September 2014

Industry Perspective – Investment & Leasing NBFC

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NBFC

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-NBFC is a company registered under the Companies Act, 1956

-Engaged in the business of loans and advances, acquisition ofshares/stocks/bonds/debentures/securities issued by Government or localauthority or other marketable securities of a like nature, leasing, hire-purchase,insurance business, chit business

-Does not include any institution whose principal business is that of agricultureactivity, industrial activity, purchase or sale of any goods (other than securities) orproviding any services and sale/purchase/construction of immovable property.

- A non-banking institution which is a company and has principal business ofreceiving deposits under any scheme or arrangement in one lump sum or ininstallments by way of contributions or in any other manner, is also a non-bankingfinancial company (Residuary non-banking company).

NBFCs are today an Integral Part of Indian Financial System showing improving

health:

Increase in resource profile

Significant decline in NPA

Substantial improvement in brand image Improvement in profitability margins

Maturing industry in which financially & managerially weak companies

already weeded out

Surviving companies are large corporates with good brand image

NBFCs on strong turf

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NBFCs enjoys a Niche position in the financial sector due to:

Better Customer service

Innovative & flexible financing options

Continuously reducing NPA’s

Healthy Capitalisation

Innovative resource mobilisation Focused Operation – Products/Customers/Geography

NBFCs on strong turf

Classification of NBFC

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Broad categorization of different types of NBFCs are as follows:

1. Asset Finance Company(AFC)2. Loan Company (LC)3. Infrastructure Finance Company (IFC)4. Core Investment Company (CIC)5. Leasing and Hire purchase Company 6. Infrastructure Debt Fund7. Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI)8. Non-Banking Financial Company – Factors (NBFC-Factors)

Core Investment Company (CIC)

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CIC is an NBFC carrying on the business of acquisition of shares and securities which satisfies the following conditions:-

(a) It holds not less than 90% of its Total Assets in the form of investment in equity shares, preference shares, debt or loans in group companies;

(b) Its investments in the equity shares (including instruments compulsorilyconvertible into equity shares within a period not exceeding 10 years from thedate of issue) in group companies constitutes not less than 60% of its TotalAssets;

(c) It does not trade in its investments in shares, debt or loans in groupcompanies except through block sale for the purpose of dilution ordisinvestment;

(d) It does not carry on any other financial activity except investment in bankdeposits, money market instruments, government securities, loans to andinvestments in debt issuances of group companies or guarantees issued on behalfof group companies.

Regulatory framework- CIC

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• CICs, having an asset size of less than Rs 100 crores are exempted from all therequirements of NBFCs – including registration.

• Note that for this purpose, all CICs belonging to a group will be aggregated.

• CICs which have assets of Rs 100 crores or above will be considered assystematically important.Registration requirements applicable for such companies.Maintenance of 30% capital adequacy ratio and leverage restraints.

• The rest of the prudential requirements currently applicable to NBFCs isexempted in case of systematically important CICs adhering to the aboverequirements.

• If the CIC in question does not adhere to the CAR and leverage requirements, itssubjected to the complete prudential requirements as before.

Regulatory framework- CIC

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Inv Co?

NBFC?

CIC?

Directions not applicable

Normal NBFC Directions apply

Belonging to a group

NoYes

No

AggregateAll groupCo assets

Asset More than Rs.100 Cr?

Yes

No

Satisfies CAR and leverage requirementsYes

Normal NBFCDirections apply

Prudential Requirements

Exempted

No

Yes

Yes

NBFC registration not required

No

Operational issues for CICs

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Assets : 90% of the assets must be in equities, debt and loans to group companies

Out of 90%, at least 60% must be in form of equities. That leaves a scope for only 30% for non-equity investments, that too, within the narrowly-defined concept of “group”

Since 90% investments have to be within the group, we are left with a breathing margin of 10% - That is, the remaining 10% investments also cannot be directed towards any activity other than deposits in banks, investments in government securities, etc.

•Liability : There are 2 major requirements – leverage restraint and a capitaladequacy ratio.capital requirement of 30% of risk- weighted assets is a huge capital to be kept.Notably, as most of the investments would anyway have to be in equity shares,the risk weight is unlikely to be less than 100%. So, if 30% of the risk-weighted assets have to be in form of “net ownedfunds”, it is only the balance 70% that may be in form of debt, subject to the overall leverage limit of 2.5 times

Operational issues for CICs

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•Funding :

Bank Loans Not Available : Banks can fund only upto Rs 20 lacs against Shares .

Heavily Rely on NBFC for LAS , NCD and ICDs/Unsecured loans

Hence high cost of borrowings

•ALM Mismatch :

NBFC Money available for 1 year with Put/Call quarterly ,semi annually whereas Investments are for long tenor

• Mark to Market Margin requirement due to Market Volatility Margin of 50% and top up of shortfall within 3-5 days thru shares or cash Offloading of shares by Lenders leading to crash in Share price putting more pressure on topup with other lenders.

Operational issues for CICs

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• Limitation on selling of shares : Cannot sell its holdings except by way of block deals

• Trading Window : High Monitoring required for trading in stock

• Margin Funding in Non Promoter Entity : During meltdown in stock market ,positions gets squared off leading to tremendous pressure on Margins calls of Promoter Borrowings in CICs

•In short, the apparently liberal mood of the RBI in granting the exemption to CICs has completely been scuttled by the very narrow definition of CICs, latching to an even more narrow definition of “group companies”.

Leasing - Competitive Landscape

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Currently, leasing sector in India is characterized by the presence of a few organised medium to large scale lease providers, which can be segmented into four business models.

• Third party financiers/Non Banking Finance Companies (NBFCs)

•Emerging Asset Life Cycle Management (ALCM) companies

•Captive leasing and financing arms of leading manufacturers

•Rental operators

Leasing – Signs of Revival

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The sector has again shown signs of revival, this time around fuelled by strong economic growth with the following characteristics:

• A high capital investment in several industries

•An increase in the presence of MNCs which operate on an asset light business model

•An increasing usage of big ticket plant & equipment that come with high technological obsolescence, and

•Emergence of professional lease providers with specialised expertise in asset management and residual value risk management

Leasing – Signs of Revival

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•Leasing of construction equipment is expected to rise with introduction of large ticket size sophisticated equipments from International OEMs and significant demand for capital investments across all infrastructure sectors.

• Leasing of information technology and office equipment are expected to be driven by high pace of technological obsolescence, trend towards outsourcing of non-core assets and rise in MNC culture of operating on an asset light model.

• Medical Equipments is another segment where leasing is expected to pick up significantly, driven by introduction of equipments with rapidly changing technology from international manufacturers and emergence of corporate hospital chains..

Regulatory and Legal Constraints

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• Discrepancy in the treatment of depreciation for leasing transactions

• Subjectivity on part of the tax authorities

• Levy of an additional level of VAT on leasing transactions

• Lease rentals being subject to dual taxation

• Disallowances in claiming input tax credit on various components of tax including VAT, Service Tax and Central Sales Tax

•Disallowances in claiming set off for Life Time RTO Tax imposed by various states which makes the inter-state movement of construction equipment unviable.

Operational issues for Leasing Company 1/ 2

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Uncertainties in the legal and taxation environment governing leasing

transactions continue

Enablers for emergence of an efficient leasing market under-developed

Mindset of the Indian customer of pride in owning an asset.

Unequal competition from Banks & MNCs – Cost of Funds

No focused / dedicated Recovery Mechanism - Housing Finance

Corporations / Banks enjoy special recovery platforms such as DRT’s / Recovery

officers / Securitisation Act 2002

TDS on interest payments – Not applicable to banks

Operational issues for Leasing Company 2/ 2

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Past Stigma – Credibility issues , Industry brand image

Competition for talent - From newer financial services players

Poor availability of medium and long term funding

Although right of repossession of assets recognised there are impediments in implementation

Multiplicity of taxes - Sales tax / Service tax / Entry tax on lease transactions

Multiple Regulators - Lack of Comprehensive Legislation

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