

Indian Economic Journal, Economic and Political Weekly, The

Economist, etc., including dailies.

48
 3. Major international journals such as American Economic Review,

Journal Intermediation, and Reports and Working papers of World

Bank, IMF, NBER, WBER, ADB, BIS etc.

4. The performance of two leading CNX-NIFTY JUNIOR Index

Companies – Mahindra and Mahindra Financial Services and

Shriram Transport Finance Company over the past five years.

PERIOD OF STUDY

The study covers a period of 33 years, i.e., from 1981 to 2013.

The period from 1981-82 to 1995-96 represents the pre-reform period which

marks the period of initiatives taken for liberalization and from 1996-97 to

2007-08 represents the post-reform period which experienced the

liberalization effects and 2008-09 to 2012-13 represents after financial crisis.

The NBFCs sector started flourishing with reform process that began earlier in

the eighties, continued with remarkable progress during the nineties and

existing with the pruned regulatory system at present. However, the period

varies depending upon the availability of data and the nature of the subject

dealt with.

STATISTICAL TOOLS USED FOR THE STUDY

The study used the following techniques:

1. Simple and popular tools like percentages and ratios.

2. Multiple regression analysis for examining the impact of financial

sector reforms on the NBFCs in terms of select indicators viz.,

Number of NBFCs, quantum of deposits and loans and investments.

49
 3. CAMEL Model for assessing the performance of the select hire

purchase and leasing companies for studying the impact of financial

sector reforms in terms of norms.

4. ‘t’ test for examining the effective financial performance of hire

purchase and leasing companies in terms of few financial ratios.

CHAPTERISATION

Chapter 1 : Introduction and design of the study

Chapter 2 : Review of Literature

Chapter 3 : NBFCs regulations in India

Chapter 4 : Analysis of NBFCs before, after reforms and crisis

Chapter 5 : CAMEL MODEL Analysis Two leading listed CNX

JUNIOR NIFTY companies.

Chapter 6 : Summary of findings, suggestions and conclusion.

LIMITATIONS

1. The number of NBFCs compiled by the Department of Company

Affairs on the basis of registered companies at work, classified in

terms of their main object clause at the time of registration.

However, they also include companies which may be dormant and

not carrying out any business. The information on the number of

NBFCs under the Companies Act, 1956 category-wise is not

published. Hence, the study takes into account only the reporting

companies which submit reports to the RBI.

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2. The data considered for assessing the effective performance of hire

purchase and leasing companies between 1991-92 to1995-96 and

1996-97 to 1999-2013 are based on the performance analysis of

finance and investment companies done by RBI at regular intervals

which includes varied number of companies.

3. Due to the Regulatory Framework 1998 which has included new

concepts like public deposits, entry norms, new prudential norms

etc., the data pertaining to the period from 1991-92 to 1997-98 are

not strictly comparable with the data pertaining to the period from

1998-99 to 2012-13. Hence, multiple regression model used for

assessing the impact of financial sector reforms on NBFCs

considered only those data till the year 1997-98.

51