Criteria for Rating of Non-Banking Financing Entities
22nd January 2019 (Version 3)

Executive Summary

Non-Banking Finance Companies (NBFCs) have played an important role in the Indian financial market in terms of extending financial services mainly to Tier II and Tier III cities across India apart from encouraging product innovation and customisation. NBFCs have historically bridged the gap between unorganised finance companies and banks. They can be broadly classified into asset finance companies, equipment leasing, hire purchase finance companies, investment companies, loan companies and residuary non-banking company. However, they operate in diverse segments such as commercial vehicle finance, loan against property or shares, housing finance, infrastructure finance, gold loans, and unsecured retail loans or micro-finance. NBFCs have also played a pioneering role in securities-based lending such as Loan against Shares (LAS), Margin Funding, Initial Public Offerings (IPO) Financing, securitization to name a few.

NBFCs have spread across the entire gamut of risk spectrum, including - personal loans, consumer durable loans, dealer or vendor financing and - segments such as home loans. 

Acuité's rating criteria for NBFCs is similar to that of banks and financial institutions. However, difference in the risk matrix necessitates focus on certain parameters such as diversification in product portfolio and innovation, cost competitiveness, capital adequacy, access to low cost funds, resources mix, established brand equity and level of technological integration.

Market Position

  • Size, Asset profile and Market presence
  • The size of operations determines the benefits derived by an NBFC in terms of economies of scale, ability to service large clients and preference over smaller companies for alliances. It also determines the ability of the company to sustain the fierce competition and create entry barriers for new entrants. Also, the size of operations can be assessed based on the total assets under management vis-à-vis the total assets under management of overall NBFCs. Further, the year-on-year growth in size of assets under management against year-on-year growth in various asset classes is an important parameter in determining the market position of the company. Additionally, size of operations, the asset profile and segments in which an NBFC operates, sheds additional light on the market position. Large NBFC's that have been operating for a long time and serving diverse asset classes tend to enjoy better market position and brand equity. This translates into benefits such as lower establishment and promotional expenses, more predictable income stream, preferred financier status and lower risk perception by customers.

  • Product Portfolio
  • Product innovation and customisation has not only aided NBFCs in creating a niche position in urban and semi-urban areas but also in gaining an edge over banks. Thus product innovation and customisation are key determinants of the market position enjoyed by an NBFC.

    The company's presence in various segments is required to be analysed in the light of segmented concentration and stability of earnings. Majority of the NBFCs operate as uni-product model companies to concentrate on their core competencies. However, the same also exposes these companies to business cycles within the segment. Further, high exposure to a single segment would also impact asset quality. Thus, diversification across segments assumes greater importance in the NBFC industry. A diversified portfolio helps them mitigate the impact of business cycle risk. However, certain NBFCs specialise in serving particular segments, grow large therein and are successful in defending their market positions despite competition from other financial institutions. Acuité also evaluates the strength and speciality an NBFC may have in serving a particular segment.

    Acuité shall evaluate contribution of each segment in the company's revenue profile and history of delinquencies within the top-contributing segments. Higher contribution by a single segment or top three segments would translate into lower earnings stability and deterioration in asset quality.

  • Market Presence or Distribution Network
  • NBFCs particularly operating in retail financing are required to develop strong distribution network of branches, direct sales or marketing offices, dealers, sub- dealers to name a few. In addition to distribution network, strong origination skills are a pre-requisite for establishing strong market reach. However, larger geographical presence is associated with higher operating costs. Thus, it is essential for companies to employ expansion strategies that aid in optimisation of operating costs vis-à-vis growth. The company's ability to effectively utilise cross selling techniques, strong origination and sourcing abilities are key elements that provide an edge. Acuité shall review the geographical reach of the company in light of the cost-effectiveness of the growth strategy.

  • Customer Relations, Service Standards and Fair practices
  • NBFCs have been successful in gaining market share in urban and semi-urban areas on account of customer oriented product innovation and superior customer service. Lesser turn-around time (TAT) compared to banks enables NBFCs to establish a strong market presence. Efficient customer service would in turn help build customer relationships. The presence of transparency and fair practice codes also assist NBFCs in a robust market position. Acuité shall review their track record in providing efficient customer service against industry standards.

Operating Efficiency

  • Appraisal and Monitoring Systems
  • Nature of operations of NBFCs demands strong appraisal as well as monitoring systems. Also, those operating in a competitive environment are required to monitor profitability, cost competitiveness and asset quality necessitating companies to incur large investments in IT infrastructure and information systems. Strong credit appraisal, monitoring and recovery systems enable companies to maintain risk and return profile. 
    Acuité shall evaluate systems and policies laid down by the company with respect to credit appraisal, extent of use of credit bureau information, data monitoring systems including frequency and finally integration of branch level data.

  • Adherence to Regulatory Requirements
  • Entities in the financial sector are subject to regulations of multiple regulators. Deficiency in compliance with regulatory requirement hampers the smooth functioning of the company and negatively impacts the image. Accordingly, consistent adherence to regulations is imperative for the smooth functioning of NBFCs. Acuité shall review the track record of the company in complying with the regulatory norms laid down by RBI, SEBI, IRDA or any other agency. Any deficiency in compliance shall have a negative impact on the rating of the entity.

  • Asset Quality
  • Asset quality, a critical parameter in assessing an NBFC's credit risk profile often acts as a mirror of overall operational performance and risk appetite of the entity. Asset quality is determined by studying the company's asset profile. The product and geographic diversification, mix of loan portfolio (exposure to unsecured assets), average ticket size, customer profile and movement in each of these parameters can help understand the inherent risk that an NBFC's portfolio is exposed to. Acuité evaluates the NBFC's risk management policies once the inherent risk profile of the asset portfolio is established. This gives an insight into how the asset risk is being managed. Strong risk management policies manifest themselves in lower credit losses during the aftermath of weak economic cycles. The strength of underwriting mechanisms, early warning systems, control and recovery measures go a long way in building a company's asset quality.

    Parameters such as GNPA (Gross Non Performing Asset) and NNPA (Non Performing Asset) percentages, track record of the delinquencies within each asset class are analysed. Finally, the recovery mechanisms for collection from delinquent accounts and the track record of recovery also help assess the NBFC's asset quality.

  • Resource Raising Ability
  • The company's access and ability to raise funds in a cost-effective manner ensures stability of its operations. The resources profile can be analysed based on the funding mix, support and access to funds in times of liquidity crunch, and growth in resources over the years vis-à-vis incremental cost of funds. Further, the resources profile should be studied against the nature of asset to be financed as well as the other uses of the resources and their nature. Diversified resources profile eases the liquidity position of an NBFC. Regulatory guidelines govern NBFCs' access to various resource-raising avenues. The company's access to capital markets or support from parent or group companies is also taken into account while evaluating resource raising ability.

  • Technology
  • Technology and IT infrastructure play an important role in the smooth operations of an NBFC. Retail financing implies smaller ticket size and large volumes, necessitating NBFCs to invest significantly in technology. Greater technological integration enables the company to remain cost effective.

Financial Risk

  • Capital Adequacy
  • NBFCs are required to maintain capital adequacy ratio as prescribed by the regulator from time to time. However, in addition to being a regulatory requirement, capital adequacy ratio gives an indication of the capital available to absorb losses arising from credit risk and market risks (in case of loses on marked-to-market portfolio). A higher capital adequacy can also indicate risk perception/tolerance of the NBFC. Most of the NBFCs operate in homogeneous product segments exposing them to higher business cycle risk demanding higher capital requirement. Thus, there is a greater need of inbuilt liquidity cover in the form of core capital to insulate the company in times of liquidity crisis.

    Capital adequacy is also required to be studied in the light of past history of NPAs, additional provision required for the same and potential losses from stressed assets. Capitalisation levels also provide insight into the management's aggression with respect to growth of the portfolio and the extent of reliance on debt to grow the balance sheet.

    Acuité also assesses the trends with regard to amount of capital, proportion of Tier I/Core capital, the management's capitalisation policy and extent of conformity to regulatory requirement.

  • Earnings Quality
  • Earning quality determines the stability, sustainability and growth in revenues. Studying an NBFC's income profile is essential to assess its earnings quality. Evaluating an NBFC's earnings quality involves analysing its asset portfolio as also its composition and diversity. The contribution to the top line from various segments and the trend in such contribution is particularly important to assess revenue stability. Contribution of each segment, once evaluated in relation to borrowing costs, gives a picture of the net interest spreads and net interest margins earned by the company in relation to the asset profile it carries. Riskier asset segments should ideally involve higher spreads. One way to improve spreads is to lower the borrowing costs while retaining the asset/investment portfolio. NBFCs usually rely on wholesale/bulk funds and are exposed to higher interest risks hence analysis of borrowing costs play an important role in evaluating earnings.

    Administration costs and credit costs (provisions and write-offs) form the next pillar in ascertaining earnings quality. An NBFC's operational efficiency and strong risk management practices generally translate into lower operating expenses and credit costs. Endeavours to constantly protect interest spread; reduce credit and administration costs enable NBFC's to confidently navigate through economic and interest cycles without impairing the earnings quality. Acuité shall also compare trends in incremental interest spread, operating expenses ratio and return on total/average assets of the NBFC and compare the same with industry peers to better categorise earnings quality.

  • Liquidity
  •  

    NBFCs and HFCs are exposed to relatively higher liquidity risks vis-à-vis banks due to the absence of structural liquidity support mechanisms as existing in the latter case.

    The maturity profile of asset and liabilities and any mismatch thereof, has significant bearing on the liquidity profile of the company. While many NBFCs and HFCs consciously run an asset-liability mismatch to ensure better funding and higher spreads, their ability to manage such mismatches during a difficult liquidity scenario is a critical element in their liquidity assessment.

    Acuité shall study the maturity profile of assets and liabilities, board approved policies of the company with respect to liquidity management and its access to funds from diverse sources including its parent (if any) during any exigency.

     

  • Accounting Quality
  • Accounting quality to be assessed in terms of conformance with Generally Accepted Accounting Practices (GAAP). Standard accounting practices facilitate comparison across the industry. In India, NBFCs are required to follow the accounting standards prescribed by the Institute of Chartered Accountants of India (ICAI). Acuité shall review the company's accounting policies, notes to accounts, and auditors' qualification if any, thoroughly. Non-conformance with the prescribed guidelines could impact rating.

Management Risk

  • Corporate Governance
  • Corporate governance evaluation takes into account management risk in terms of performance and accountability of the management towards various stakeholders such as shareholders, employees, customers, suppliers and lenders. Acuité shall also analyse the qualitative and quantitative parameters that determine accountability of the management towards various stakeholders. In addition, Acuité appraises the management of NBFCs on the following parameters:

  • Competency
  • Competency of the management is assessed based on the management credentials, organisation structure, performance track record, strategies employed by the management in response to the change in environment and finally impact of the strategy implemented on the performance of the company.

  • Integrity
  • Integrity of the management is assessed on the basis of the track record of the management in adhering to statutory requirements by various regulatory authorities, litigation and such related issues. Management for this purpose includes senior management of the company, directors and promoters. 

  • Risk Appetite
  • Risk Appetite of the management is an important parameter in determining management risk. It is ascertained on the basis of the tendency of the management to enter into risky business segments, exposure to risky segments in the past and management philosophy for mergers and acquisitions.

    Acuité lays out a comprehensive framework to assess risks inherent in the NBFC industry that includes credit, liquidity and interest rate risks. Additionally, it also incorporates marketing, operational and financial risks to arrive at the credit risk profile. The framework integrates qualitative as well as quantitative assessment of an NBFC.

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