In this article, Mitalee Mulpuru pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses how NBFCs usually raise money in India
Lack of Traditional Sources of Money Supply
NBFCs are Non-Banking Financial Companies, meaning many of them do not rely on CASA (Current Account Savings Account) deposits in order to raise resources. CASA deposits are meant only for banks, wherein the RBI provides the banks with licenses in order to accept monies from the public. This means that NBFCs have to look for alternate sources of money supply, which are higher than the traditional deposits taken by banks, where the interest rate offered is between 4%-6%.
Business Model – NBFCs
As these financial institutions lack the ability to raise money supply at a low rate like banks, they end up raising funds at a higher interest rate, thereby causing the hurdle rate on their funds to increase proportionately in order to maintain Net Interest Margins between 1-3%. This causes NBFCs to seek alternative strategies for deployment of funds in order to generate a higher return (thereby taking on a higher risk pattern).
Measuring the Effectiveness of Fund Raising
The main objectives while raising funds are,
- Monitoring the mismatch between assets & liabilities;
- Minimising the mismatch.
Assets, in this case, are defined as the investments made (equity/debt/structured products) in the operations of an NBFC as a financing organisation, while liabilities are defined as the amounts owed to parties that have supplied the monies for the financing activity. The interest rate charged between both leads to an arbitrage, thereby resulting in a Net Interest Margin. The arbitrage so created is the value derived from the expertise and experience of the officials in the NBFC to identify correct segments for investment at a higher risk-reward ratio and generate extra-ordinary returns in the Indian/Corporate context.
Treasury and Rupee Resources Departments
Broadly, the act of raising money supply lies within the ambit of the rupee resources department, which manages long and short term instruments used within an NBFC to match the supply with the demand. Once the resources are raised and the funds are with the company, the Treasury department is responsible for the deployment, any asset liability mismatch and call/money market instruments to be decided when the funds are parked.
Source: CAIIB
Key Performance Indicators in assessing Asset/Liability match in an NBFC
For this purpose, the treasury and rupee resources departments rely on the following critical risk factors:
1. Liquidity Risk
The risk of an investment that cannot be marketed or sold off easily to a third party, in order to minimize losses.
2. Interest Rate Risk
Risk in interest rate while raising monies that affects the Net Interest Margin adversely, and erodes the value of the net worth of the NBFC.
3. Foreign Exchange (Forex) Risk
Risk of suffering losses in adverse exchange rate movements (such as the current demonetisation efforts), especially during an open position, either spot or forward or a combination.
4. Equity Price Risk
Risk that a loss may occur on account of public/private equity shares held in the portfolio, for the equity investments made by the NBFC. NBFCs manage and control their treasury activities on the basis of the various risks involved rather than on the basis of the particular type of financial instrument dealt with. Extensive IT systems are put in place to measure these risks along with VaR (value at Risk), and an appropriate haircut is made to the investment when necessary. At all times, a probability of default and a Loss given Default (LGD) is calculated, that varies with the change in the profile of the company that is invested in. The VaR method would be employed to assess potential loss that could crystallize on trading position or portfolio due to variations in market interest rates and prices within a defined period of time.
The changes in market interest rates have earnings and economic value impacts on the institution’s banking balance sheet (book size). Given the range of loan product offerings of an NBFC, it would be endeavoured to measure IRR on the banking book that assesses the effects of the rate changes on both earnings and economic value. As the simplest measure, the Treasury Mid-Office may compute simple maturity (fixed rate) gaps, re-pricing (floating rate) gaps and duration gaps. Considering the volume of data practically all the NBFCs use IT systems for maintaining treasury operations.
Sources of Funds – NBFCs
There are three primary sources of funds looking to raise money without deposits:
a) Long Term
These are through term loans obtained from banks in a single quantum, after deciding on the amount of funds to be deployed in the normal course of operations of the NBFC. The advantage of doing so is that banks can usually lend at much lower rates owing to the nature of the CASA deposits, which favours the business model of NBFCs that have a more aggressive risk-return profile. These kind of loans can be unsecured or secured through G-secs (which again is monitored by the Treasury Department), and repayment can be done in bullet or a structured schedule. This repayment should ideally be mirrored with the repayment schedules of the assets on the balance-sheet. A good credit rating is mandatory for raising large sums at a competitive interest rate.
b) Long Term
Bonds are used as a common route to reduce the interest rate on the sources of funds. The coupon rate on the bond is selected in order to reflect the rating profile of the NBFC as well as a return better than the G-Secs. In some cases, tax-free bonds are also issued for priority sectors such as infrastructure and roads. The maturity profile of these bonds coincides with the repayment/interest schedules of the investments made by the NBFCs (and displayed as assets on the balance sheet). Bonds can be issued to retail investors as well, which is a primary advantage for NBFCs during bond placement.
c) Short Term
Short term loans offered by an NBFC can be issued by raising funds through Commercial Paper (CPs). CPs are short term unsecured promissory notes issued by companies, with a tenure of 3 months to 12 months.
Asset Liability Committees in NBFCs
The ALCO would primarily be responsible to manage liquidity and interest rate risk of the organization. Such committees are usually headed by the CXOs in the organization, to keep an eagle eye on the costs should they spiral out of control and impact profitability, especially in a down market.
Role of the ALCO
- Balance sheet planning for appropriate risk-return, and the management of interest rate and liquidity risks.
- Product pricing for loans and advances, and assessment of a base rate.
- Deciding on desired maturity profile and mix of assets and liabilities that can be added on in the future.
- Developing a perspective on the interest rate and deciding on the future business strategy to contain interest rate risk.
- Reviewing the funding policy to minimize liquidity risk.
Liquidation: Treasury Ops
The Treasury Ops are divided into The Front Office, the Mid Office and the Back Office. The Treasury Front Office within the institution is the clearing house for matching, managing and controlling market risks. It also provides investment support for the assets and liabilities generated by regular business of an NBFC. All dealers active in day-to-day trading activities have to adhere to FEDAI / FIMMDA and other regulatory codes of conduct. The dealers must also adhere to the Internal Stop Loss Limit.
The back office ensures compliance of transactions undertaken. Moreover, prompt reconciliation of all dealing accounts is an essential control to ensure accurate identification of risk exposures.
The mid office is an on-site monitoring department and to provide value added support to Front office activities. It acts as independent risk monitoring functionary.
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