Lower-rated NBFCs facing multiple headwinds: Ind-Ra

There has been a visible slowdown in the overall non-bank finance company (NBFC) space, predominantly in the lower-rated (A and BBB) space. Furthermore, this slowdown is across asset classes and segments. There are multiple reasons for this slowdown, namely, asset quality stress, elevated funding cost, and slowdown in partnership and co-lending business, resulting in a decline in the pace of disbursement due to the cautious approach adopted by NBFCs. There are certain segments such as microfinance institutions (MFIs), gold loans and unsecured loans (personal and business) where the fall in the growth rate is steep, according to India Ratings & Research.

“As the overall NBFC segment loan growth slows down, the impact for ‘A and BBB’ category rated entities is higher due to the challenges resulting from asset quality stress, an elevated funding cost, and a slowdown in the partnership and co-lending businesses,” says Karan Gupta, Head and Director Financial Institutions, Ind-Ra.

Funding cost has remained elevated for the sector; however, the recent cut in the repo rate would provide some relief with a lag. Lower rated NBFCs mainly rely on banks and larger NBFCs for their funding needs. They have negligible funding from the capital markets where the softening of rates would be faster. Due to their funding largely from banks, the benefits of a softening in rates is passed on to them with a lag.

There has been an increase in the credit cost across asset classes due to overleveraging at the borrowers’ end, especially in the unsecured loan segment. Also, inflationary pressures are narrowing gap between income and expense, thereby impacting borrowers cashflows. In the unsecured lending space, the rise in credit cost is to the extent that the entity could make losses, thereby depleting the capital buffers. As per Ind-Ra, the provision coverage ratio especially for unsecured lenders is still below the prudent levels and the entities need to increase these gradually, which will keep profitability under pressure till the catch up happens.

However, with the decline in growth rates, the buffers have depleted further as negative operating leverage is impacting pre-provision operating buffers. Also, there are instances of covenant breaches for some entities which leads to either an increase in borrowing cost or a restriction on further borrowing. This affects the portfolio expansion and profitability. However, the secured asset classes in this rating space are reporting reasonable credit parameters.

Impact on Profitability: Profitability of these NBFCs has been impacted due to the growth slowdown, margin compression and rise in credit cost. For fintechs, a substantial amount of revenue is generated by way of processing fees and spread income which is linked to the disbursement run rate. A decline in the pace of disbursements leads to a contraction of this income stream which has a disproportionate impact on return ratios. Returns are generated without deploying capital for the off-book portfolio, where also the growth and thus ROE has been impacted due to the slowdown seen in the co-lending and partnership business. There was a revival in profitability in FY23 and FY24 post the pandemic; however, the weak operating performance of MFIs and unsecured lenders led a compression in profitability FY25.

Adequate Capital Buffers: NBFCs in this rating category operate at a modest leverage of 2x – 3x; and even in a stress case scenario, they maintain a reasonable amount of capital buffers. Buffers have been supported by lower loan growth and equity capital infusions by the sponsors to support the franchise.

Adeptly Managed Liquidity: NBFCs have prudently managed liquidity in the current liquidity scenario by cautiously growing the on-balance sheet assets and mobilising funds (though at an elevated cost) at regular intervals. Most of the entities carry on balance sheet liquidity and unutilised credit lines equivalent to meet one to two months of debt repayment.