Nbfc – a word which only our half angrez IAS baboo(n)s could have coined. It starts with a negative – ‘non banking’ but what an nbfc does is 99% similar to what a bank does. Is there anything which an Nbfc does but a bank does not do?

Well the baboo(n)s coined this word and the word stays. So Hdfc Ltd – a housing finance company – is called an NBFC. Like many other companies – Cholamandalam Investment and Securities, Dhfl (Dewan Housing), Sundaram Finance, Shriram Transport, etc

They borrow money from the markets and lend it to some other players in the market. They are also playing the role of disintermediation. So they can borrow Rs. 20,000 from about 10,000 lenders and lend Rs. 2 crores to at least 10 people. In its simplest form it is this.

What is capital adequacy?

Is the capital adequate to meet the needs of the company if it goes belly up? That is the question that capital adequacy tries to answer. This is like if you wish to borrow Rs. 20L to buy a car. The banker sees if you have adequate ASSETS to pay with if you lose your job, or your cash-flow for whatever reasons. So the banker is likely to give you a better rate if you put more of your money, and take the loan for a shorter period.

Forget the numbers, that is for RBI to worry, what should you know about adequacy?

Is the balance sheet adequately diversified? If there is one reason to invest in an Nbfc, it is that they can be far more smartly diversified than any other business. For example you could run an nbfc with exposure to cement, steel, fmcg, IT, auto, real estate, retail, etc. Now if you are diversified across 10/12 industries, across the geography of the country, across time (3 month loans and 30 year loans), the chances are that you will hurt less when there is a down turn in one sector. For example if you have lent money to a hotel chain and an IT export / service business, and an imported car franchisee – you are hedging against the dollar. The rising dollar will hurt the car imports, but will help the hotel and the IT business. Even in one industry you want to see diversification. For an Nbfc with say 10,000 crores to the Real Estate Industry, obviously the best case scenario is a portfolio of 10,000 individuals borrowing Rs 1 crore each. However that is utopia from a risk diversification angle, and a nightmare from an administrative angle. However if it is say 5 builders who have a Rs. 200 crore exposure, a few people with a Rs. 200 crore Loan against property for doing their own business which is not construction, Rs. 1000 crores lent to 100 people as housing loan, Rs. 2000 crores lent to 500 people for home improvement, Rs. 2000 crore lent to 4000 people as a home loan, small ticket loans, big huge luxury apartments, SRA houses, etc. – that is also a better diversification instead of 5 borrowers of Rs 2000 crores each.

So a well diversified bank (or Nbfc) will do far better than a less diversified nbfc.

Similarly if an Nbfc has diversified across time – short term loans, medium term loans and long term loans, it is likely to hurt less when interest rates move against what you had predicted. Of course buying puts and calls is one way of managing this, but I am not wanting to complicate this article. That is for another day.

In the borrowing side, you have to see ‘does the company have adequate capital to meet the shortfall if all the assets were to be sold today and the company liquidated’. The assumption in any company is “going concern” – because the minute that is threatened, it is difficult to say whether the company will survive. True even for State bank of India – forget a small or big Nbfc. If there is a panic run it will collapse. Now if the company has a diversified shareholder base (awesome base of Hdfc Ltd) vs too much held by the finicky public, you assume that Hdfc is more stable. However over long periods of time you can build a loyal base of shareholders who will stand by you through thick and thin. You should also see how much of the earnings does the Nbfc keep with itself and how much it distributes (Cholamandalam for example keeps about 90% of its earnings). The next question to ask is – ‘is the borrowing done from a big range of lenders’. I like a company which is listed, has adequate reserves, borrowed from institutions (debentures), banks, retail investors (fickle, but will accept a much lower rate), etc.

So look for an Nbfc with well diversified (industry, geography, business groups), has adequate margins, diversified across time, good quality assets – asset side diversification AND liability side diversification too.

We will worry about quality of management in a different post….