By Anita Baid (firstname.lastname@example.org)
For an economy as diversified as India, even the financial sector consists of several intermediaries. Apart from banking entities, there are several other entities that offer financial services and may be broadly classified as non-banking financial institutions. In India, the term ‘non-banking financial companies (NBFCs)’ generally refer to such entities which are not banks, and yet carry lending activities almost at par with banks. Some of them may also accept deposits, however, these are term deposits and not demand deposits.
The significance of NBFCs in India lies in the massive capabilities of NBFCs. Apart from the disability of not accepting demand deposits and undertaking remittance function, the ease of entry and lightness of regulation applicable to NBFCs makes it a tremendous focus of interest, particularly for foreign investors wanting to enter India’s financial sector.
NBFCs are broadly classified in terms of the type of liabilities- deposit and non-deposit accepting NBFCs and by the kind of activity they conduct- such as Asset Finance Company (AFC), Investment Company (IC), Loan Company (LC), Infrastructure Finance Company (IFC), Systemically Important Core Investment Company (CIC-ND-SI), Infrastructure Debt Fund, Micro Finance Institution (NBFC-MFI), Non-Banking Financial Company – Factors (NBFC-Factors) and others.
The Mid-term Review of Annual Policy for the Year 2006-07, was the first document that stated that RBI shall be introducing guidelines for the re-classification of NBFCs, to provide a separate classification for NBFCs engaged in financing tangible assets, as a consequence of requests received from representatives of NBFCs. Earlier to 2007, NBFCs were classified into four different groups for the purpose of acceptance of deposits by NBFCs, namely:
- Equipment Leasing (EL) company that carried on as its principal business, the activity of leasing of equipment;
- Hire-Purchase (HP) company that carried on as its principal business, the activity of hire purchase transactions;
- Investment Companies (IC) company that carried on as its principal business, the acquisition of securities; and
- Loan Companies (LC) company that carried on as its principal business the providing of finance whether by making loans or advances or otherwise for any activity other than its own but did not include an equipment leasing company or a hire-purchase finance company
Subsequently, it was proposed to re-group such NBFCs as asset financing companies and RBI came up with its notification no RBI / 2006-07/200 DNBS.PD. CC No. 85 / 03.02.089 /2006-07 dated December 06, 2006. Upon re-classification of NBFCs, companies financing real/physical assets for productive / economic activity were classified as Asset Finance Company (AFC) as per the prescribed criteria. The remaining companies continued to be classified as loan/investment companies. Accordingly, the following categories of NBFCs emerged:
- Asset Finance Company
- Investment Company
- Loan Company
Asset Finance Company- Eligibility Criteria
As per the aforesaid notification, the then existing classification in the Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 1998 was modified as follows:
AFC would be defined as any company which is a financial institution carrying on as its principal business the financing of physical assets supporting productive / economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines. Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising therefrom is not less than 60% of its total assets and total income respectively.
Currently, the Master Direction – Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016 (updated till May 31, 2018), (“Master Directions for NBFC-D”) continues to use the same definition for “Asset Finance Company” as mentioned above in the erstwhile directions.
Relevance of classification
The category of AFCs was created by merging leasing/hire purchase companies into a common category. The intent of the AFC category is clearly to distinguish AFCs from loan companies. Loan companies give monetary loans, whereas AFCs assist borrowers by providing funds directly linked with physical assets used in economic/productive activity. Therefore, the critical element in categorization as an AFC is not the physical asset, but the use of the physical asset acquired by the borrower, into a manufacturing/productive/economic activity, as opposed to consumer assets.
Loan Company and AFC
Categorisation of a company as an NBFC depends on the principal business of the company. The principality of business is defined by the RBI. Where the financial assets of the company are more than 50% of the total assets and the financial income generated by the company is more than 50% of the its total income, then the company is required to register itself as an NBFC. Where the principal business of any company is to carry out financial activity, the company shall be deemed to be an NBFC and shall require registration with RBI.
Further, based on the type of activity conducted, there is a difference between a Loan Company (LC) and an AFC. A LC means any company which is a financial institution carrying on as its principal business the providing of finance whether by making loans or advances or otherwise for any activity other than its own but does not include an AFC. On the other hand, any NBFC carrying out asset-backed lending business is categorised as asset finance company or NBFC-AFC.
However, the principality in case of NBFC-AFC is different from that of a LC. In case of an AFC the aggregate of financing real/physical assets supporting economic activity and income arising therefrom shall not be less than 60% of its total assets and total income respectively. Further, an NBFC-AFC can either be registered as a deposit taking NBFC or a non-deposit taking NBFC. Accordingly, the classification would be incorporated in the Certificate of Registration issued by the Bank as NBFC-Asset Finance Company; NBFC-D-AFC if accepting deposits and NBFC-ND-AFC, if not accepting deposits. List of AFCs registered with RBI is available at RBI official site. As on June 30, 2018, there were a total of 362 Asset Finance Companies (AFCs) in India registered with RBI.
Master Directions for NBFC-D prescribes the ceiling on quantum of deposit and restrictions on investments in land and building and unquoted shares for an NBFC-AFC:
1.An AFC having minimum Net Owned Fund (NOF) as stipulated by the Bank, and complying with all the prudential norms, shall accept or renew public deposit, together with the amounts remaining outstanding in the books of the company as on the date of acceptance or renewal of such deposit, not exceeding one and one-half times of its Net Owned Fund (NOF).
2.An AFC, which is accepting public deposit, cannot invest in land or building, except for its own use, an amount exceeding ten per cent of its owned fund; and in unquoted shares of another company, which is not a subsidiary company or a company in the same group of the non-banking financial company (excluding the permitted limit in equity capital of an insurance company), an amount exceeding ten per cent of its owned fund.
However, Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016 (“Master Directions for NBFC-SI”) do not lay down any specific guidelines for NBFC-AFCs. The regulations as applicable on an NBFC-ND-SI are as a whole applicable on NBFC-AFCs as well.
Benefits of Classification
Acceptance of External Commercial Borrowings (ECBs)
Earlier, AFCs were permitted to avail ECBs for financing the import of infrastructure equipment for leasing to infrastructure projects, however, LCs were not allowed to avail ECBs. Subsequently, NBFCs categorized as AFCs, along with NBFC-IC and CICs, have been allowed to avail of ECB under the three tracks, i.e. Tack I, Track II and Track III, whereas all other remaining NBFCs coming under the regulatory purview of the RBI, fall under Track III. The end-use prescriptions for ECB raised under the respective track has also been prescribed.
Further, the individual limits of ECB that can be raised by eligible entities under the automatic route per financial year is up to USD 750 million or equivalent for NBFC-AFCs under Track I, however, for remaining NBFCs falling under Track III, the limit is up to USD 500 million or equivalent.
As per the Basel III framework, commercial banks are required to assign risk weights on their investments in NBFCs for the purpose of determining capital adequacy. The risk weighting of the investments made by the banks in AFCs, is done on the basis of the credit rating of the Company. Thus, investments in an AFC with higher rating will attract lower risk weight and is more favoured by the banks to make investments. On the other hand, any exposure of the banks in NBFCs other than IFC and AFC are subject to a risk weighting of 100%. This is a very significant advantage enjoyed by deposit taking NBFC-AFCs over other NBFCs, for availing bank finance.
Qualifying Assets under AFC- Treatment of various financing transactions
Asset finance by NBFCs predominantly takes the form of secured loan or leasing. Asset financing has a wide coverage from cars to healthcare, education, IT equipments, commercial vehicles, used vehicles, construction equipment, air-planes, windmills, solar panels, etc. However, it is significant to examine whether such financing is directly linked with physical assets used in economic/productive activity
Though the category of AFCs was created by merging leasing/hire purchase companies, however, the criteria for an asset to qualify under AFC, as mentioned earlier, suggests that the physical assets must support productive/economic activity. By applying the rule of interpretation, i.e. ejusdem generis, it can be inferred that the term ‘physical asset supporting productive/economic activity’ is describing asset such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines. The assets that support productive or economic activity have a multiplier effect on the economy by generating incomes, employment, etc. On the contrary, general purpose lending or pure consumer credit may lead to expansion of credit, without any direct consequential economic benefits. In addition, the use of the asset should be directly into economic or productive activity; indirect or consequential economic benefit may arguably appear in every case, however, that is not the intent of the AFC classification.
Based on the above rationale, various asset types that are usually funded by an NBFC can be evaluated for consideration as an eligible asset under AFC:
As the market is holding a very bullish view on the development of the infrastructure being a sine quo non to the development of the economy, the sector offers huge demand. Assets like dumpers, excavators, crushers, utility assets like cranes etc are being leased out. Since mining activity is looking to revive demand for earth moving mining equipment is on a rise as well. All such asset are eligible to be considered under AFC classification.
Office Infrastructure/Furniture and Fittings
The financing towards office equipment is not to acquire an asset supporting productive/economic activity. Even if the property is used for commercial purpose but is not supporting any productive or economic activity. Hence, financing towards such furniture and fixtures cannot be regarded as an eligible asset for AFC classification.
Passenger Vehicle (Auto lease)
Most of the larger corporates enable acquisition of vehicles by their employees through the leasing route. At the end of lease term the asset gets transferred to the employee. This is being used as a device to encourage employees to own up their cars. These cars used by employees are not supporting any economic activity. It is a means of communication used for convenience of the employees and is not directly or indirectly linked with any productive/economic activity and seeming is merely a facility provided to the employees by the employer. The same cannot be considered as an eligible asset under AFC.
Commercial Vehicle (finance/refinance)
Commercial vehicle such as those used by small contractors, taxi operators and small road transport operators, are also financed by NBFCs. The owner of such asset earns revenue by plying these vehicles. Funding is given usually for the acquisition of such commercial vehicle, including used cars, and refinance is towards upgrading the quality of such vehicles. Here, the fact whether it is a new or second hand asset does not make a difference. The intent of the financing facility should be to provide financing for commercial vehicle supporting the economic activity of such transport operators. If the user in these cases have an existing asset (say a truck), and he acquires funding against the same, the financier is anyways releasing the money that went directly into the acquisition or holding of the asset which otherwise would qualify as productive asset.
Repossessed assets get either released back to the customers, who continues to use the asset, on payment of due amount or are sold to a third party and the asset automatically moves out of the book. While on the books, it can be considered as an eligible asset in case the original financing was towards an asset supporting productive/economic activity. Only such repossessed assets can be considered as supporting a productive/economic activity and hence, shall be an eligible asset under AFC.
Office IT Equipment
Nowadays, IT equipments both hardwares and softwares and other technical equipment are very commonly taken on lease. IT equipments used in the IT Industry, Business Processing Outsourcing (BPO) or Knowledge Process Outsourcing (KPO) sector forms an integral part of their business. Any funding or financial facility towards the acquisition of such IT equipments shall qualify as an eligible asset since they are supporting the economic activity of such BPO/KPO. In such cases the asset qualifies as productive asset.
Finance towards softwares & licenses
Looking at the examples set out in definition of asset finance business, wherein it states that the principal business should be of financing of real/ physical assets supporting productive/ economic activity such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines – it will be difficult to establish that financing of software & licenses will be included in the calculation, for the purpose of asset finance classification. The fact that financing of an asset should lead to income generation, may be directly or indirectly. Financing of software & licenses in this regard will fail this test, is not in lines with the examples cited above and may not meet the test of being physical asset as well.
Medical Equipment Finance
Generally assets in this segment are highly capital intensive and have huge cost implications. Further, most of the equipment required are imported. Financing the acquisition of such medical equipments for hospitals, diagnostic centers and clinics can be done by way of leasing as well as secured loans. It is to be noted that these assets or machines are the backbone of the medical industry and support economic activity of the medical institutions. Hence, they shall also qualify as an eligible asset under AFC.
Commercial real estate
The financing is against real estate and not necessarily to acquire an asset supporting productive/economic activity. Though the property can be commercial in nature but is not supporting any productive or economic activity. Hence, the answer whether it shall be considered as an eligible asset is very clearly negative.
Loan against Property (LAP)
In case of LAP, the financing is against an existing real estate and not necessarily to acquire an asset supporting productive/economic activity. In this case the end use is not regulated by the NBFC. Further, at time even if the NBFC takes a confirmation from the borrower, the same cannot be considered as an eligible asset under AFC. If we take a contrarian approach, then by the same analogy even normal loan transaction would have been classified as eligible asset by obtaining an end use confirmation from the borrower. Since the latter is not considered as an eligible asset, LAP shall also fall out of the eligible asset criteria.
PTCs and SRs
As per RBI guidelines on securitization transaction DNBS. PD. No. 301/3.10.01/2012-13 dated August 21, 2012, originating NBFCs are required to have a continuing stake in the performance of securitized asset for the entire life of securitization process by way of Minimum Retention Requirement (MRR). The guidelines make it mandatory for the securitizing NBFC to retain the minimum investment in its books. There can be instances where had the Company not securitized these assets, it would have continued to be in the books and would have been eligible towards the asset financing criteria. In case of such securitization transactions, if the loan portfolio was originally eligible as an asset under AFC, the exposure in form of PTCs shall also qualify as an eligible asset.
Further, similar analogy can be drawn in case of security receipts (SRs) issued by a securitization company or reconstruction company to any qualified institutional buyer pursuant to a scheme, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in the securitization. The loan portfolio can be standard or non-performing assets (NPA), as the case may be, but must be eligible under the AFC criteria for the PTCs or SRs to qualify under asset financing criteria.
Solar power assets
Whether roof-top solar equipment or solar parks, lease of solar equipments has been doing really well in India. While the solar power industry is in its nascent stage of growth, the government though its policies has mandated usage domestically manufactured solar cells and modules and has set aggressive targets for increasing solar power generation stimulating growth in solar equipment finance. These solar asset can either be used commercial purpose or retail. Depending upon the end user, the eligibility shall be determined. Retail shall not qualify to be supporting any economic or productive activity whereas commercial may qualify as an eligible asset under AFC.
Windmills and any specially designed devices which run on windmills installed and any special devices including electric generators and pumps running on wind energy installed, work towards generation of wind energy. The definition of asset finance business states that the principal business should be of financing of real/ physical assets supporting productive/ economic activity such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines – generation of wind energy is also an economic activity for the purpose of asset finance classification -in line with the examples cited above.
The quantum of NBFC-AFCs is quite less compared to the total strength of NBFCs in the country, since the discretion lies with the RBI to classify a company which is a financial institution as a loan company or an investment company or an asset finance company. Considering the difference of opinion in the treatment of several asset eligible as qualifying under AFC criteria, the final call is taken by the RBI, having regard to the principal business of the company and other relevant factors.