Non-banking financial companies, or what is popularly known as NBFCs, are financial entities, albeit different from traditional banks. NBFCs don’t possess a banking license issued by RBI.
NBFCs are legally authorized to sanction loans and initiate credit facilities to debtors. Some NBFCs also help individuals with retirement planning.
Investment banks, money market funds, hedge and private equity funds, chit funds, mortgage lenders and even peer-to-peer lenders fall under the category of an NBFC. A financial entity qualifies as an NBFC:
- If its financial assets make up more than 50% of its total assets;
- And if the income from the financial assets constitutes more than 50% of the gross income.
Also, an NBFC cannot indulge in a principal business whose primary activity is agricultural, industrial, purchase or sale of any goods except securities, construction, sale or acquisition of immovable assets.
In this article, we will talk about everything that one would need to know about an NBFC.
What Is the Difference Between an NBFC and Bank?
While NBFCs and banks are both major lending institutions in the economy, there are some fundamental differences between the two:
1. Demand Deposits
Demand deposits are the kind of deposits that can be withdrawn without any prior notice to the financial entity.
Banks can accept demand deposits in the account holder’s current and savings accounts, but NBFCs cannot.
2. Issuing Cheques
Unlike banks, NBFCs are not part of the payment and settlement ecosystem and cannot issue cheques to be drawn on themselves.
3. Deposit Insurance
When a depositor places their money with the bank, it is backed by insurance, which cushions them from losses in case of failure of the bank. NBFCs do not insure the funds they get from depositors.
4. Reserve Ratio Compliance
As per RBI guidelines, banks are legally required to set aside a portion of the deposit as reserves. However, no such compliance requirements are levied on NBFCs.
5. Foreign Capital
There is a cap of 74% foreign investment for banks, but no such cap exists for NBFCs.
|No banking license required||Banking license issued by the RBI|
|Under Companies Act, 1956|| |
Under Section 22 of the Banking Regulation Act, 1949
|NBFCs cannot accept demand deposits or issue cheque to be drawn on themselves|| |
Collects deposit from the public and loans it, managing cash flow
Legal Reserve Ratios
|No maintenance required|| |
Required to maintain up to 10% of the deposit base
Foreign Investment Allowance
|Up to 100% allowed|| |
Up to 74% for the private sector
|Deposit insurance facility||Not available|| |
Types of NBFCs
Factors like types of liabilities, like acceptance of deposits and non-deposits, their activities and size determine the category to the NBFC they belong to:
- Asset Finance Company (AFC)
- Investment Company (IC)
- Loan Company (LC)
- Infrastructure Finance Company (IFC)
- Systemically Important Core Investment Company (CIC-ND-SI)
- Infrastructure Debt Fund
- Micro Finance Institution
- Mortgage Guarantee Companies (MGC)
- NBFC- Non-Operative Financial Holding Company (NOFHC)
- Non-Banking Financial Company – Factors (NBFC-Factors)
Also Read: Sovereign Gold Bond vs Fixed Deposit: A Detailed Comparison
How do NBFCs Raise Money?
As NBFCs do not enjoy access to deposits from current or saving accounts for fundraising, they look for alternative sources of money supply. Here are some sources through which Non-banking financial companies raise money:
1. Low-Interest Long Term Loans
NBFCs apply for long term loans from banks. Due to their easy access to deposits from current and savings accounts, banks lend to NBFCs at a low-interest rate.
These loans can be secured through government securities or could even be unsecured. The repayment of these loans can easily be one in a structured schedule.
NBFCs duly record the repayment of loans as soon as they are done on their balance sheet along with assets. NBFCs should hold a good credit rating to raise a large sum of funds at competitive interest rates.
2. Foreign Direct Investment (FDI)
Soon after 1991, in the post-liberalization era, there has been a considerable increase of FDI in India. Lately, NBFCs have been granted permission to receive 100 per cent foreign investment under the automatic route.
3. Issue Commercial Paper for Small Term Loans
NBFCs also raise funds by issuing commercial papers.
Commercial papers serve as short term unsecured promissory notes issued by financial companies with a tenure that ranges from 3 to 12 months.
NBFCs with a minimum net worth of INR 100 crores are eligible to list commercial papers.
4. Issue Bonds
NBFCs can avail money easily, at a low cost, by issuing bonds. The rating of an NBFC helps decide the coupon rate of the bond they offer.
The maturity profile of bonds corresponds to the repayment of interest schedules made by the NBFCs. Some NBFCs also issue bonds to retail investors.
5. Securitization of loans
NBFCs also rely upon the securitization of loans as an effective tool to manage liquidity, raise funds and correct ALM mismatch.
Role of NBFCs in the Indian Economy
- Promote financial inclusion by facilitating credit to the under-served, unbanked segments of the country.
- Provide credit access and other allied services to support the growth of businesses.
- Wealth management services like portfolio management through investments in stocks, shares and securities.
- Quick loan sanction due to the use of advanced tech solutions like open banking and API banking.
This was everything you needed to know about an NBFC and the role it plays in the Indian economy. If you want to know more about how you can invest in an NBFC’s offerings, subscribe to this space and we will keep you notified.