Are Non banking financial companies (NBFCs) the new banks ?

“Necessity is the mother of invention.” This quote by Plato succinctly explains the emergence of  NBFCs in the ocean of banks.

Do you remember standing in big queues just to deposit and withdraw money? Those operational efficiencies of the banks because of which you had to waste the entire day to apply for a loan? 

These very problems had led to the creation of an NBFC, an organisation that performs almost all the functions of a bank, but more efficiently and effectively.

But how are these NBFCs different from banks? Are these safe? You might have a plethora of questions in your mind. The answers to these questions are in this blog. So, stay glued!

What are NBFCs?

Before moving to what NBFCs are, let us look at a situation that will help you understand the purpose of an NBFC.

Households have exhibited a good transition whereby people have resorted to storing emergency funds in banks instead of simply hoarding cash. For decades, people have been putting their extra money in banks or some institutions so as to earn interest in it. These institutions then lend that money to other people at a higher rate of interest. This is roughly what an NBFC does!

NBFCs stand for Non-Banking Financial Companies. As the name clearly suggests, these institutions are not banks but financial companies. These companies do not have a banking license but they perform almost all the functions of a bank.

NBFCs have been on the news for the past few years. Be it in the stock market or in the economy, they have always been a hot topic to talk about. To give you an overview, let us look at the recent valuations of top NBFCs in the country:

Look at those ROE figures! These clearly show that NBFCs have been improving consistently over the years. But, both banks and NBFCs have the same purpose right? Well, technically not! This is a very important concept to understand if you want to study any NBFC thoroughly.

1. Acceptance of Deposits

The basic and the most important difference between an NBFC and a Bank is that banks can accept ‘Demand deposits’ but NBFCs cannot.

Wait, didn’t we already talk about the business model of NBFCs above? About how they accept deposits and then lend them further, earning a spread in between? So, what is this new term ‘Demand Deposits’?

A demand deposit is basically money that is deposited in a bank with funds that can be withdrawn at any period of time, without any prior or advance notice to the bank. Demand deposit funds are usually used for everyday expenses by the depositors. Usually, banks and other financial institutions offer very low or zero rates of interest on these kinds of deposits. In layman terms, we are talking about Savings & Current Accounts.

Can NBFCs take no deposit then? 

No, it’s nothing like that! NBFCs can accept some other types of deposits but they are regulated very strictly by the RBI. NBFCs can accept public deposits for a minimum period of 12 months and a maximum of 60 months. About the interest rate, the maximum rate of interest that an NBFC can give is capped at 12.5%.

Talking about deposits and we don’t talk about CASA ratio? Nah, not possible! Let us discuss the CASA ratio, the one which acts as a boon for all the banks.

2. CASA Ratio and NIM

Before understanding the CASA ratio, let us understand why the CASA ratio has to be taken into consideration.

The lending business is highly dependent on borrowings. And all that matters in the lending business is the Cost of Borrowing. The lower the cost of borrowing, the better it is for the lender. If an institution has a very high borrowing cost, it would not be able to survive in this competitive market.

Now, what is the CASA ratio?

CASA stands for current and savings account. The CASA ratio shows how much deposit a bank has in the form of current and savings account deposits, out of the total deposit. Have a look at some of the popular banks having high CASA ratios:

A higher CASA ratio means that a higher portion of the deposits in the bank has come from current and savings deposits, which is a cheaper option for the banks in comparison to the other sources of funds. Many banks do not pay interest on current account deposits and pay a minimum percentage of approx 3.5% interest on savings account deposits. This makes borrowing really cheap for the banks.

Hence, the higher the CASA ratio, the higher is the NET INTEREST MARGIN.

So, what is this NIM?

Net interest margin is the total difference between interest income and expenditure. It is shown as a percentage of average earning assets. A higher CASA ratio will improve the net interest margin, as the cost of funds is relatively low. For example, most banks lend at over 10%, whereas the rate of interest that they pay on savings deposits is just 3.5%. Hence, the total cost of borrowing reduces and the actual realization of the bank increases.

But you know what, NBFCs do not have this advantage as they do not have this kind of deposit with them. So, that’s why their NIM is usually lower than banks.

3. Regulation

Regulation plays a very important role while differentiating the banks from the NBFCs. Banks are very strictly regulated by RBI as they accept public deposits. NBFCs are also regulated by RBI but the extent of control is lesser as compared to the banks. NBFCs are registered under the Companies Act whereas Banks are registered under the Banking Regulation Act.

But why is this such a big deal?

If people invest their life savings in an institution they need to make sure that their money is safe and sound. So that’s why RBI comes into play here. People trust banks because they are strictly regulated by the RBI but in the case of NBFCs, the regulation is less and hence, so is the trust.

This is the primary reason why there are only a handful of NBFCs where people make deposits. 

Here you can check out the course on " How to pick NBFC Stocks"?

Banks vs NBFCs - a snapshot

Although most of the important differences have been covered in detail, we cannot cover everything in this blog. So, the remaining differences between the two have been shown in the form of a table:

Conclusion

NBFCs have been on the rise these days and thus, understanding this sector becomes quite pivotal. It will not be an exaggeration to say that these days NBFCs are as important as banks. These companies have surely made financial transactions a lot easier and simple for people.

In fact, with the acclaimed success of the likes of Bajaj Finance, the popularity of NBFCs has grown so much that many banks have also started operating in models similar to these NBFCs! Now that’s what competition does to incumbents, isn’t it?

But everything aside, do you think NBFCs can replace banks in future? Do let us know in the comments section.