Unsecured business loans showing early signs of stress
Traditional NBFCs operating through the brick-and-mortar model as well as fintechs extending UBLs are showing signs of increase in delinquency levels.
NBFCs are planning to diversify into secured lending products to mitigate the impact on credit cost, however these are newer segments and require different expertise to build a franchisee. (Image: Freepik)
The unsecured business loans (UBLs) segment has started showing early signs of stress in asset quality, possibly due to the increasing competitive intensity among lenders, continuing pressure on cash flows in certain end-borrower segments, on-field attrition, lower-than-expected recoveries leading to higher write-offs and overleveraging of borrowers, according to India Rating and Research (Ind-Ra).
While the denominator effect was playing out over most of FY24, the need to recognise the rising delinquencies, provide for them and write-off the same has increased the credit cost pain since 4QFY24. With the near-term profitability taking a hit, the agency is closely monitoring the developments in the sector and believes that the situation is still not alarming as leverage is at reasonable levels (1QFY25: 3.1x; FY24: 2.9x; FY23: 2.8x).
Traditional non-bank finance companies (NBFCs) operating through the brick-and-mortar model as well as fintechs extending UBLs are showing signs of increase in their delinquency levels. These business models are designed to offer UBLs to micro enterprises in ticket sizes of up to INR1,000,000 at yields upwards of 25% rate of interest. Fintechs offer these loans as part of their on-balance sheet exposure as well as through off-book arrangements in liaison with a lending partner which can be a larger NBFC or a bank.
“Post the MFI segment, early signs of stress are visible in the unsecured business loan segment with an increase in credit costs and higher-than-expected write-offs. On-field attrition, pressure in certain end-borrower segments and overleveraging of borrowers are the factors that have contributed to this asset quality pressure,” said Karan Gupta, Head and Director Financial Institutions, Ind-Ra.
Owing to the pent-up demand post COVID-19, micro-enterprises have benefitted from a higher order flow which had led them to borrow more for working capital requirements in FY23 and FY24. With on-ground demand now plateauing, the added expansionary business cost and rising competition have started to bite into the margins of micro-enterprises, leading to cashflow challenges. This has led to a rise in delinquencies to a certain extent.
The growth in asset under management (AUM) has slowed down in the UBL space because of the caution exercised by lenders (both on- and off-book) and conservatism practiced by them since they are seeing stress building up. This can affect the top line since fintechs make substantial profits on new originations and lending partners would exercise caution in growing the book. There also could be seasoning-led credit cost spikes as growth moderates for the fintechs extending UBLs.
Also, NBFCs extending UBLs write-off delinquent loans based on their vintage and offer credit loss protection as per the default loss guarantee guidelines to the lending partner. They have also seen an uptick in the consolidated credit cost. While pre-provision operating profit buffers can absorb some of the increase in credit cost, the business models are heavy on operating cost which also compresses the profitability.
Due to the elevated credit loss, lending partners can also alter commercial arrangements between them and NBFCs, which means a higher hurdle rate and reduced spread for the latter, leaving less buffers to absorb the on-book credit loss and high operating cost. This will affect the operating leverage benefit for fintechs where the profitability depends on scaling up of franchise.
The funding cost for NBFCs did increase initially due to the rise in the repo rate from May 2022 and post increase of the risk weight stipulated by the Reserve Bank of India on banks’ exposure to NBFCs. NBFCs which are in the lower rating category saw a higher impact of these developments, which essentially means reduced margins. All these NBFCs have substantial amount of borrowings from larger NBFCs and small finance banks and they are on their path to borrow from public sector banks which would give them funding cost advantage. However, the journey would get elongated with the drop in performance.
NBFCs have also faced technology challenges with co-lending partners where the flow of information regarding a delinquent customer comes to the originator with a lag, leading to delayed recovery efforts and impacting delinquencies for both partner and originator.
NBFCs are planning to diversify into secured lending products to mitigate the impact on credit cost, however these are newer segments and require different expertise to build a franchisee. There has been also rising competition from banks, leading to margin pressure in this segment for fintechs as covering operating expense and credit cost would leave hardly any profitability at their cost of funds. The secured lending segment already has a lot of competition, which means there will not be enough flexibility to charge higher rates of interest. In a nutshell, it is not an easy path to walk.
The risk return trade-off would completely change with the contribution of secured products in AUM. Also, secured products can be extended through cross-sell to existing UBL customers where fintechs could act as digital direct selling agents and offer better products through partnering with banks and larger NBFCs, thereby following the off-book strategy for secured products.
Capital buffers are still reasonable for NBFCs with most of them operating at a leverage of below 3x. But, one needs to be mindful of the credit cost that they have to bear on the off-book portfolio. The sponsors are still supporting the platform in terms of equity so there is no solvency risk for these NBFCs; however, management of the ROA tree is the key issue to be addressed.
