Tag Archive for: NBFCs

Vinod Kothari and Dayita Kanodia | finserv@vinodkothari.com

There have been recent concerns that the RBI is not happy with NBFCs extending revolving credit facilities; there are also some reports to suggest that the supervisor has shown opposition to supply chain funding.

This write up delves into what could be the objections of the regulator in NBFCs extending revolving lines of credit, and why supply chain funding, if properly structured, is not a revolving credit facility that the regulator may be objecting to. It is a credit facility for sure, like every other credit facility, but it is way different from a revolving credit facility such as a cash credit, overdraft, or a credit card.

What could be the objection to revolving lines of credit by NBFCs ?

One of the traditional functions of a bank is credit creation, which, in essence, is the multiplied availability of money supply in an economy. For example, a bank accepts a demand deposit of Rs 100 from customer X, keeps 10% of the money as cash, and lends Rs 90 to customer Y, X still has a spending power of Rs 100, and Y has a spending power of Rs 90, though the system has a total cash of only Rs 100. The bank does it on the basis that X or similar depositors do not withdraw all their deposits at a time; therefore, the bank may keep liquidity as a part of its demand liabilities, and deploy the rest.  It is a different issue that Basel requirements of LCR require banks to keep liquid resources, not necessarily in hard cash.

In another way, banks may create liquidity by granting overdraft or cash credit facilities. That is, customer, customer X who has deposited Rs 100 may be permitted to draw upto Rs 200. As the bank estimates that not every customer who has overdraft sanctions will fully use the same, each such customer has a spending power, without the need to have actual cash. 

This is, of course, different from an actual loan, where the money would have moved from the lender to the borrower.

A revolving line of credit is a flexible credit facility that offers borrowers access to a pre-approved amount of funds, which they can draw upon, repay, and redraw as needed. 

Credit card is another classic case of a revolving line of credit – the card company creates spending power, equal to the available credit on each card. If, on an average, every card is drawn to the extent of, say, 33%, a card issuer may create spending ability equal to 3X the money the issuer has.

Credit creation has macroeconomic implications; central bankers use expansion of credit and contraction of credit as tools of achieving macroeconomic objectives.

Since NBFCs are not banks, if NBFCs start creating credit, without actual funding, there may be an exception to the central bank’s powers to control credit in the economy. 

In case of credit cards, the revolving line of credit is also used as a payment instrument. In essence, the card is used to settle payment obligations – therefore, the one who accepts a payment by use of a credit card is acquiring the right to receive money from the card issuer. The card issuer is, in that sense, making an obligation to pay money represented by the card to anyone accepting the card. Such a privilege can only be given to authorised entities. Banks are, by their very nature, authorised entities for the payment system; NBFCs need specific authorisation.

The key features of a revolving line of credit, which may have the regulator’s disapproval, are as follows:

1. It is a line of credit and not a funding attached to a specific usage. The grantor of the facility approving any particular drawdown or usage of the line of credit does not arise.
2. The line of credit may be tapped any time, and does not have any major end-use restrictions, except, may be a negative list. 
3. It may be paid back any time.
4. Once paid back, it will auto replenish -that is, it will be available for withdrawal again. Even though a revolving facility may have a sunset, but until it lives, it continues to revolve.
5. Given the fact that there is no specific time for repayment of any particular usage, a revolving facility is considered to be out of order only when it breaches some of the triggers – may be set with respect to the asset-liability cover, or otherwise.

For further details on revolving line of credit – See Lend, Recover, Replenish: A guide to revolving lines of credit

Why is supply chain financing important ?

Supply chains have become extremely important as manufacturing has moved to aggregation. Any large manufacturing operation today is, indeed, a substantial extent of assembly and aggregation of the components made at different places by different suppliers. Thereby, the dependence of a business on upstream vendors has increased. In the same vein, the ability of a business to enable supplies to the end user  with minimum time has become very important. All these factors make effective supply chain management a very important function for most businesses. 

Meaning of SCF

SCF, also known as channel finance or reverse factoring, is a financial arrangement that helps companies optimize their working capital and improve the efficiency of their supply chain operations. It involves the use of financial instruments and techniques to facilitate the smooth flow of funds between buyers, suppliers, and financial institutions.

The Global Supply Chain Finance Forum defines Supply Chain Finance as, 

“the use of financing and risk mitigation practices and techniques to optimize the management of the working capital and liquidity invested in supply chain processes and transactions. SCF is typically applied to open account trade and is triggered by supply chain events. Visibility of underlying trade flows by the finance provider(s) is a necessary component of such financing arrangements which can be enabled by a technology platform.

In a SCF arrangement, the buyer procures goods or services from a supplier and receives an invoice for the transaction. The supplier receives upfront payment based on the invoice amount, improving their cash flow. This arrangement provides the buyer with the flexibility to settle the payment by the invoice’s due date, optimizing working capital for both parties.

Importance of SCF

1. Working Capital Optimization: Buyers can extend their payment terms, which can free up cash for other investments, while suppliers can access early payments to meet their financial obligations.
2. Increased chances that the buyer will pay on the due date: Due to the presence of a financial institution, it is more likely that the buyer will pay on the due date. 
3. Improved Supplier Relationship: Due to SCF, the supplier receives early payment while the buyer has the flexibility to pay on the due date. This also improves the buyer-supplier relationship.

Various modes of SCF

The following are some of the SCF product types:

1. Receivables discounting: Sellers of goods and services sell individual or multiple receivables to a finance provider at a discount.
2. Factoring: Sellers of goods and services sell their receivables at a discount to a ‘factor’. Typically, the factor becomes responsible for managing the debtor portfolio and collecting the payment of the underlying receivables.
3. Reverse factoring (Payables finance): It is a buyer-led program within which sellers in the buyer’s supply chain are able to access finance by means of receivables purchase.
4. Purchase-order finance: Pre-shipment or purchase-order finance is a loan provided by a finance provider to a seller of goods and/or services for the sourcing, manufacture, or conversion of raw materials or semifinished goods into finished goods and/or services, which are then delivered to a buyer.

The Global Supply Chain Finance Market has increased by 7% to USD 2,347bn in the year 2023. 

For further details on Supply Chain Finance – see Unlocking Working Capital: An Overview of Supply Chain Finance

Credit with a purpose vs Credit on demand

The key defining features of revolving line of credit will help us to differentiate the same from SCF. In fact, SCF emerged as an alternative to the traditional mode of working capital finance – viz., overdraft or cash credit. SCF reduces the need for revolving facilities for working capital – hence, it is referred to as an alternative working capital financing product.

The table below distinguishes between SCF and RLOC. 

It is important to note that in SCF like in case of a RLOC, there can be a sanctioned credit limit within which the drawdowns can be made. However, the setting of a credit limit is common for any credit facility. However, in SCF unlike RLOC, the drawdown would depend upon the availability of an invoice pertaining to a specific sale or a purchase, of goods or services which are either approved by qualifying criteria, or are approved specifically by the facility provider. 

RBI’s Concerns About Evergreening

The RBI has raised concerns about the practice of “evergreening” in financial arrangements, particularly when it comes to credit facilities such as RLOCs. Evergreening occurs when additional funds are borrowed to pay off existing debt, creating a cycle of borrowing without actual repayment, often concealing the true creditworthiness or financial health of the borrower. This practice poses systemic risks, as it may lead to artificially inflated financial statements and delayed recognition of bad debts.

Why RBI’s Concerns Do Not Apply to Supply Chain Financing:
The structural design of SCF mitigates the risk of evergreening. Since each drawdown in SCF is linked to a specific, commercial transaction, further financing is typically contingent on the timely settlement of previous advances. If a borrower fails to repay a previous drawdown on schedule, additional financing for new transactions is withheld, preventing the borrower from obtaining funds solely to meet previous obligations. This transaction-based financing model ensures transparency and aligns with RBI’s efforts to curb evergreening practices, as each drawdown must have a legitimate underlying trade transaction.

RLOC and Evergreening Risks:
In contrast, an RLOC does not impose restrictions on the use of funds or require them to be linked to specific transactions. Borrowers may potentially use an RLOC to repay prior debts, thus getting their line of credit reinstated and then further borrowing.